[Lee Jong-woo's Economic Reading] The World Now, Deliberating Policies to Reduce Debt Without Economic Shock

Global Debt Increases by $15 Trillion Over 9 Months... Total Amount Equals 31 Quadrillion KRW
Rises to 365% of Global GDP
Debt Size and Growth Rate Reach Risk Levels

The International Institute of Finance (IIF), a non-profit global association of financial institutions, has released data on the increase in debt following the COVID-19 pandemic. Over the past nine months, global debt has increased by $15 trillion, and it is projected that the total debt will reach $277 trillion by the end of this year. Converted to Korean won, this amount corresponds to 31 quadrillion won. As a result of the debt increase, the global total debt-to-GDP ratio rose from 320% at the end of last year to 365% this year. The increase in debt was particularly pronounced in advanced economies. The debt-to-GDP ratio increased by more than 50 percentage points to 432%, with half of the increased debt attributed to the United States. The total U.S. debt, which was $71 trillion at the end of last year, is expected to reach $80 trillion by the end of this year. This surge in debt occurred because various economic agents borrowed to cover shortfalls when economic activities were halted due to COVID-19.

So far, debt has played a positive role in the economy. It provided the means to overcome the economic lockdown caused by COVID-19 and helped drive up asset prices such as real estate and stocks. As of the end of October, the global market capitalization of listed companies was about $91 trillion. Debt amounting to more than 16% of this market capitalization was created worldwide within nine months, and some of this debt flowed into asset markets, exerting tremendous influence.

The negative effects of the debt increase will be the burden the global economy must repay in the future. Debt has a self-reinforcing nature. When real estate loans increase, demand for real estate rises due to these loans, causing asset values to grow proportionally. The more borrowers there are, the higher real estate prices go. As prices rise, lenders believe they have been prudent in issuing loans so far and proceed with more real estate lending and development. It is fortunate if this process ends at a reasonable level, but such cases are rare. Typically, debt grows to an unsustainable level and causes problems at a certain point. Over the past 200 years, global financial crises have often been accompanied by large increases in debt prior to the crisis. The 2008 U.S. financial crisis was similar. In the five to six years before the crisis, mortgage loans more than doubled to $10.6 trillion, and commercial real estate loans increased faster and more significantly than residential loans.

An increase in debt does not immediately trigger a crisis. In Japan, asset price bubbles and a construction boom peaked in the late 1980s, but the stock market began to decline in 1990 and real estate prices started falling in 1991. In the U.S., housing construction peaked in 2005, and housing prices began to decline in 2006, but the crisis occurred in 2008. It takes several years for the maximum effects of debt to manifest and problems to arise, and issues often worsen during this period.

What about now? Both the scale and speed of debt growth are at dangerous levels. According to research by the Governors Woods Foundation in the U.S., if the private debt-to-GDP ratio rises by 15-20% or more over five years and the total private debt-to-GDP ratio exceeds 150%, the likelihood of a financial crisis is high. This year, global total debt increased by nearly 50% in just nine months. Both the speed and scale of this increase are beyond imagination, making the possibility of problems high. It would be somewhat fortunate if the debt structure had been sound in the past, but the situation was not much different. In the ten years following the financial crisis, countries continued low interest rates and liquidity supply, which led to a significant increase in debt. When interest rates are 1%, one can borrow four times as much debt at the same cost compared to when rates are 4%, so there was no reason to refuse borrowing.

The increased debt has played a role in raising asset prices, including real estate and stocks. Currently, the price-to-earnings ratio (PER) of the U.S. S&P 500 index exceeds 25 times. Over the past 50 years, this level has only been surpassed during the IT bubble in 2000. This indicates that stock prices are very high. Real estate is similar. Real estate prices in advanced economies have surpassed pre-financial crisis peaks. In Europe, prices are more than 20% higher than in 2007. Bonds are also at unprecedentedly high prices, as evidenced by negative interest rates in Europe.

Over the past 20 years, there have been two global asset price declines. The first was in 2000, when the IT stock bubble burst. The second was in 2008, when real estate caused problems in the U.S. Both times, bubbles formed and burst in specific assets, but now prices of all assets, including real estate, stocks, and bonds, are high. If debt causes problems, a broad-based decline in asset prices is likely.

Asset price declines can occur through various channels, but they most often start from a high price level triggered by an external shock. The most anticipated trigger currently is rising interest rates. Because of the large debt scale, even a slight increase in interest rates can cause shocks. It is more likely that market interest rates will rise due to economic factors such as inflation and growth recovery, even if central banks keep benchmark rates unchanged. Advanced economies issued a large amount of government bonds this year to overcome COVID-19. Given the weak foundation of the bond market, fluctuations in inflation and the economy could cause rapid interest rate increases, putting pressure on asset prices.

Once COVID-19 subsides, governments worldwide are likely to focus on how to reduce debt. The current debt scale is too large to ignore. Among advanced economies, only the U.S. has succeeded in managing debt policies after the financial crisis. Although it did not significantly reduce debt levels, it raised interest rates without shocking the economy. Europe attempted this once early after the financial crisis but then abandoned efforts. This was partly due to fiscal crises but mainly because the economy was not strong enough to withstand interest rate hikes. Going forward, reducing debt will be more difficult than immediately after the financial crisis. Economic structures in many countries have become overly dependent on debt. Households and companies, accustomed to low interest rates, are not prepared to handle rate increases. For these reasons, the policy goal can only be to 'reduce debt over a long period without shocking the economy.'

This content was produced with the assistance of AI translation services.