Business & Economics

Finding a way out of our debt spiral

The biggest financial challenge facing the world is how to deal with unsustainable debt. Global debt is pretty much out of control; it is running at more than double the world economy. 

Different countries are facing different challenges. In Australia, the main problem is household debt fuelled by a once-in-a-century housing bubble. It is running at about 116 per cent of GDP, whereas government debt is a more modest 44 per cent of GDP – less than half the OECD average. 

In the US, the situation is reversed: government debt is 123 per cent of GDP, whereas household debt is 62 per cent of GDP.

There are problems in China, where property lending is so out of control it is estimated that the number of condominiums is enough to house more than double the population. The Chinese authorities are frantically printing money to keep the banks from collapsing. Bizarrely, China’s money supply is more than double GDP, whereas in normal circumstances it should be about one to one.

And Japan is in the worst position of the major economies, with government debt at 217 per cent of GDP.

So what can be done about it, especially as the era of extremely low interest rates seems to have come to an end? One option is what is called a debt-for-equity swap.  This has occasionally been done in previous debt crises, and it may prove to be the best way out in the current one. 

There are two basic forms of capital: debt and equity. Debt has an interest rate on it and the risk is taken by the borrower, the receiver of the money. That is why borrowers have to provide collateral in case they cannot meet the interest payments. 

With equity, either in the stock market or in a private company, the situation is reversed. The provider of the capital takes the risk, and the recipient is only required to pay dividends from profits. Investors usually get most of their returns when the value of the asset rises – that is, the price of the shares goes up. 

Most capital is in the form of debt. Europe, for example, mainly relies on bank lending to fuel economic activity. What equity there is, mostly is held in private companies and controlled by powerful families.

Other countries have large public equity markets, especially the US, which has the world’s biggest. America has the deepest and most diverse capital structure, in part because there is also a very large corporate bond market, the other side of the equity coin. Companies on the stock market are also able to issue commercial debt, which effectively sits between debt and equity.

Australia has a sizable stock market, but not much of a corporate bond market. Japan has a big stock market, but it has been moribund since 1990 when the country’s debt bubble burst. China nominally has a large stock market but is heavily controlled by the Chinese Communist Party; its credentials as a free system are questionable.

The social and investment impacts of the two types of capital are very different. For thousands of years, debt markets have routinely collapsed because underlying economic activity tends to be linear, whereas interest costs go up geometrically as they compound.

As the economic historian Michael Hudson has demonstrated, a pattern of debt markets failing has persisted for centuries.

Equity markets, by contrast, are more robust. There is no compounding of interest payments and they tend to be priced on future value, whereas debt is priced in the present. It is assumed that the future value of the bond will stay the same, but usually share prices tend to rise in value over time.

When there is an economic crisis, banks, which rely on debt, often crack. But stock markets act more like a shock absorber. Share prices may fall in the short term but they almost inevitably bounce back. With shares, there is only a loss incurred if you sell. Not acting is therefore beneficial with shares because if you wait the price often recovers. Debt problems, by contrast, get worse if you do nothing.

What are the authorities likely to do about the debt? The obvious, unattractive, options are: default, allow high levels of inflation to erode the real value of the debt, or eviscerate government spending in order to reduce government deficits.

Defaults have occurred in some international contexts, but generally this is not a realistic option in Western financial systems, which are dominated by private banks. They become insolvent if there is even a small amount of debt cancellation.

It is a bit different in China because the banks are government owned. So, theoretically, the Chinese Communist Party could cancel some of the debts, but this would still be extremely disruptive.

High inflation, especially if it becomes hyperinflation, erodes a population’s standard of living and usually results in higher interest rates, which only makes debt obligations harder to meet. 

Slashing government expenditure easily becomes a chasing-the-tail exercise because, while it shrinks the amount of spending, it also reduces the amount of tax collected as the economy starts to weaken.

For thousands of years, debt markets have routinely collapsed because underlying economic activity tends to be linear, whereas interest costs go up geometrically as they compound.

On average about two-fifths of the GDP of Western economies is government expenditure; it is just under that in Australia.

There is some precedence for debt-for-equity swaps. The mechanism was used in the Latin American debt crisis in the 1980s to save Western banks when Latin countries defaulted on their debt. It was the first global banking crisis of the modern era and it did stave off collapse.

There are glimmers of it in Australia. Reverse mortgages are a type of debt-for-equity swap; the person reduces their debt obligations in return for giving some equity to the bank when they die.

But, in the current circumstances, considerable innovative thinking will be required. When there is a debt-for-equity swap with a corporation that has got into trouble, it involves increasing the shares on issue for a company that already exists. If there is a debt-for-equity swap with government debt, a new type of instrument would have to be created.

Changing the capital can be successful. A largely unnoticed fact is that equity investments tend to outperform debt, despite the higher risk. Professional investors routinely diversify between the two types, but equity tends to be superior, perhaps because a higher level of trust is required.

Much of the world is heading into a debt crisis. As the 19th-century philosopher Lord Acton said: “The issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the bankers.” 

As the analyst Alex Krainer writes, struggling banks become dangerous to the general population when the debt starts to fail. 

“Their methods entailed periodically flooding the economy with credit and generating a boom. Then, when the bankers’ nets were full and everyone was in debt, the bankers would abruptly withdraw credit. The practice was simply predatory. 

“The triggering event usually involved a high-profile bank failure, which would cause an economy-wide avalanche of bankruptcies. Large, politically connected banks would then take over choice businesses, farmland and real estate for pennies on the dollar. Within our lifetimes, the Lehman Brothers’ failure in 2008 would have been a typical example of this, but Covid pandemic response in 2020 served the same predatory purpose.”

Finding a way to avoid a repeat of this pattern has become crucial. Catalysing debt-for-equity swaps may be one way out.

Published on 25 January 2025.

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Photo by Mathieu Stern on Unsplash.

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About David James

David James has been a financial journalist for 28 years. He was a senior writer and columnist at BRW for 25 years, a senior journalist at AAA Banking magazine, an editor and writer for stockbroker JB Were & Sons and a journalist at The Melbourne Herald. He has a PhD in English Literature from Monash University and now works as a freelance journalist and editor.

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