We have two adjustment phases likely to impact growth: a debt and a structural economic adjustment…

A country heavily in debt will depend on a) future human capital earnings and b) returns on invested productive capital to reduce debt and increase GDP.  

Weak prospective returns on capital invested and low expected returns on human capital increase the risks of default where the present value of the debt exceeds the present value of future returns on capital. 

Such low returns on human capital and productive capital impact growth in domestic expenditure sources and increase the reliance on external demand sources.  Low returns can be impacted for a number of reasons: debt financing and repayment may take up a larger element of income lowering expenditure, lowering growth and hence gross domestic income; whereas previous growth was influenced by annual increases in debt  financed expenditure, future growth will be impacted by either a reduced rate of growth, no growth or contraction in debt, which means that future expected returns on capital will fall.

It is the relationship between debt and economic growth that is important in terms of assessing the impact of debt on growth and the risk of default.  In other words, as debt accumulates, there will come a point when debt servicing and repayment impact expenditure, impacting the absolute and relative debt levels, further impacting economic returns on capital.  

If every country is in the same boat, he or she who defaults first has the better chance of initial recovery.  The initial capital flight caused by a default will be the biggest determinant of the short term exchange rate.

Default followed by devaluation, import substitution and increases in exports should shorten the debt adjustment phase. 

The trouble is, is that most of the world’s economies are in the same boat: many smaller economies would have been better off getting the excess debt adjustment phase out of the way in 2008/2009/2010.   Indeed, it might even make sense for the likes of Greece and Spain to do this now, but they are tied into a shared pain agreement with the Eurozone, and of course, everyone else is trying to export their way out of debt.  

Austerity appears to be the only proffered solution, but austerity is a prevarication: austerity accelerates consumer and corporate debt defaults, especially in fixed exchange rate regimes, further increasing the eventual risk of sovereign default. 

The best time for consumers and corporates to default is while sovereign debt and budget deficits are low, thereby allowing fiscal stimulus to support the adjustment phase.   The trouble is the fiscal support phase increases government debt, which needs to be serviced and/or repaid: this lowers the potential growth rate of the economy.  The benefit this approach is that an economy may have adjusted allowing it to be better able to cope with a lower growth rate. 

The trouble here is that debt is endemic and global while at a time when global economies remain structurally imbalanced.  There is therefore no balance in any economy until the whole has rebalanced. 

We can therefore simply surmise that the drag on average annual future growth is more or less equivalent to:

historic annual growth rates over a certain period (minus) annual historic real debt increases as a % GDP over that period (minus) the average annual expected real reduction of debt as a % of GDP over a future time period + (plus) or (minus) labour force and total factor productivity factors – net structural adjustment factors resulting from in an unbalanced domestic and global economy.  

It is clear, at a fundamental level that excess debt accumulation impacts future economic growth, but that a balanced economic structure, something which does not exist, is the best one to manage the transition.  So we have two adjustment components that are likely to be acting simultaneously and iteratively, a debt and structural adjustment phase.

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