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Financial Instability Hypothesis, Debt Deflation, and Debt-to-GDP

The debt-to-GDP ratio is one of the indicators of the health of an economy; governments aim for low debt-to-GDP ratios which most likely indicate that they can stand up to the risks from increasing debt levels as they have higher profit margin.

Margin Debt Study and Steve Keen

Steve Keen, professor in economics and finance at the University of Western Sydney, advocates the debt-to-GDP measure as a key signal of credit bubble. Most of his recent work has focused closely on margin debt. Specifically, Mr. Keen finds a relationship between the change in margin debt and asset prices. He further points out that there is a correlation between the acceleration in margin debt and the rise in asset prices. If the points of his theory holds true, the acceleration of margin debt will drive rising equity prices, and inversely, when the acceleration slows down equity prices will decline.

Financial Instability Hypothesis and Hyman Minsky

Hyman Phillip Minsky (1919 – 1996), an American economist and professor of economics at Washington University in St. Louis, whose research exclusively provides an understanding and explanation of the characteristics of financial crisis, argues that a key mechanism that pushes an economy towards crisis is the accumulation of debt by the non-government sector, i.e., external debt. In Mr. Minsky’s The Financial Instability Hypothesis (Working Paper No. 74, May 1992), he starts from the characterization of the economy as a capitalist economy with expensive capital assets and a complex, sophisticated financial system. The economic problem is identified following Keynes as the “capital development of the economy,” rather than the Knightian “allocation of given resources among alternative employments.” Mr. Minsky later identifies three types of borrowers that can be attributed to the accumulation of insolvency:

1)      Hedge borrowers. Hedge borrowers are able to make debt payments (interest plus principal) from current cash flows from investments.

2)      Speculative borrowers. Speculative borrowers can serve the interest due from cash flows from investments, but the principal must be rolled over on a regular basis.

3)      Ponzi borrowers. Ponzi borrowers believe that the appreciation of asset value will be sufficient to refinance the debt, however, Ponzi borrowers cannot make full payments on interest or principal with the cash flows from investments.

The Financial Instability Hypothesis implies that an economy will be deflation and depression if its debt-to-GDP ratio is too high. The explanation is simply: on one hand, falling asset price results in a rising outstanding debt in real terms; on the other, the deleveraging of outstanding debts increases the rate of deflation. Therefore, debt and deflation react to one another which will eventually result in depression.

Debt Deflation and Irving Fisher

Irving Fisher’s Debt Deflation theory attributes the crises to the bursting of a credit bubble, which unleashes a series of effects that negatively impact an economy:

  • Debt liquidation and distress selling
  • Contraction of the money supply as bank loans are paid off
  • Pessimism and loss of confidence
  • Hoarding of money
  • A fall in the level of asset prices
  • A greater fall in the net worth of business, precipitating bankruptcies
  • A fall in profits
  • A fall in nominal interest rates and a rise in deflation-adjusted interest rates
  • A reduction in output, in trade and employment

Beyond that, there are other interrelations that can be implied from the Debt Deflation theory. To summarize, price change causes corresponding fluctuation in the volume of trade, employment, bankruptcies, and rate of interest. My key takeaway from this book is that if the Debt Deflation holds true, the infectiousness of depressions internationally is primarily due to a common gold monetary standard and there should be found little tendency for a depression to pass from a deflating to an inflating or stabilizing economy. Great depressions are preventable through reflation and stabilization.

Reinhart and Rogoff and The Debt-to-GDP Ratio

In January 2010, Carmen M. Reinhart and Kenneth S. Rogoff exploit a new multi-country data set on central government debt as well as more recent external debt evidence to search for a systematic relationship between debt levels, growth and inflation. The key findings are summarized below:

RR Summary Table

*Source: Growth in a Time of Debt, Reinhart & Rogoff, National Bureau of Economic Research

Reignhart and Rogoff also find:

1)      The relationship between government debt level and real GDP growth is weak for the debt-to-GDP ratios below a threshold of 90 percent of GDP.

2)      The threshold for government debt is similar in advanced and emerging economies.

3)      There is no contemporaneous link between inflation and government debt levels for the advanced economies.

4)      By contrast, in emerging markets, inflation rates rise sharply as government debt level increases.

Herndon, Ash, and Pollin and The Debt-to-GDP Ratio

On April 15th, 2013, Thomas Herndon, Michael Ash, and Robert Pollin released their most recent work where they replicate Reinhart and Rogoff (2010a and 2010b) and find that coding errors (in the RR working spreadsheet, they entirely exclude Australia, Austria, Belgium, Canada, and Denmark from the analysis, which results in overstatement of growth in the “Below 30%” category by +0.1% and understatement of growth in the “30% – 60%” category by -0.2%), selective exclusion of data, and unconventional weighting of summary statistics lead to errors that inaccurately represent the relationship between government debt and GDP growth among 20 advanced economies in the post-war period.

They revise the average real GDP growth rate for countries carrying a Debt-to-GDP ratio of over 90 percent to 2.2 percent, as opposed to– 0.1 percent (please refer the summary table), which means that the average GDP growth at the ratios over 90 percent is not dramatically different than when the ratios are lower. Additionally, Herndon, Ash, and Pollin show how the interaction of government debt and GDP growth varies significantly from time to time and from country to country.

Despite all these foundations, analyzing and accurately interpreting the debt-to-GDP ratio is fairly challenging, as a high debt-to-GDP ratio may NOT necessarily be a negative. Different levels across countries may have different indications:

  • A higher debt-to-GDP ratio may be acceptable when the buyers of the debt are domestic investors or repeat buyers. For instance, Japan’s buyer is domestic and the U.S.’s buyer is China, who purchases debt to keep a favorable trade balance with its largest consumer
  • A higher debt-to-GDP ratio may also be acceptable when an economy is rapidly growing as its future earnings will ensure that it can pay back debt more quickly.
  • Furthermore, if countries can come up with viable plans to address the high debt-to-GDP ratio, they may receive leniency from rations agencies.


1)       Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff, by Thomoas Herndon, Michael Ash and Robert Pollin, April 2013

2)       Growth in a Time of Debt by Carmen M. Reinhart & Kenneth S. Rogoff, National Bureau of Economic Research, January 2010

3)       The Debt-Deflation Theory of Great Depressions by Irving Fisher, Page 337 – 357

4)       The Financial Instability Hypothesis by Hyman P. Minsky, Working Paper No. 74, May 1992


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