The lily & the pond

Steve Keen

Try this riddle. A lily in a pond is doubling in size every day. It takes 31 days to grow to cover half the pond. How many more days will it be before it covers the pond completely? The answer, of course, is just one more day.

The object of the riddle is to point out the insidious nature of exponential growth. A sustained growth process - like a cancer - is almost imperceptible when it starts. But if you ignore it, it will "suddenly" overwhelm the organism.The lily, for example, goes from covering 0.75 per cent of the pond on its 25th day, to 1.5 per cent on its 26th - and the average gardener wouldn't even notice it. Yet a few days later, it grows from 12.5 per cent to 25 per cent - and clearly it's a problem. But by the time it has reached that size, your pond may well be doomed.

The is the story behind Australia's private debt. It has been growing more than 4 per cent faster than our GDP for 53 years. Back in the 1960s, that meant very little - the ratio of debt to GDP would increase by no more than 1 per cent a year, and it was at comparatively trivial levels anyway. It grew from 27.3 per cent of GDP in 1966 to 28.2 per cent in 1967. Forty years later, that ratio is increasing ten times as fast. It is 147.1 per cent now. If the rate of growth doesn't slow down, it will crack 150 per cent of GDP by March 2007, and it will exceed 160 per cent of GDP by the end of 2007. We simply can't keep borrowing at that rate. We have to not merely stop the rise in debt, but reverse it.

"So when will this recession begin? On current data, the domestic economy may already be in one - though the China boom has more than compensated for the domestic downturn." Unfortunately, long before we manage to do so, the economy will be in a recession. The reasons are simple: paying down excessive debt causes borrowers to stop spending - whether that means households that cancel order for the latest LCD TV, or firms that put off that planned expansion of capacity. Income plummets, but debt continues to rise, simply because of the effect of compound interest. The debt to GDP ratio starts to fall only when a substantial slab of income is devoted to paying debt, but that in turn means a serious recession.

We have suffered two such debt-driven downturns since the end of WWII: the long 1973-1983 recession, when unemployment blew out from a mere 1.8 per cent to over 10 per cent; and the 1990 'recession we had to have', when unemployment exploded from 5.6 per cent to 10.6 per cent in just over 3 years.

Both recessions were preceded by booms in which private debt rose to previously unheralded levels. During both, the ratio 'headed south', against its long term trend. But the momentum of debt meant that the turnaround in the ratio followed the start of the recession itself. It continued rising, for nine months after unemployment began to rise in 1973, and for a whole two years in 1990.

So when will this recession begin? On current data, the domestic economy may already be in one - though the China boom has more than compensated for the domestic downturn. What can be done to avoid it? Unfortunately, almost nothing. We have two sources of spending power: what we earn and what we borrow. During a boom, borrowing adds to our spending power - and it's added massively in the last decade, as debt has blown out from 88 per cent of GDP at the end of 1997 to 147 per cent now. But during a slump, once we get on top of the momentum of debt, repayment of debt subtracts from our spending power. This feeds back on income itself, reducing its growth still further, because investment ends, consumer spending drops, and unemployment rises even more.