Countries that build up high levels of debt suffer longer and deeper recessions than low-debt countries according to a new study released by the American Institute for Economic Research (AIER). AIER research fellow Polina Vlasenko’s analysis looked at all kinds of debt (sovereign debt, business debt, or household debt) and found that those countries with the highest total debt-to-GDP levels (Japan and many European Union countries) suffered greater GDP declines than countries with lower rations (Canada and the United States). Vlasenko explains:
A financial crisis inhibits financial flows by heightening risk and uncertainty. Individuals and businesses cannot get their hands on the money they need to engage in all of their planned financial activities. There simply is not enough credit available to support a robust economy.
As far as financial crises go, the data says that it does not matter who borrowed the money. What matters is how much was borrowed. It does not matter if the debt is sovereign debt, business debt, or household debt.
Leverage is leverage, and leverage always brings with it increased risk. Every investor knows that leveraging multiplies profits when markets rise, but it also multiplies losses when markets fall.
All this implies that an economy can be made less susceptible to the devastating effects of a financial crisis if the reliance on debt financing is kept at a reasonable level.