Malcolm Turnbull turned debt, Government debt, into a big issue this week. He says he’s worried that Federal Government debt will rise by $200 billion over the next couple of years. Why he’s worried isn’t quite certain, after all we have nearly $700 billion of foreign debt and another $1.3 trillion or so of household and business debt.
And yet, apart from a few worryworts, no one’s too fussed about that. In fact debts held by businesses and households have started shrinking, financed by falling interest rates, contracting demand and repayments. Tens of billions of dollars of debt has been replaced by share issues from big and small companies in the markets.
That, plus the slowdown, is producing the usual boost in national savings that occurs every time there’s a slump.
Some economists get worried about that and claim it’s a bad thing: but other, longer sighted analysts say rising savings brings forward the day when consumers and businesses will start increasing their spending
The AMP’s Dr Shane Oliver explains:
A key determinant of the severity of the recession both globally and in Australia will be the extent and speed with which households boost their savings to cut their debt levels.
This is commonly referred to as ’de-leveraging‘.
The pessimists tend to think that all or much of the surge in household debt over the last 20 years will need to be unwound, requiring a massive fall in consumer spending which will put us into a severe recession if not depression.
The relative optimists agree debt will be unwound to some degree but think that it can be cushioned by lower interest rates and increased government spending and tax cuts.
The post 1980 savings slump and debt surge
There is good reason to be concerned about the impact of ’de-leveraging’.
The past thirty years have seen a massive rise in household debt relative to income, particularly in Anglo countries.
In Australia the ratio of total household debt to total household disposable income in the economy has gone from 38% in 1980 to 160%. See the chart below.
This went hand in hand with a fall in household saving rates from around 10% of household disposable income prior to 1980 to around zero in both the US and Australia.
Lots of pressure on savings to rise and debt to fall
The rise in debt and fall in savings over the past few decades reflects a range of factors including: the increasingly easy availability of credit following financial market de-regulation in the 1980s; falling interest rates which made debt more affordable; younger generations becoming more comfortable with debt as memories of war and serious economic problems faded; and rapidly rising wealth levels which reduced the need to save (as indicated in the chart below) and supported a higher level of debt.
The trouble is most of these factors are now in reverse.
The implosion in global credit markets is reducing the supply of credit to households.
This is forcing tighter credit standards, pushing financing back via the banks that have stricter lending standards even in normal times and reducing competition amongst lenders. Increased regulation will act to ensure tighter credit conditions longer term.
The end result from the global financial crisis is likely to be a much tighter lending environment for five to 10 years to come.
The recession and rising unemployment will make the current generation of borrowers far more aware of the downside of having ’too much’ debt and of not saving much.
This is likely to see a big reduction in the level of debt most borrowers are comfortable with and a more positive attitude towards saving.
There has been a big fall in wealth levels. Household wealth is down about 20% in the US and by about 10% in Australia from 2007 highs. Further falls in house prices will add to the wealth loss in Australia.
This will have two effects. Firstly, the fall in asset values reduces the level of debt people are comfortable with.
Secondly, it reduces the level of savings for retirement which may force baby boomers that are getting close to retirement to save more out of their current income to make up the gap.
So, just as the rise in wealth was associated with a fall in savings the fall in wealth will likely boost savings. Household debt levels are already falling in the US and UK thanks to defaults & write-offs, reduced credit supply and less interest in borrowing.
Growth in household debt in Australia has slowed to a crawl. But all of these considerations suggest the downwards pressure on debt levels is likely to intensify.
But by how much?
Some argue that household debt ratios need to fall back to early 1990s levels.
For example, to unwind the surge in the US household debt to income ratio back to 1990 levels would require a $US5 trillion reduction in the level of debt, equal to 37% of US GDP.
And if the Australian household debt to income ratio were to be wound back to 1990 levels this would require an $A780bn debt reduction, which is about 65% of annual GDP.
If this were to be achieved quickly it would trigger a massive collapse in economic activity.
However, this approach seems rather arbitrary and extreme. Why should debt to income ratios fall back to 1990 levels?
Why not 2000 levels?
A simpler approach is to focus on the saving rate, since it will largely be by saving more that debt will be reduced.
A likely outcome from the current turmoil and the increased pre
