It is often said that the Global Financial Crisis (GFC) was caused by defaults on sub prime loans in the United States. Such defaults were merely symptoms of the underlying problem, rather than the cause, which of course was the over accumulation of debt by both businesses and consumers alike. Although investment markets have since seen significant appreciation since March 2009, it is now perhaps timely to review what, if any, improvements have really been made in the battle against the pernicious debt burden.

Household Debt in Australia

From an Australian perspective, household debt has only continued to increase, buoyed by a combination of first home buyers grants (now concluded), favourable domestic economic conditions and relatively low interest rates (now increasing). It is clear then that the Australian consumer has not really learned any lessons from the GFC and has not yet started to deleverage in any shape or form.




In fact personal credit continues to grow, exacerbated by rising asset prices.  House prices in Australia remain among the highest in the world. In the short term this trend appears unlikely to change as housing demand in major capital cities continues to exceed supply. Further, the labour market remains buoyant.  Nevertheless, US housing prices before their housing collapse were far lower in relative terms but still fell heavily as the recession, and the subsequent hike in unemployment, led to mass foreclosures.  Should Australia enter a deep recession at some stage later this decade then it is not implausible to suggest that a similar experience could unfold.  A recession can lead to high unemployment which would face severe pressure on the ability of mortgage holders to continue to meet loan repayments. Under this scenario, it is perhaps inevitable that forced sellers would exceed demand and lead to moderate, to potentially heavy, price falls (depending on the extent of unemployment). 

The consumer’s inability to deleverage is in stark contrast to the corporate sector, which is much advanced courtesy of the enormous capital raisings and asset sales that transpired during the GFC. In this sense the corporate sector (outside the banking sector which continues to lend voraciously to over indebted consumers) has perhaps learned the lessons from the GFC. This is a positive for investors as the corporate sector is in better shape to weather another downturn should one arise.

Nevertheless, a large proportion of the corporate sector remains hostage to the frailties of the consumer. A large proportion of economic growth since 1960 has been driven by the increase in credit. Incomes dictate the degree of expenditure possible but, when combined with debt, expenditure (and therefore economic growth) can multiply. If household debt is reaching a crisis point then the ability to continue to fund further growth via debt is reaching a limit. At some stage consumers will have to reign in debt, which will reduce consumption and impact upon corporate profitability.



Critics would perhaps argue that we have overblown the potential risks as housing prices and the domestic consumer emerged relatively unscathed from the GFC.  The reality of course is that a disaster was averted in Australia by virtue of the rapid and synchronised global response to the GFC. The flood of liquidity helped lower interest rates (where banks otherwise would have been forced to ration credit causing a large hike in interest rates) and fiscal stimuli assisted upholding demand (preventing much higher unemployment).  So, in the face of escalating household debt, household income actually improved due to the lower interest rates. Despite much higher mortgages, individuals were able to meet repayments.



Clearly though we are reaching a tipping point. The ability for individuals to service loans is now severely curtailed should interest rates rise even modestly (defaults are likely to rise significantly should home loan rates rise above 8%), let alone if unemployment rises. Yet the timing of the tipping point remains difficult to predict. Debt levels have been very high now for the best part of decade. It is possible for growth to continue against this backdrop while asset prices continue to rise and employment prospects remain sound.  Yet the warning bell has been rung. A period of high unemployment and/or high interest rates is all that is needed to convert this warning to a harsh reality.

Private Sector Debt in the United States

At first glance, the chart below represents the parlous state of the United States economy, showing private sector debt to GDP approaching an astonishing 300%. Private sector includes both business and household debt. 



We contend that this chart is somewhat misleading because household debt to GDP in the United States is around 100% of GDP (and decreasing, albeit slowly, as the US consumer has started to deleverage) and therefore the balance must be attributed predominantly to the business sector.



But here is the distinction. Outside the finance sector, we know that the average balance sheet in corporate America is in reasonable shape. We also understand that debt in the finance sector (investment banks, hedge funds, banks) roughly doubled between 2000 and 2007. So the majority of private debt can be attributed to the finance sector, large parts of which have already succumbed to the financial crisis (banks and hedge funds have failed and much of the toxic debt has been dealt with or written off). Once figures are adjusted for these failures then actual private sector debt may no longer look quite as daunting.