Central bank policies are causing debt-fuelled asset price bubbles
Global household debt has reached around 75 per cent of gross domestic product
The world’s advanced economies are trying to keep their balance on an unstable platform of high consumption, asset prices and household debt as we enter the 2020s. Any significant shock or increase in volatility could trigger “doom loops” that compromise the economic and financial systems.
The great recession ended more than a decade ago. In recent years, personal consumption augmented by government deficit spending has underpinned growth. Rising employment helped people purchase more. But with wage growth low, borrowing against buoyant housing and stock prices was a major factor in consumption. Central bank and government policies that engineered high asset prices and collateral values allowed scope for additional borrowing.
In theory, the wealth effect increases consumption. But higher asset prices may not translate into cash flow and households can go deeper into debt. Think of using low interest rates to invest in the residence, borrowing against home equity and undertaking leveraged purchases of rental properties and financial assets to build wealth.
Global household debt has reached around 75 per cent of gross domestic product, with especially high levels in some advanced economies. The comparable figure was around 57 per cent in 2007 and 42 per cent in 1997. Even with very low interest rates, household debt service ratios, which measure aggregate principal and interest repayments to income, remain high, ranging from 8 per cent to 16 per cent.
This high consumption/prices/debt combination is unsustainable and can lead to self-reinforcing feedback loops. Initially, increases in asset prices facilitate an expansion in credit and consumption that leads to further price rises. Slower growth, unemployment, or falling income or asset values can quickly send the cycle into reverse.
Negative shocks ripple through the structure of household finances. Looked at from a balance sheet perspective, assets such as houses and financial investments are financed by mortgages and other debt. On a cash flow view, employment and investment income must cover consumption and debt repayments.
Any income shock — unemployment, lower earnings, declines in interest or dividend income — must be offset by reduced consumption. Higher debt repayments or inability to refinance pressures the ability to consume. Falling housing prices or values of financial investments weaken the household balance sheet, forcing reduced consumption or accelerated debt reduction.
These first-order effects spread through successive disturbances, which rapidly amplify the stress.
One area of contagion is the financial sector. Major negative shocks expose excessive risk-taking by borrowers and lenders. If employment markets worsen, vulnerable households can’t service borrowings. Non-performing loans increase. Banks tighten credit, making it less available, harder to get and more expensive. Maturing debt becomes difficult for borrowers to refinance even where repayments are current, worsening cash flow pressures.
Forced sales, defaults and repossessions set off a spiral of falling prices across asset classes. Shrinking household net wealth and collateral value force even less consumption. Postponed home purchases and upgrades impact construction. This has a material impact on the US and euro area, where housing accounts for about one‑sixth of the economies.
Where banks are a major part of the stock market, such as in the US, UK and Australia, further contagion comes from reduced bank profits pressuring share prices and dividends. The loss of net worth and income further hits consumption by investors who rely on this cash flow.
Then there are government finances. General tax collections decline. Direct revenue derived from property and financial transactions falls. If the government has to support financial institutions — a persistent feature of asset price busts — the funds required to recapitalise banks and guarantee deposits stress government balance sheets. These are already weaker after 2008. Capital flight or reduced inflows as foreign investors exit squeeze the current account and currency.
The cycle continues through successive phases until a new balance is achieved. Australia has just experienced this process. A shock induced by tightening credit conditions set off falling house prices that slowed growth and weakened the financial sector. Interest rate cuts of 0.75 per cent, loosening credit controls and government actions have brought temporary stability.
Recent central bank actions around the world — an easing bias and resumption of quantitative easing — reflect the realisation that policy must prop up asset prices to safeguard consumption, which constitutes around 50 per cent to 60 per cent of GDP in advanced economies. The problem is that these policies perpetuate and increase debt, prevent normal asset-price cycles and increase the vulnerability of households.
The ability to maintain this inherently unstable equilibrium remains key to the prospects of advanced economies. The social strains that it’s coming under, for example, in terms of purchasing power and affordability of housing, are increasingly expressed in mass protests across the globe.
Satyajit Das is a former banker and the author of A Banquet of Consequences.
Updated: January 5, 2020 12:36 PM