Dealing with debt-fuelled bubbles

Financial markets have been in the news a lot recently, especially private equity and hedge funds. There's a lot of new investors with a lot of money buzzing around.

These huge market players are being viewed with some suspicion. The giant American private equity group Kohlberg Kravis Roberts was scrutinised over its bid for Coles, for example. A consortium of big private equity players has expressed interest in Qantas, raising tensions about the "national interest".

Following on from deregulation in the 1980s and globalisation in the 1990s, financial instruments and investors have been growing, in both size and complexity. This has allowed money to be allocated to its most productive uses, risks to be shifted and wealth to be created. Overall, this has been good, bringing a healthy level of flexibility and financial innovation to our economy.

Indeed, although much of the money receiving attention is foreign, a lot of it belongs to ordinary Australians through superannuation funds. More people than ever have a direct interest in financial markets.

Corporate debt and interest rates have been low recently, and profits strong. As a result, business debt is beginning to climb. The Reserve Bank's February Statement on Monetary Policy noted that "business credit growth remains well above its average" and "there are signs of increased appetite for risk". Just look at the Qantas takeover proposal: using debt to turn it private, then probably restructuring before selling it at a profit.

Such behaviour is risky in itself. Yet the dangers of private equity and high corporate debt generally seem underappreciated. Asset market booms and busts are emerging as the biggest threat to Australia's economy, according to former Reserve Bank Governor Ian Macfarlane. His successor, Glenn Stevens, has also recently warned of excessive risk-taking in financial markets, and the dangers of hedge funds.

Debt-fuelled bubbles, which often involve money being freely lent out to companies that later go bust, are hugely problematic in the current economic climate.

Household debt, as measured by income to asset ratios, is near record levels. Growth in mortgages, credit cards and personal loans, coupled with robust economic growth lifting consumer spirits, has driven this. High household borrowing - including for investment in property or shares - has increased the risk that, should the economy suffer a negative shock or recession, households will bear the brunt.

In the past 15 years or so, burdens (and risks) of debt have gradually shifted away from governments and businesses, and onto households.

If corporate debt was to follow a similar pattern of indebtedness as households, even a small hiccup could trigger a mini financial crisis (or economy wide recession) and end the golden period of growth we're in.

Booms, as we know, are often followed by busts. Investment and property bubbles have have a tendency to end badly: think of the US and Europe after the 2001 tech bubble, or Australia after the 1980s corporate property and stock market booms, resulting in the 1991 recession. If we're not careful, current financial market behaviour may be leading us down this path. Vigilance is crucial.

There are also other, newer, dangers alongside higher corporate debt.