Excesses and excuses - the household sector’s role in the GFC

A glass or two of red wine is very pleasant to have with a meal or on a picnic or just to enjoy at a social occasion. Three or four glasses of wine is also quite nice, but as one drinks more and more, there are problems that are obvious and well known. There is at best, a hangover; at worst, it is catastrophic with personal dislocation often resulting.

Debt is very much like red wine. In moderation, borrowing money and accumulating debt is a desirable thing. It allows people to buy a house, a car and to bring forward purchases that might otherwise be unattainable if people had to rely on accumulated savings to make those purchases. As the economics text books say, borrowing and debt accumulation facilitates immediate consumption but it occurs at a cost of lower future consumption as, at some point in the future, consumers repay that debt.

This theory of debt accumulation and repayment works well provided there are no disruptions such as a credit crunch, surging unemployment, substantial interest rate changes or falling assets prices between the time the debt is taken and the time it is due to be repaid.

This is the obvious problem which resulted in the global financial crisis.

While some debt is good, too much debt is clearly bad, in much the same way that the fifth, sixth and seventh glass of red wine leads to undesirable consequences.

One important aspect of the global financial crisis was that it was driven by a self-inflicted binge of consumer borrowing that was aided and abetted by profligate banks who lent to any Tom, Dick or Sally with only scant reference to their ability to ever meet their interest obligations let alone repay the principal. What’s more, the borrowers were complicit in sowing the seeds of the crisis. Too frequently, the household sector blindly signed up for loans that they didn’t understand and worse, couldn’t afford. And when it came time to reduce spending so that the interest on that debt could be paid and debt levels reduced many consumers didn’t have the capacity to do so.

What’s worse, when those householders realised that house prices could go down as well as up, and then sold their houses to cover their debt, they found all too often that the sale price was less than the amount they borrowed and as a result, the banking sector and economy cascaded into the disaster that continues to this day.

Consumers borrowed like drunken sailors on the belief that house prices always went up and that they would always have a job and therefore an income whereby they could service the loan. For a time, this fuelled strong economic growth and multi-decade lows in unemployment rates, but as is clear now, it was an economic performance built on foundations of sand.

As this problem grew and grew, the regulators and others kept their heads in that sand. They said “we have a new paradigm”, that “growth was being driven by a productivity miracle” and the like. Regulators had a strong disposition to let the economy and market “self-regulate”. There were scant requirements for borrowers or lenders to test the veracity of the loans being made, and this lack of guidance and supervision was a telling mistake.

Householders and even banks need guidelines in which to operate in much the same way that people need to be told to stop at a red traffic light and not go. We need health inspectors to check restaurants for hygiene. We need regulators to say it’s not acceptable to steal property. It is well known that regulators (the police) will impose a fine on people who drop litter in the street or on those who drive even 10 kilometres an hour above the speed limit.

These regulations tend to work well.

But the regulators of the financial system and the economy let banks and borrowers (admittedly they were consenting adults) do what they wanted. They drove too fast, lived an unhealthy existence and littered the economy with junk borrowings. Debt levels were increasingly large and decreasingly secure; they let people whose house had increased in value borrow against their “new found” wealth and to spend that money as they pleased. There were few rules let alone guidelines for the amount people could borrow, who could borrow and for the purpose they could use the borrowed funds.

It sounded and looked like a problem at the time and while the party lasted a little longer than one would normal expect given the imbalances in the economy, when it ended, there was the global financial crisis.

The problem in the aftermath of the crisis and when the economy starts to recover, there will be the strong probability that householders be less keen to borrow and less willing to spend and rack up debt at frenzied levels. As a result, the pace of economic growth will be constrained. It will be a jobless recovery without huge gains in wealth. While consumers will bounce back to some extent, the prior wealth destruction, job losses and evil of excessive debt will be too clear and too fresh in people’s memories for there to be a consumer led resumption of 3 per cent plus GDP growth, at least not in the G10 economies.

Making the matter all the more problematic will be the risk of over-regulation or over-cautious lending practices imposed by financial institutions many of whom, after all, owe their existence to government bailouts and tax payer cash.

In all, the outlook for the world economy points to an extended period where consumer demand is unlikely to repeat the rampant growth of the 1990s and early 2000s. Very unlikely. What is more likely when market and economic conditions finally stabilise, and even start to recover, is a very modest pick up in consumer spending and with it a slow process of reducing unemployment and rebuilding the wealth that has been destroyed during the crisis.

Households and consumers will be reluctant to borrow too much, banks will be more prudent in their lending and the regulators will make it harder for the excesses to be rekindled by imposing a range of measures to prevent silly and unsustainable economic behaviour.

This will not necessarily be a bad thing for the long run sustainability of the next upswing in the business cycle. If household debt levels are low, the vulnerability to a credit crunch is low. High debt levels leave open the possibility that lenders will, one day and for whatever reason, want their money back. When this happens, borrowers need to sell their assets, often into a falling market, compounding the downturn. Without excessive debt, there is no such problem.

So enjoy that glass of wine - have two. It’s actually good for you. Don’t be afraid of debt, just don’t borrow or lend any amount that is not based on a prudent set of guidelines. In this instance, the upturn will be less potent than what we saw in the 1990s, but it is likely to be much more enduring.