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% of gross domestic product, with especially high levels in some advanced economies. The comparable figure was around 57% in 2007 and 42% 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% to 16%.
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.
Manufacturing Economy Weakest in a Decade
December ISM index comes in at 47.2. Anything below 50 represents sector contraction.