Some brief thoughts on private debt, financial fragility and economic growth

I am very interested in the intersection of private debt, financial fragility and economic growth because I believe this intersection is pivotal in understanding whether the secular forces which led to the Great Financial Crisis have been arrested. I want to use Ireland as a jumping off point here for a wider questioning.

The Ireland focus comes via this article at the weekend in the Irish Independent:

New figures seen by this newspaper also show a steep rise in the number of people who have been forced to declare themselves bankrupt after falling into debt.

The figures, from the company behind the debt defaulter’s magazine Stubbs Gazette found the average consumer now owes €13,067 – about 23pc more than last year’s average debt of €10,600.

Six years ago, when the economic downturn first started, the average consumer debt was only €2,442.

Many counties sank further into debt over the last year – and the average consumer debt recorded in most counties has exploded since the recession started.

In 2008, the highest average debt recorded for an Irish county was €7,359 for Kerry.

But today, the most indebted county in Ireland is Monaghan, with an average debt of €47,166. Donegal is the second most indebted county in Ireland, with an average debt of €26,311, followed by Longford, which has an average debt of €19,235.

Here’s what we know.

• Ireland has been one of the best performing countries in the eurozone periphery as the European sovereign debt crisis has faded from the headlines. We have seen 14 straight months of growth in the manufacturing sector where the latest PMI was 55.4, among the highest in the eurozone.
• Moody’s believes the economy will expand twice as fast as the overall eurozone.
• As business activity has picked up, so have office rents. They are up
• Property prices are up 12.5% year-on-year after a steep decline post-crisis. Prices are now still 43% off their peak.
• Housebuilding demand has really pickup as a result with housing starts up 132% in January – April versus the year ago period.
• But, problems remain and they are enormous aside from the unsecured debt problem. Unemployment is still 11.5%
• At the end of 2013, government debt to GDP was 123.3%, up from 24.8% pre-crisis. Debt to GDP declined to 122.2% after Q1 2014. But the deficit was still 5.6% of GDP, meaning that government debt can still rise across the business cycle as a percentage of GDP despite growth.
• As a result, the EU still prescribing more austerity. Jean-Claude Juncker is on record saying so.
• And that means infrastructure cutbacks. Before the crisis, Ireland planned to boost investment in education to over a billion euros annually. But by 2011, a deep recession meant the government had to cut its capital spending plans education to about half that level.

The bottom line is that, despite the cyclical bounce, Ireland has deep structural problems and a large debt overhang that will make it difficult for consumer spending and economic growth to be robust in the absence of asset price appreciation.

I think this goes to the general problem across economies in North America and Europe that suffered in the crisis. The debt overhang is diminished, but still large. In Ireland, where expunging debt is more difficult, we are seeing a huge surge in unsecured household credit even while the mortgage debt overhang still exists. All of this is manageable in a cyclical upswing in the midst of rising asset prices. But once the economy turns down, how resilient is the economy to deal with these problems? I don’t think we know the answer to this.

The eurozone has a special complicating factor because of the lack of currency sovereignty. And I think this will be siginificant when the cycle turns down. In the US, where the credit crisis exposed money markets to losses as they ‘broke the buck’, a desire to invest in safe assets has increased. Non-government assets in the U.S. do not enjoy the same bid that government assets due simply because investors recognize now that those assets are not truly safe. And with governments attempting to rein in government spending just as the bid for safe assets has increased, it has meant even lower yields on public sector debt in the U.S. and Europe. Bloomberg wrote today:

One of the biggest winners in the push to make money-market funds safer for investors is turning out to be none other than the U.S. government.

Rules adopted by regulators last month will require money funds that invest in riskier assets to abandon their traditional $1 share-price floor and disclose daily changes in value. For companies that use the funds like bank accounts, the prospect of prices falling below $1 may prompt them to shift their cash into the shortest-term Treasuries, creating as much as $500 billion of demand in two years, according to Bank of America Corp.

Boeing Co., the world’s largest maker of planes, and the state of Maryland are already looking to make the switch to avoid the possibility of any potential losses. With the $1.39 trillion U.S. bill market accounting for the smallest share of Treasuries in six decades, the extra demand may help the world’s largest debtor nation contain its own funding costs as the Federal Reserve moves to raise interest rates.

Now, in Europe, we see convergence across the board as investors, starved for yield, pile into riskier sovereign credits, thinking they have implicit backstops that will compensate for the spread to German Bunds. But that backstop may be tested in a downturn where even the likes of Ireland are going to see debt to GDP grow as deficits widen out. I think this will mean a rush away from periphery sovereign debt similar to the flow out of private debt bought in money market fund, toward German Bunds.

In the US, releveraging has begun. And given the ultra easy monetary policies promoting the releveraging, the question is what impact this will have on the real economy that would increase financial fragility at the cycle trough. The disproportionate increase in subprime auto loans in the consumer credit space and in junk bonds in corporate credit is due to the lack of yield and signals an increase in the percentage of so-called ‘speculative’ and ‘Ponzi’ borrowers within the credit system. This is classic top of the cycle stuff that I believe will increase financial fragility in the U.S. as well.

In short, both in the U.S. and in Europe, this business cycle needs to be longer and incomes need to be higher to prevent the same secular issues which caused the Great Financial Crisis from precipitating another crisis when this credit cycle ends. The emphasis on monetary policy – via low rates and liquidity schemes – at the expense of measures to reduce debt or increase incomes will hurt our ability to deal with these issues.