Debt Story
Raymond James
By Scott J. Brown
November 21, 2011
Loan growth plays a key role in economic expansion. Simply put: no loan growth, no economic growth. However, there’s a downside. Debt doesn’t matter until it does. Debt has played a key part in the economic downturn and in the gradual recovery. Europe’s sovereign debt crisis has continued to escalate, with no easy way out. In the U.S., the government has borrowed more, but the markets have not punished it for doing so. There’s no sign that that is going to change anytime soon.
Household debt burdens increased substantially building up to the financial crisis. The “over-borrowed consumer” concept has been around for decades. However, the level of debt is largely irrelevant. What matters is debt service burdens. In this credit cycle, the bubble was centered in mortgages. As the bubble built, debt was roughly matched by increases in equity. However, once home prices crashed, many households were left underwater, owing more than their home is worth. More than three years on, that’s still the case. Most of these borrowers will continue to make mortgage payments, hoping that home prices will recover, but if a spouse loses a job or becomes seriously ill, or if there’s a divorce, the mortgage debt becomes more troublesome. The longer home prices stay low, the longer there will be a wealth-effect drag on consumer spending growth.
Business also borrowed more in the bubble, but it’s a mixed bag. Early in the recovery process, corporations were able to access bank lending and the credit markets, refinancing at lower rates. There’s little sign that debt service burdens are much of an issue for corporate America. Small firms, however, are not so lucky. Credit was tightened significantly for small firms during the downturn and has only begun to ease gradually. Moreover, many small businesses had loans backed by housing equity. As a consequence, we’ve had a reduced rate of business creation, which has contributed to disappointing job growth.
While mortgage and business debt were important factors in the bubble build-up, much of the leverage occurred in the financial sector. The financial sector has undergone a massive deleveraging in the last few years, one that may have a bit longer to go. While the federal government has borrowed a lot in the last few years, total net borrowing has been relatively low. There’s no sign that government borrowing is crowding out private borrowing. Moreover, in a financial crisis, there’s typically a strong demand for safe assets. Those expecting increased government borrowing to boost long-term interest rates have been wrong. Granted, the Federal Reserve took some of the added government debt out of the market. However, without the Fed’s purchases, long-term interest rates would still have been very low (just not as low as they are now).
The situation is different for the troubled countries in Europe. However, there root cause is not the debt itself. Rather, economic and financial weakness makes the government debt situations more problematic. The prescribed medicine, austerity, is partly treating the symptoms rather than the disease. Note that the U.K. also has a terrible budget outlook, but borrowing costs there are low (even with inflation running at 5%). The difference is that the U.K. has its own currency, while Italy does not. This has led to increased calls for the ECB to step up and declare itself the lender of last resort – a role the ECB has strongly resisted. The Germans, having experienced the consequences of hyperinflation many years ago, are naturally fearful of ECB asset purchases. Others worry about the moral hazard issue – that an ECB rescue would undercut efforts at financial and economic reforms in the troubled countries.
A meltdown in Europe poses a number of risks for the U.S. economy. Direct exposure to Europe’s sovereign debt is limited, but the U.S. financial system has exposure to Europe’s banks. During the meltdown three years ago, many of the big global banks briefly stopped doing business with each other, fearful of counterparty risk. Actions by the Fed and other central banks to boost liquidity helped offset these worries, and we could see a repeat of those kinds of effort (which ought to limit the downside). Bank credit is tightening in Europe, which will increase the likelihood of a European recession. About 22% of U.S. exports go to Europe. U.S. firms would then see some reduction in earnings from Europe, which could depress share prices and, through the wealth effect, restrain consumer spending growth here. A lot would depend on the magnitude of a European meltdown, whether one or more countries exit the euro, or even whether the euro survives. There’s no road map.
Growth is the easy way out of debt troubles. Efforts to boost jobs should be a key priority. Such efforts are missing in the U.S., but there ought to be enough momentum to carry us along.
(c) Raymond James
