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Credit and debt are essentials of the modern economy but as my mother used to say, life is often either a feast or a famine and we are closer to the latter now.
Whether modern life is better than past times can be a matter for conjecture. US billionaire investor Warren Buffett said in an interview in 2006 in reference to a business titan of a century before: "I tell the students that come out here; they`re living better than John D. Rockefeller lived. I mean they`re warm in the winter and cool in the summer, and they can watch the series or they could do anything in the world. I mean -- and they literally live better than Rockefeller."
Rockefeller contemporary and son of a West Cork emigrant, Henry Ford, had manufactured, for the first time, "a mass-produced consumer's item that cost between 10 and 20 per cent of a family's annual income," wrote historian Daniel Boorstin in "The Americans: The Democratic Experience."
Henry Ford helped to invent the American middle class. In 1914, factory workers earned as little as $1 per day while Ford workers were averaging $2.34. With the Model T's innovative car assembly line in operation from the previous year, Ford shocked his fellow industrialists by raising the minimum pay to $5 per day. He also shortened the workday to 8 hours with three daily shifts and added $10m of profit sharing for the factory workers. Low-paid workers became middle-class consumers, who could afford to buy the cars they made.
The American dream of each generation doing better than their parents is however, no longer generally valid and it is likely to be a similar experience for many Europeans.
In the US as incomes beyond the top earners stagnated, access to credit grew and consumer spending could be supported by equity release from rising property values. In Ireland and other bubble economies, prosperity was built on quicksand.
Earlier this year when new US Congress rules on mandatory information for credit card customers took effect, I was struck by this information: The average American household had $10,000 in credit card debt. Assuming no new borrowings and an 18 per cent annual percentage interest rate, it would take 48 years to become debt-free by just paying the monthly minimum.
The White House estimated that nearly 44 per cent of American families carry a balance on their credit card and pay around $15bn in penalty fees each year.
In January we reported on a McKinsey Global Institute (MGI) report on debt in several countries. MGI said the analysis added new details to the picture of how leverage grew around the world before the crisis and how the process of reducing it could unfold. MGI found s that:
Leverage levels are still very high in some sectors of several countries - - and this is a global problem, not just a US one.
To assess the sustainability of leverage, one must take a granular view using multiple sector-specific metrics. The analysis identified ten sectors within five economies that have a high likelihood of deleveraging.
Empirically, a long period of deleveraging nearly always follows a major financial crisis.
Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 per cent. GDP typically contracts during the first several years and then recovers.
If history is a guide, many years of debt reduction are expected in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.
The right tools could have identified the unsustainable build-up of leverage in pockets of several economies in the years leading up to the crisis. Policy makers should work to develop a more robust system for tracking leverage at a granular level across countries and over time. One needs to look at specific metrics such as the growth of leverage, and the borrowers' ability to service debt if there is a disruption to income or rise in interest rates. MGI found that sufficiently granular data do not exist today.
MGI's analysis provided support for several of the financial regulatory proposals, including improving the quality of bank capital through higher Core Tier I ratios, monitoring leverage as a proxy for asset bubbles, and creating better macro-prudential regulation to reduce systemic risk. However, the analysis raised questions about some aspects of the current regulatory agenda, such as limiting gross leverage ratios (which did not change appreciably in most banks).
Coping with pockets of deleveraging is also a challenge for business executives. The process portends a prolonged period in which credit is less available and more costly, altering the viability of some of business models and changing the attractiveness of different types of investments. In historic episodes, private investment was often quite low for the duration of deleveraging. Today, the household sectors of several countries have a high likelihood of deleveraging. If this happens, consumption growth will likely be slower than the pre-crisis trend, and spending patterns will shift. Consumer-facing businesses have already seen a shift in spending toward value-oriented goods and away from luxury goods, and this new pattern may persist while households repair their balance sheets. Business leaders will need flexibility to respond to such shifts.
The Economist had a special section last week on debt.
Debt increased at every level, from consumers to companies to banks to whole countries. The effect varied from country to country, but the survey by the McKinsey Global Institute found that average total debt (private and public sector combined) in ten mature economies rose from 200% of GDP in 1995 to 300% in 2008. There were even more startling rises in Iceland and Ireland, where debt-to-GDP ratios reached 1,200% and 700% respectively. The burdens proved too much for those two countries, plunging them into financial crisis. Such turmoil is a sign that debt is not the instant solution it was made out to be. The market cheer that greeted the EU package for Greece lasted just one day before the doubts resurfaced.
In America, the non-financial corporate sector increased its debt-to-GDP ratio from 58% in 1985 to 76% in 2009, whereas the financial sector went from 26% to 108% over the same period. It was that leverage that made the banks so vulnerable when the subprime market collapsed in 2008; the assets they ended up owning were illiquid, difficult to value and even harder to sell. Banks such as Bear Stearns and Lehman made the fatal mistake of assuming that the markets (often their fellow banks) would always be willing to roll over their debts, but they suffered a bank run. The only difference was that the charge was led by institutions instead of small depositors.
In America private-sector debt alone rose from around 50% of GDP in 1950 to nearly 300% at its recent peak. The origins of the boom go even further back, reflecting huge changes in social attitudes. In the 19th century defaulting borrowers were sent to prison. The generation that lived through the Great Depression learned to scrimp and save. But the wider take-up of credit cards in the 1960s created a “buy now, pay later” society. Default became just a lifestyle choice. The reckless lender, rather than the imprudent debtor, was likely to get the blame.
Now the two challenges in rich countries are 1) promoting economic growth while adjusting to a post-crisis world of higher taxes and the end of easy credit 2) reducing public debt, and private debt where the price of related assets such as houses remain in a trough for a long period.
Discussing whether debt in the global economy will stabilize in 2016, with Dean Baker, Center for Economic & Policy Research and Steve Forbes, Forbes; CNBC's Ron Insana and Evan Newmark, Mean Street:
