The Inconvenient Truth of Consumer Debt

(Bloomberg View) -- Oh, but for the days the hawks had a hero in Sydney. Against the backdrop of a de facto currency war, the Reserve Bank of Australia stood as a steady pillar of strength. The RBA held the line on interest rates, maintaining a floor of 2.5 percent, even as its global central bank peers drove rates to the zero bound and beyond into negative territory.

The abrupt end to the commodities supercycle drove the RBA to join the global currency war. The mining-dependent nation’s economy was so debilitated that policy makers felt they had no choice but to ease financial conditions. In February 2015, after an 18-month honeymoon, the RBA reduced its official rate to 2.25 percent, marking the start of a cycle that ended last August with the fourth cut to a record low of 1.5 percent.

The Bank of Canada has taken a similar journey in recent years. It embarked upon a mild tightening campaign in 2010 that raised the overnight loan rate from a record low of 0.25 percent to 1 percent in September 2010. The bank maintained that level until early 2015. Two weeks before the RBA’s first cut, the Bank of Canada lowered rates to 0.75 percent. The January move, which shocked the markets, was followed in July 2015 with an additional ease to 0.5 percent, where it remains today.

Bank of Canada Governor Stephen Poloz, who replaced Mark Carney after he departed to head the Bank of England, explained the moves as necessary to counter the downside risks to inflation emanating from the oil price shock to the country's economy.

Two resource-rich economies reacting similarly to body blows is intuitive enough. They eased the pressure on their given economies.

How they’ve landed in their current predicaments is less easy to explain. Propelled by soaring home prices from Sydney to Toronto to Melbourne to Vancouver, Australia’s household debt-to-income has hit a record 190 percent, the highest among developed nations; it is trailed closely by Canada, which has a 167 percent ratio.

To put this in perspective, at the peak of the housing bubble, debt-to-income in the U.S. peaked at 130 percent.

Then, economists took perverse pleasure in squelching the alarm these frightening figures elicited. “It’s not the level of debt that matters, it’s the cost to service that debt.”

Is it a surprise that economists today are equally dismissive of households’ heavy debt burdens? Mortgages take a lifetime to expunge; incomes flow in every year.

That myopic mindset best captures the shackles that bind today’s global economy. Of course it’s acceptable to build infinitely high levels of debt -- as long as rates never rise. But then there's the inconvenient truth that when the price of the collateral backing those millions of subprime mortgages cratered, those irrelevant debt loads became relevant overnight.

The same can be said of today’s delicate dynamic. Australia and Canada will be just fine so long as they don’t suffer a shock in any form to their respective economies.

Some policy makers have begun to push back against the conventional stupidity. “Sometime between now and Armageddon, interest rates will go up,” warned Australia’s Treasury Secretary John Fraser on May 30. “That’s something people need to be mindful of.”

Bear in mind that household debt has been growing at multiples of income, a disconnect that can only exist in a wonderland of permanently low interest rates.

Call it a global cultural tectonic shift. For close to a decade, the almighty Federal Reserve’s holding interest rates near the zero bound and its unconventional monetary maneuvers have bled into every nook and cranny of the global economy; it has altered the way investors of all stripes approach the very idea of debt.

Asset pricing, the way it was taught in Finance 101 courses, has no place in the new unreal world. And sadly, the impetus to save has died in the wake of the end of compound interest. All the while, governments and major corporations have borrowed without a thought about potential ramifications. 

Demographics add to the problem: We don't die as young as we once did. What to do? Close our eyes and make a wish that the world’s central bankers maintain the illusion of debt service being the only thing that ever has to matter. We ride the coattails of record levels of global quantitative easing being pumped into the system to keep the patient on life support. We tell ourselves that risky asset prices are at the precipice of the rally of the century, even though the run-up is the second-longest on record.

Without the comforting embrace of such delusions we could hardly dismiss as hysterical hyperbole reports such as that recently released by the World Economic Forum, which said longevity and lackluster investment returns will viciously collude to create a $400 trillion retirement savings shortfall in 30 years’ time. That figure is five times global output.

At the very least, Fraser has an optimistic take on how far out the day of reckoning will be. Debt is, “all fine until it ain’t. When interest rates do, in the centuries to come, go up, it’s something to watch.” Pray you aren’t the lucky soul with front-row seat tickets.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Danielle DiMartino Booth, a former adviser to the president of the Dallas Fed, is the author of "Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America," and founder of Money Strong LLC.

To contact the author of this story: Danielle DiMartino Booth at Danielle@dimartinobooth.com.

To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.

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