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Too much debt in the system

10 July 2014  |  Economics

DebtThe global financial markets got a shock in 2008 the like of which has rarely, if ever, been seen in history. For one thing, the markets now are truly global; the near-collapseof the US banking system would have quickly undone the world's banking system. DIY super investors should realise that we are still in risky times, and the danger to the entire system has not gone away.

The Bank for International Settlements (BIS) remains worried, and rightly so. Its latest report says the legacy of the Great Financial Crisis (GFC) persists and the forces that led up to it remain unresolved. At least the problem is now understood, but there is a long way to go. The tendency is to revert to business as usual habits, but the situation is far from usual. This is what the BIS says:

"Policy needs to go beyond its traditional focus on the business cycle. It also needs to address the longer-term build-up and run-off of macroeconomic risks that characterise the financial cycle and to shift away from debt as the main engine of growth. Restoring sustainable growth will require targeted policies in all major economies, whether or not they were hit by the crisis. Countries that were most affected need to complete the process of repairing balance sheets and implementing structural reforms. The current upturn in the global economy provides a precious window of opportunity that should not be wasted.

"Looking further ahead, dampening the extremes of the financial cycle calls for improvements in policy frameworks - fiscal, monetary and prudential - to ensure a more symmetrical response across booms and busts. Otherwise, the risk is that instability will entrench itself in the global economy and room for policy manoeuvre will run out."



Because of the massive build up of debt -- and this does not include the meta-debt in the derivatives market, which the BIS values at over $700 trillion -- the markets have become very sensitive to interest rate policy.

The BIS says it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally. The disconnect is largely due to continued monetary stimulus in the form of money printing and record low interest rates by many developed economy central banks. Private debt outside the banking sector now 30 per cent bigger than it was before the financial crisis. It is saying there is a "window of opportunity" to raise rates before it gets worse:


Debt levels from BIS 84th Annual Report  



Growth has picked up, but it is the debt that is the main issue. Interest rates (the cost of that debt) have become extremely important.

"Financial cycles encapsulate the self-reinforcing interactions between perceptions of value and risk, risk-taking and financing constraints, which translate into financial booms and busts. Financial cycles tend to last longer than traditional business cycles. Countries are currently at very different stages of the financial cycle. In the economies most affected by the 2007-09 financial crisis, households and firms have begun to reduce their debt relative to income, but the ratio remains high in many cases. In contrast, a number of the economies less affected by the crisis find themselves in the late stages of strong financial booms, making them vulnerable to a balance sheet recession and, in some cases, serious financial distress. At the same time, the growth of new funding sources has changed the character of risks. In this second phase of global liquidity, corporations in emerging market economies are raising much of their funding from international markets and thus are facing the risk that their funding may evaporate at the first sign of trouble. More generally, countries could at some point find themselves in a debt trap: seeking to stimulate the economy through low interest rates encourages even more debt, ultimately adding to the problem it is meant to solve."

We are now being ruled by the financiers.

In 2001, the largest industry sector in Australia was manufacturing, which accounted for about 12 per cent of GDP and about 12 per cent of employment. Financial services accounted for about 9 per cent of GDP and less than 4 per cent of employment.

A decade later, financial services accounted for the largest proportion of Australian GDP, 11 per cent. Manufacturing had fallen to 9 per cent. The finance sector’s share of employment remained about the same.

There is a similar trend in Europe and America. In Britain, the financial sector’s share of GDP leapt from 7 per cent in 2000 to over 12 per cent in 2007. The rise in America was more steady, increasing from 7 to 8 per cent over the same period. But the general trend is the same.

There has of course been slippage in the financial sectors of developed economies since the global financial crisis – although far less so in Australia, which has had a good Great Recession – but it is only a hiccup. The shift to making money from money, rather than making something useful to serve the real economy, remains relentless.

Financial firms like to think of themselves as businesses, and in the sense that they create products and sell them to customers, that is true. But they are more than that. Finance is a set of rules. After thirty years of financial “de-regulation” – a nonsense, because rules cannot be deregulated – the rule makers have changed. Instead of governments being in charge of the system, “de-regulation” has meant that private companies have been allowed to make up their own rules -- a free-for-all that almost resulted in the collapse of the entire global banking system in 2008. By allowing finance to grow as big as it has, financiers have become our new sovereign.

The BIS is waking up to the problem, and is warning that governments need to change. For investors, it means that it pays to be humble. The uncertainties are huge.

How to re-establish interest rates to a more "normal" level without setting off problems in such an indebted environment, is the main policy challenge, as the BIS notes:

"Looking forward, the issue of how best to calibrate the timing and pace of policy normalisation looms large. Navigating the transition is likely to be complex and bumpy, regardless of communication efforts. And the risk of normalising too late and too gradually should not be underestimated."








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