Canadians are now paying the price for past views on debt
In Canada household debt now accounts for 106 per cent of GDP, up from just 81 per cent of GDP at the end of 2007.
By Russell NapierContributing Columnist
Mon., Dec. 5, 2022timer7 min. read
There is much pointing of fingers across the developed world as to who or what is to blame for the sudden dire economic conditions that confront us.
Is the current malaise the result of the war in Ukraine and high oil prices? Is it to do with the sudden and, to some, surprising appearance of inflation? In the United Kingdom some blame a risky "dash for growth" by a now deposed administration and of course there is always Brexit to blame for everything that goes wrong.
There is a simpler explanation for why the entire developed world now faces dire economic outcomes: an explosion in debt burdens that cannot be serviced at interest rates that reflect higher inflation.
For a generation it was thought by most policymakers and their advisers that debt levels in the economy, whether in the government, household or corporate sector, simply did not matter. Inflation would always remain quiescent, interest rates would always remain low and debts could always be serviced. It was of course convenient to believe in the continuation of such a world of low inflation and low interest rates, but it was also fundamentally stupid and dangerous.
We all must now pay the price for this institutional mistake.
The world economy began to slow down at the end of 2007 and then contract. The cash flows that serviced debts declined and the price of much of the key collateral that backed loans also declined. By late 2008, with the collapse of Lehman Brothers, the fourth-largest investment bank in the United States, the world appeared to be heading to a new Great Depression. That we didn't enter a depression had much to do with central banks' actions to deliver record low interest rates and government actions to underwrite swaths of private sector credit risk.
The fire was put out but at a terrible cost. The rise in the levels of debt in the developed world economies that began in the 1980s continued as the cost of credit remained low for more than a decade. The advanced economy debt-to-gross domestic product ratio of 242 per cent at December 2007 had been dangerously high. By March 2022, when the last data was made available, it had reached 281 per cent of GDP.
The countries that added the most debt post the crisis of 2008/2009 were those that had weathered that particular storm with greater ease.
Canada was one of those countries. Canada's total debt-to-GDP ratio has risen from 223 per cent in December 2007 to 325 per cent of GDP in March 2022 — one of the highest levels amongst the advanced economies.
When interest rates rise and/or recession arrives, it is usually the private sector that has the greatest difficulty in servicing its debt obligations. In Canada household debt now accounts for 106 per cent of GDP, up from just 81 per cent of GDP at the end of 2007. Non-financial corporate debt has risen over the same period from 81 per cent of GDP to 119 per cent of GDP. Canada's debt surge has lifted its gearing levels well above even the elevated average levels of advanced economies where household debt-to-GDP averages 74 per cent and corporate debt-to-GDP 93 per cent.
Measuring the level of debt in any economy relative to GDP is to measure a stock of debt relative to the annual flow of economic activity that we know as GDP. Throughout the surge in debt levels there has been general apathy regarding the consequences in the belief that lower interest rates mean that higher debt levels are perfectly manageable. However such complacency ignored the fact that, even as interest rates fell to their lowest levels in history, and we have records on interest rates back to 3,000 BCE, the ability of the private sector to service debts was worsening.
For Canada, the percentage of private sector income needed to service debts actually rose from 21 per cent at the end of 2007 to 23 per cent in March 2022 despite the collapse in interest rates and thus interest expense. This occurred as Canada's 10-year government bond yield, a proxy for the cost of credit for the private sector, declined from 4.7 per cent in 2007 to 1.8 per cent in March this year when the last data for the private sector debt service ratio is available. As the price of borrowing got lower the private sector added so much debt that their ability to service such debt, even with interest rates at 5,000-year lows, deteriorated. The result is that Canada's private sector debt service ratio has remained at very high levels even as interest rates have plummeted. An analysis of historical data for private sector debt service ratios suggests that the risks of a private sector debt crisis increase markedly when more than 20 per cent of private sector cash flows are required to service debt and interest rates rise.
When calculating the ability of the private sector to service its debts we look at the total interest expense and also the cost of repaying a portion of the principal. With the rate at which principal is repaid not altering greatly, the key factor that impacts the ability of the private sector to service its debts is a change in interest expense. If we use Canada's 10-year government bond yield as a proxy for the likely rise in interest expense for the private sector, the interest expense for some borrowers will have risen by more than 80 per cent since March 2022. Not everyone will be unlucky enough to see their interest expense rise by such a magnitude. Many borrowers will have borrowed at low fixed interest rates and will only see their interest expense rise as those loans expire. However the clock is ticking and with every day that passes more borrowers see their interest expense soar at a time when private sector debt service ratios are at very high levels. It is this toxic truth that is undermining the economic outlook across the advanced economies.
The higher cost of borrowing also has negative implications for the public sector. There are many reasons why the new UK government budget has been focused on austerity but a key element has been the surge in interest expense. In the last fiscal year the UK government paid £56 billion, ($89 billion CND) in interest but for the coming fiscal year interest expense is estimated to be £120 billion, ($190 billion).
This jump in interest expense is caused by higher interest rates but also the higher rate of inflation that forces the government to pay more money to those creditors who hold the government's inflation protected debt. That £64 billion ($102 billion) increase in government spending, due to rising interest rates and rising inflation, takes interest expense to 12 per cent of total government revenues and the highest level since just after World War II.
On top of this payment to its creditors, the UK government has just paid £11 billion ($17.5 billion) to the Bank of England to compensate it for the loss made as rising interest rates have led to losses on the bond portfolio they accumulated in their long quantitative easing program. The UK government, along with the governments of many other advanced economies, underwrote the credit risk for loans extended during the COVID-19 emergency by commercial bankers. As higher interest rates force some of those borrowers into default, governments will have to compensate commercial bankers for the ensuing losses. Higher interest rates are undermining government finances and leading to worsening economic outcomes for many. In this regard Canada is in marginally better shape with government debt to GDP of just 100 per cent compared to the UK government debt burden of 118 per cent of GDP. Better shape, however, is not the same as good shape.
Regular readers will know that your columnist does not expect governments to bend to this new reality of higher interest rates by imposing austerity in the public sector and accepting default in the private sector. It is much more likely that they will force savings institutions to buy government debt at the interest rates governments wish to pay rather than the rates savers demand to compensate them for the risk of future inflation. Government bonds will become, as they were post World War II, certificates of compensation as they will yield less than the rate of inflation.
There is one key cause for our current malaise and that is that debt burdens are too high. In the democratic tradition they will now have to be inflated away much as they were post World War II.
Debt does matter and the mistake of this generation of economists and policymakers in pretending it doesn't will be a cost primarily born by savers.
Sometimes intellectual failures matter and few will matter more than the still prevailing belief amongst many that debt does not matter.
Russell Napier is an adviser on asset allocation to institutional investors. He is a freelance contributing columnist for the Star. Reach him via email: russell@sifeco.org