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Is household debt ruining the economy?

When households don’t spend, the economy slows.

If you’re like most Australians, chances are you’ve got some debt weighing you down. Households in Australia have credit cards, personal loans and big-ticket mortgages. With the cost of living increasing and wages not keeping pace, this means little money to spare for spending at the shops, or worse, households not meeting debt repayments and defaulting on loans.

When households don’t spend, the economy slows. Recessions can be driven by mortgage debt, as seen in the United States 10 years ago. In 2007, Australia survived due to a combination of factors, including a resources boom, a need for those exports, plus stricter lending policies. What will happen now that the resources boom has levelled out and borrowing has gone through the roof?

We asked the head of Deakin’s Department of Economics, Professor Pasquale Sgro, what you can do and how government regulation can help to stabilise the economy to prevent a recession this time around.

Are household debts making the economy unstable?

A lucrative resources boom, increasing wages up to 2013, low unemployment and easy loan approvals has seen total household debt hit an all time high, having increased over the last 50 years and now growing at a faster rate than it was 10 years ago.

This is something to be concerned about as ‘household debt can be a contributor to a slow-down in the economy if it restricts consumers spending on goods and services to such an extent that it effects the rate of growth,’ Prof. Sgro explains.

In fact, a 1 per cent increase in domestic credit raises the likelihood of a banking crisis by 6 to 8 per cent, according to Deakin School of Business Dr Rashad Hasanov’s research into financial crises.

Dr Hasanov’s research explains the important institutional and political variables, including time-to-elections, government stability and central bank independence, to explain the determinants of a credit boom. His results show that the presence of an independent central bank reduces the probability of a banking crisis by controlling the likelihood of an unsustainable credit boom.

Currently, the Australian Prudential Regulation Authority (APRA) has taken measures to strengthen lending policies and the Reserve Bank of Australia (RBA) is well aware that levels of debt and housing prices also affect the resilience of our economy to future shocks.

Mortgages might signify a healthy demand for housing stock and add to economic growth; and credit card expenditure on goods and services helps economic growth too. But the issue, Prof. Sgro says, is ‘who has access to or can afford to pay the higher prices for the increased housing’.

If we can’t afford to go out and spend our money on consumables, then the economy slows. One of the ways we can up consumer spending in these times of high household debt is to ‘increase wages and incomes’, he suggests. Wage growth affects household debt and the whole economy, but remains stuck at just under 2 per cent per year.

As RBA Governor Philip Lowe states ‘wage growth will need to catch up to housing inflation if the Australian economy is to become more resilient to the problems caused by burgeoning household debt’.

Regulations to help consumers and the economy

Government policy that targets higher employment by creating jobs through public investment and productivity, and having a liveable minimum wage that would increase what lower income earners take home, are some measures that would help to increase wage growth and reduce household debt.

To reduce the likelihood of a banking crisis due to mortgage debt, Prof. Sgro says the government also needs to ‘regulate the loan conditions on bank mortgages to ensure that consumers do not overcommit and have enough income to cope with potential increases in interest rates’.

However, if the RBA cuts interests rates again, he adds, ‘there will be an increase in housing demand’. When housing demand increases, that could mean consumer spending decreases, and the economy slows once again.

How you can help the economy

In order to help manage your debt and do your bit for the economy, don’t overcommit to debt, Professor Sgro advises. If you’re just treading water now, you’ll likely start drowning if interest rates increase down the track.

Most households can cope, but if something goes wrong such as illness, job loss, divorce or a death in the family, debt can become overwhelming. The Australian Security and Investment Commission’s (ASIC) MoneySmart website has some good advice on managing debt.

‘Personal debt is different to public debt in that pubic debt is a charge or claim on “future generations” whilst private debt is incurred by “current consumers” and needs to be repaid by them now’.

With that in mind, now is probably a great time to head over to our article on how you can grow your savings without sacrificing your lifestyle. It might not solve all our economic issues, but it’ll certainly help your bank balance!


Originally published on this.

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