Stop worrying about private sector debt

Well, OK, don’t quit worrying entirely, but it’s not a major problem in this cycle yet. Total debt is pretty quiet, measured as a percent of GDP, with household debt ratios in particular, very stable. The one area that is of some concern is non-financial corporate debt.

At this stage in the business cycle we should ask two questions about debt. First, is it so high and dangerous that it could easily trigger a recession, perhaps with just a small change in expectations or a mild rise in interest rates? And secondly, is it high enough that, if something else triggers a recession, it is going to make the downturn long and nasty?

Lets look at a few charts showing various measures of debt to GDP. First, total non-financial private debt. It surged in the early 2000s to 170% of GDP, fell back to 150% from 2008-11 and has barely budged since. Obviously asset prices have moved up a lot since 2011 so debt/asset ratios will have improved significantly. Of course a fall in asset prices (stocks, houses, commercial real estate essentially) would erode that, but markets would have to slump a long way from here to get back to 2011 levels.

The Bank for International Settlements puts a lot of store in analysing this measure. Not the level so much as the deviation from trend. When this ratio surges there may be a problem, as there was in 2007. No surge recently, at least in overall private sector debt.

OK, so what about the components of private sector debt, household and business? Well, household debt has sagged even more. It surged during the housing bubble but then fell back and it is still falling back as a share of GDP. Maybe there are pockets of potential problems such as auto debt or student debt, but overall household debt again, just does not look like a problem.

So what about non-financial corporate debt. This one does sound a warning bell. The ratio has been rising steadily and is nearly back to 2007 levels. How much should we worry? Well, first let’s remember that the crisis in 2007 was not triggered by excessive corporate debt. It was triggered by household debt (in the face of falling house prices) and all the derivative nonsense that went with mortgages. So, corporate debt rising back near 2007 levels probably isn’t a threat to the upswing in itself. Could it make a downturn worse? Yes, that is where I do worry. Today, profits are high, the stock market is high and commercial real estate prices are high. Take away those three things – which a recession certainly would – and some of that debt would be shaky. But I do take comfort from the fact that this ratio is still not making new highs. Yet.

One issue in particular stands out here – the surge in commercial real estate prices. The RCA commercial real estate index suggest prices are now almost 30% above the September 2007 peak, which also puts them about 6% higher in real terms. That is in stark contrast to houses where nominal prices have now climbed 10% above the 2006 peak, but that still leaves them 10% below in real terms.

Commercial real estate nearly always plays an important role in the economic cycle but there hasn’t been that much of a boom in construction in this upswing, only in prices. In fact, given that the economy is humming and prices are rising expanding commercial construction could be an important support for the economy in the next couple of years, though it might then become overdone.

Finally, what about credit inside the financial sector? Are the banks and non-banks getting up to their old tricks and inflating leverage? Not according to the flow of funds numbers. Financial sector debt as a share of GDP dropped sharply from 2008-12 and continues to drift lower. Again, this doesn’t rule out that there are pockets of problems in there, but does suggest that there isn’t a widespread mania, as was evident coming up to 2007.

So, are these results surprising? Not really, I think. As just noted there isn’t the mania we saw prior to 2007 either in the financial sector or in the household sector. Bankers and households were traumatised by the 2008 experience and are still behaving cautiously. You see that too in the personal saving ratio which at just under 7% remains well above the early 2000s level when it dipped towards 2%. As I have argued elsewhere, housing tends to follow a (roughly) 18 year cycle so, with the last peak in 2006 it is still too early to see another big run-up and a new peak. Memories of the crash need to fade for a few more years.

What about the buoyancy in corporate borrowing? I think there is a strong underlying upward trend in corporate borrowing to GDP, independent of the cycle. Or at least there has been. Its partly a matter of low interest rates, but also there are also strong incentives to lever up the balance sheet including tax relief on debt, the attraction for corporate executives to do buy-backs, borrowing against profits retained offshore and pressure from private equity investors. So today, still (just) below the last peak, we may have further to go.

The bottom line. We don’t have a credit boom as we did in 2007 and neither the household nor the financial sector are wildly over-extended. But corporate debt and commercial real estate bear watching, especially as interest rates grind northwards. They dont look like they could trigger a recession, but if we get a recession for other reasons (political problems or oil prices for example), there could be some painful stuff to work through. Overall though, the debt picture suggests a recession now should not be nearly as serious as 2008.