What If Debt Levels Keep Rising to Maintain Past Growth Levels?

When you ask ‘what if’, your mind opens to possibilities and alternatives.

Say, you’re planning a beach wedding. The obvious ‘what if’ is rain.

Checking the average monthly rainfall data and the long range weather forecast could provide a degree confidence the ‘weather gods’ will bless your special day. But nothing is guaranteed. Prudence calls for a Plan B.

Assumptions are inevitable in forecasting. Our experiences dictate our assumptions, and the longer the reference period, the more confidence we have in our assumptions.

I recently read an article about the Australian property market that said, ‘Despite talk of a property crash, Australian house prices have suffered only minor corrections on two occasions in the past 50 years; never a crash.’

Most people draw comfort in the assumption that the future will reflect the past. But what if the past is not our future?

For example…

In July 2005, Ben Bernanke (former US Federal Reserve Chairman) was asked in a CNBC interview (emphasis mine):

‘What is the worst-case scenario if in fact we were to see [housing] prices come down substantially across the country?

Bernanke’s reply (emphasis mine):

‘Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.’

With hindsight we know Ben’s assumptions were wrong, wrong and wrong. In 2008, the economic skies opened up and rained down on 50 years of property values.

Bernanke could have saved himself the embarrassment if he’d heeded Hyman Minsky’s hypothesis that stability creates instability.

The idea is that the longer the period of price stability, the more we’ll believe the pattern will continue, which causes investors to take greater risk.

Assuming a guaranteed road to riches, why wouldn’t you borrow as much as you can for the smallest deposits on as many houses as possible?

Prolonged periods of price stability lull us into a false sense of security, and the dollar signs blind us to the risks.

I’ve been grappling with a number of ‘what if’ questions over the past few years.

What ifthe past 50 years of economic growth and financial prosperity weren’t normal?

Since 1965, the world’s largest economy, the US, increased total public and private debt from 140% of GDP to 340%…makes you wonder how 50 years could pass without a responsible adult saying enough is enough.

However, 50 years pass by in days, weeks, and months, and an incremental 3% to 4% jump each year is all it takes to achieve the existing burden.

This slow, hardly noticeable layering of debt creates the mindset that this is normal. Year after year, decade after decade, debt levels accumulate.

The concept of constant growth (despite the occasional pesky recession) is an unquestioned assumption.

But what if the ‘growth’ of the past 50 years was largely due to the growth of global debt?

The global economy has made tremendous advances in the past 50 years, especially in technology and healthcare.

However, to avail ourselves of these advancements and lifestyle improvements, we’ve gone deeper and deeper into debt.

Accessing these ‘mod cons’ and ‘medical marvels’ with more savings and less debt would have delivered a slower pace of growth.

Accelerated growth, fueled by high octane debt, created our ‘normal’ view of economic development.

From 1875 to 1980 (105 years), the Australian share market averaged a compound growth rate of 4.5% per annum.

From 1980 to now, the All Ords compound growth rate has averaged 7.5% per annum. Is it a coincidence the this growth has coincided precisely with the growing global debt levels?

I don’t think it is.

What ifdebt levels keep rising to maintain past growth levels? This is possible. However, 3% to 4% of annual debt adds up quickly. Global GDP is around US$75 trillion. A 4% credit expansion would require US$3 trillion in new debt this year. Someone, somewhere, sometime is going to have to pay this back.

The higher the debt pile increases, the greater the potential instability. Debt can’t be compounded infinitely.

If you recognise that debt accumulation has a use-by date, the next what if question should be: What if debt levels fall (not collapse) in the coming years?

Inflation (the air in the credit bubble) is would be replaced by deflation (the air escaping the credit bubble). Deflation would stall growth rates to far below ‘normal’.

Our assumptions about the growth of population, household formation, property values, wages, welfare, share prices, etc. would be thrown into disarray.

We’ve caught a glimpse of this recently with state and federal governments assuming iron prices would remain above US$100. Budgets are now awash in red ink.

On an individual level, retirement income projections based on a 7% per annum compound return from equities are likely to fall well short of the mark.

Relying on ‘guaranteed’ capital growth to offset income losses from negatively geared property is likely to destroy many a well laid plan.

Even plans made with the best intentions are bad plans if they’re made on incorrect assumptions.

Making growth assumptions based on the past 50 years is, in my opinion, a huge mistake.
The road travelled is not the one in front of us.

The ‘stability’ of the past 50 years has caused excessive risk taking, which has made our economic and financial system highly unstable and fragile.

What ifI’m wrong? A cautious approach to your assumptions can result in a pleasant surprises (under-promise and over-deliver).

What ifI’m right? You’ll be so glad you adopted a more conservative approach to the allocation of your capital, reduction of debt and living within your means.

The long range economic forecasters and past performance data all suggest mostly sunny economic times ahead. Their message is to go ahead and plan your retirement safe in the knowledge that the system is not going to rain on your parade.

Living in Queensland (the Sunshine State) did not prevent us from experiencing two ‘one-in-100-year’ floods in the space of two years. The unexpected does happen and not always in a neat statistical fashion.

The Great Depression was 85 years ago — the further we go away from the last one, the closer we come to the next one.

Just for the record, the last great debt build up in the US economy was the 50 year period from 1880 (120% of GDP) to 1930 (300% of GDP). The following 20-years were nothing like the previous ones.

What if this happens again?


Vern Gowdie,
Editor, Gowdie Family Wealth

Join Markets and Money on Google+

Vern Gowdie has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top five financial planning firms in Australia. He has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

To read more insights by Vern check out the articles below.

Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money