A couple of blogs ago I posed the question as to how the sustainable level of household debt might be identified for an economy. I then reckoned that there might be a decent 30k ft way of addressing this question. This post serves as a bit of a reverse ferret. I’m not saying that the previous approach was wrong, but after some back-to-basics thinking I understand that its rightness is overly-dependent upon the stability of something that it may or may not be wise to assume. In my defence, I reckon *every* macro approach relies on this stability (comments section please to correct me). But I take little comfort in expressing a popular view based solely on its popularity.
Debt is an entirely distributional issue. Evenly distributed in a closed economy, no level of household debt is unserviceable or unsustainable. But evenly distributed, debt is also functionless. Every sustainability question rests upon the microstructure of debt loads across different households. And so, from a macro perspective, debt is tricksy to say the least.
This all becomes clear in an example. Let’s imagine two super-simple closed economies with no sectoral flows: the Kingdom of Feudaland and the Republic of Debtzania.
The Kingdom of Feudaland consists of 10m households, each of them with perfect equality of employment income (at £20k per annum), making its GDP worth £200bn per annum. Household debt sums to £20bn, and interest rates are 15%. Debt is owed by 9.625m households to the other 375,000 remaining households (evenly). Interest costs are eminently serviceable (£312 per annum per household in transfers from the debtors to the creditor households, each of whom receives a handsome £8,000 per annum in interest).
The Republic of Debtzania also consists of 10m households, each of them with perfect equality of employment income (at £20k per annum), making the GDP worth £200bn per annum. Household debt also sums to £20bn, and interest rates are also 15%. Debt is owed by 375,000 households to the other 9.625m households (evenly). Servicing this debt costs the debtor households £8,000 per annum. The creditor households each receive a modest £312 in interest income on their savings.
Table 1: Feudaland and Debtzanian debtmetrics
The aggregate debtmetrics for Feudaland and Debtzania are exactly the same (Table 1). At 10%, the aggregate household debt to income ratio looks pretty low, as do aggregate interest payments as a proportion of GDP at 1.5%. But the microstructure of the debt distribution is what matters in assessing the sustainability or otherwise of these two economy’s debt loads.
Feudaland, despite its wealth inequality, looks to be a beacon of financial stability. The debt-to-income ratios for debtors are pretty low at 10.4% of income, and servicing ongoing interest costs is universally manageable, absorbing 1.6% of income. Feudaland’s wealth inequality might eventually prove politically unsustainable, but it would be hard to call it financially unsustainable, even in an environment where interest rates doubled.
Despite exactly the same aggregate debt-metrics, Debtzania looks much more financially fragile than Feudaland. The majority of its citizens are savers, but they have amassed claims on the small minority of financially-fragile debtors who must pay out 40% of their incomes in interest payments to keep out of default. Debtzania debtors’ debt-to-income ratios are individually high at 267%, and it is probably fair to say that a doubling of interest rates might bring meaningful problems to Debtzania’s financial system (with associated morality stories).
Now imagine being a monetary policy maker in each of the two countries. At what point should you worry about changes to aggregate household debt, and at what point could you infer that household debt in your country is too high? If a policymaker looked to their countries’ respective histories for clues they would, in so doing, be making the assumption that the microstructure of debtor-creditor relationships would be relatively static (or at least semi-stable) over time.
With a static microstructure of debt in Feudaland we might expect to see household default rates relatively unresponsive to wild changes in aggregate debt loads or interest rates. Policy makers might draw the lesson that household debt – at only 10% of GDP – is far too low to worry about, and that rising debt could be a sign that households were moving towards their optimal debt load (and so should not be met by any ‘leaning against the wind’). One could even imagine the cultural trope of creditworthiness being assigned to Feudalanders (backed by the empirical evidence of minuscule historical credit losses).
With a static microstructure of debt in Debtzania, we might by contrast expect to see household defaults rise and fall with both real (and nominal) interest rates and debt-loads. Those 375k households who do the borrowing may – if cross-country evidence holds in our mythical land – do a disproportionate amount of the spending in the economy. And so monetary policy might prove a particularly speedy macro tool for demand management: introducing higher and lower pain thresholds to debtor households and transferring higher or lower amounts of debtor household incomes to creditor households with lower marginal propensities to spend. It would be unsurprising if Debtzanians acquired a reputation of being quick to default; concerned politicians might encourage them all to save more.
In short, if the structure of the distribution of debt was utterly unchanging in both countries, policymakers might reasonably rely on each country’s individual history of debtmetrics to determine policy pinch-points.
But the usefulness of any historical comparisons (in terms of aggregate debt-to-income ratios or debt-service ratios) rests on this microstructure of debt being pretty concrete. The more changeable the microstructure, the less useful any historical comparisons.
Imagine again that the microstructure of debt distribution in Feudaland shifted to match the distribution in Debtzania, perhaps as its demography shifted through population ageing and associated changes in savings habits. A policymaker following only aggregate debtmetrics might infer that the change in default patterns was associated with some cultural shift in the population. When in fact, aggregate debtmetrics had instead done a good job at masking this demographic sea change.
It is not clear that I, or anyone else who makes macro comments on matters of household debt, has a decent framework for assessing the fluidity of this microstructure.
In the next post I look at the data that I can see readily available for the UK.