Wake up to the dangers of debt: ThePost.ie


TCH Archives > Sunday Business Post > 2005/12/18 > Wake up to the dangers of debt

Wake up to the dangers of debt
Sunday, December 18, 2005 - By Eddie Hobbs
Wake-up calls, like the gardai arriving in the middle of a ballad session after hours, aren't always welcome, but somebody has to call time.

The Economic and Social Research Institute (ESRI) issued a stern warning during the week which should be heeded by those over-borrowed on lifestyle debt or over-geared on property - where your investment property debt accounts for more than 50 per cent of your balance sheet.

So what's the bear view?

The world's population is growing quickly, and is expected to surpass nine billion over the next 40 years. Life expectancy, which was about 50 years at the start of the last century, is quickly extending, with more than 50,000 Americans now over the age of 100 and 25,000 Japanese in the same age bracket.

The developed world is greying quickly, with a substantial fall in the ratio between the number of workers and those retired.

Ireland's ratio of workers to retirees is a healthy 6:1 and, while net immigration of young workers is helping, some predictions envisage a long-term shift to 2:1.Nowonder moves are afoot to change the retirement age!

Addressing the issue of old age pensions - which, for example, in Germany account for 15 per cent of GDP - is placing a strain on developed economies. Population increases feed the appetite for raw materials, increasing scarcity and raising prices - especially for energy where nearly two-thirds of oil reserves are located in the troubled Middle East region.

Eighty per cent of the world's population is located in developing countries. Even within developed countries such as the US, wealth is skewed, with 1 per cent of the population controlling a third of the national wealth, while one in eight Americans lives below the poverty line, with annual incomes of less than $20,000.The developed nations represent a fifth of the world's population, but account for the lion's share of private consumption.

The removal of international trade barriers has created a globalised economy putting the difference in labour costs between rich and poor countries into sharp relief.

The Irish government's policy of moving up the value chain as fast as possible is a good strategic response, but it will not immunise many sectors from the effects, as Irish Ferries workers will be well aware.

The single greatest risk is a sharp correction in the world economy, triggered by the twin effects of US debt and the potential structural shift that will occur as economic power moves eastwards. The dollar has been the traditional reserve currency, but the US has accumulated an enormous budget and trade deficit. This deficit - created by importing more than exporting - is shifting dollars, principally to China, India and the nations of southern Asia, which are accumulating vast dollar reserves.

Meanwhile, the US government continues to swell money supply and ramp up its debt, much of which is purchased by foreigners, creating further dollar outflows.

These twin deficits, and the substantial debt accumulated by US consumers, businesses and financial institutions, must eventually be repaid. But confidence in the dollar may not be prolonged forever and, in the event that the US resorts to protecting its traditional industry base from the threat of foreign imports by raising trade barriers, the strategic response from developing nations may be to switch principally to the euro as the world reserve currency.

In order to lessen the real value of the debts outstanding, the US government may then be forced to let the dollar devalue very sharply. The resulting shock to the global economy could trigger a sharp recession, with falls in overvalued assets, including property.

This is only one prediction, and other analysts differ, expecting the US to gradually ease its way out of its debt without triggering these responses. But what are the stress points? The developed world, particularly the US, has become heavily debt-reliant, as governments continue to spend beyond their means by financing deficits.

The OECD reckons that, by 2008, the total amount of government debts accumulated by its members will be roughly equivalent to their total GDP.

Half of the debt mountain accumulated is owed by the US government, and issued in the form of government bonds, which, in turn are held by institutional investors and foreign governments. Interest rates, once again, are on the rise, increasing the debt repayment burden for governments.

The continuation of debt-based spending is largely dependent on confidence among investors, consumers and companies which invest in further economic growth.

The threat of deflation (falling prices) - which is already happening in core areas in the US, such as manufactured goods - has been offset by inflation (rising prices), particularly in services such as insurance and banking, and in commodity prices like oil. But the elasticity of spending on the back of increased debt can't continue indefinitely.

China's emergence as a major economic power with a vast pool of cheap labour poses a threat to the US economy, which may be met by protectionist barriers. If, as some observers believe, there is excess global capacity inmost products, then deflation could replace inflation as the major threat to the world economy in the early part of this century, a century that is likely to be dominated by the emergence of China as a major world economic and military power.

China's GDP has been growing at around 10 per cent per year, creating a massive surplus in its trade with the rest of the world, a quarter of it with the US.

Falling prices are already underway in sectors affected by Chinese imports. The reason is easy to see. Factory wages in the US are over 40 times those in China, which is poised to move up the value chain into high-tech sectors.

Neither does the Chinese government have to worry about paying old age pensions - it has none. This contrasts harshly to the greying populations of the developed world. State pensions in some European countries absorb 15 per cent of GDP and 5 per cent in Britain and the US, where there is larger reliance on private provision. But, with the ratio of workers to retirees set to change, the pension bill is becoming a major cost worry.

The history of bubbles in economic events is well documented. Irrational exuberance is nothing new, with entire populations abandoning reason to join the most recent get-rich-quick scheme.

These events range from the tulip mania that took hold in Holland in the 1630s, to the South Sea bubble in the 1740s in Britain, the property and share bubble of the 1920s,which triggered the Great Depression in the US, and the dotcom collapse in 2000 after the bubble in internet stocks throughout the 1990s.

In one of its scenarios, the ESRI sees the potential for a 30 per cent correction in Irish property values. But forecasts are invariably wrong - it's just a question of by how much.

Bubbles are typically characterised by strong growth in property or share prices, followed by dramatic growth leading to sky high valuations. The US depression of the 1930s was triggered by this pattern and, before the dotcom collapse, valuations on technology stocks in the so-called ‘new economy' reached insane levels, as did property in Japan before it was hit by deflation.

A fundamental correction in the global economy is not a new prediction. Nor is it a certainty. Throughout the course of history, there have always been significant threats to economic wellbeing, but it would be an unwise investor who blissfully ignores trends.

This shouldn't yet cause undue concern if you're reasonably well insulated in feather-bedded employment, or if you're not over-extended with debt. But 2006 is definitely the year to desist from expanding your debt consumption. Or, if you're over-extended, it would be wise to reduce your debt exposure sharply.

So, unless you're fairly well-heeled, forget hopping on a plane to buy foreign property, especially when it's leveraged against your home. That summarises the bear view. Happy valium!