High debt will lead to low growth

Feeling stressed? There is no doubt about the fact that we are still feeling the painful effects of the huge financial shock that landed last September. From that, a whole series of negative feedback loops seem to have been set in motion as an overwhelming sense of uncertainty has reverberated through the global economy. This is no longer simply a US and European affair, although conditions in those areas remain crucial in helping us to work out how and when a sense of normality may return.

For now, it's just more bad news. The past week, of example, has seen terrible numbers for unemployment, terrible numbers for house prices, and then a truly shocking revision of US GDP data for the fourth quarter – suggesting that the American economy, still the engine of world growth, shrank 6.2 per cent during the last three months of 2008.

For this correspondent, living with a large mortgage in London, the chart (available in the print edition) from Christian Broda at Barclays, showing US and UK house prices compared with a global pool, is especially depressing.

It's a simple enough chart (available in the print edition), showing how prices in the US have now fallen back to levels last seen in March 2003, while in the UK prices seem to have receded to levels seen in 2005. But look how far the UK remains out of synch with the rest of the world. There is no reason why house prices in Britain should be on a higher long-term trend than anywhere else. Yes, this is a crowded isle and there is not really any prospect of making more land. But, fundamentally, house prices have to be related to economic growth. Just ask someone in Japan, another crowded space, where property prices have been on a downward trend for 17 years or so.

The authorities in the UK, like the US, might be doing all they can to reduce pressures on stressed mortgage payers. But it is impossible to avoid the fact that until house prices fully correct, the related uncertainty will continue to drag down the economy as a whole.

How is this affecting other countries? Obviously, the growth in uncertainty has caused consumers and businesses to hold off from purchases, causing a shock to those countries producing most of the goods. Broda notes that, consistent with this, the growth of countries that are big exporters– such as Japan, Korea and Germany – has fallen more than that of countries with the largest housing busts and consumer debt levels, such as the UK, US and Spain. Note the case of Japan, which has seen economic growth decline at almost twice the rate of the UK, while Germany's decline has outstripped Spain and China has decelerated faster than the US. Broda has plotted this in the second chart (available in the print edition), showing the share of production in cyclical sectors relative to the decline in growth between the second and fourth quarters last year. The Barclays economist notes that the pattern is unmistakable – in countries with the largest exposure to cyclical sectors, GDP growth has fallen the most. And this, in Broda's view, may provide an important peek into the future:

"As the countries with the sharpest output declines do not have large housing or debt problems, and cyclical sectors are [by definition] the fastest to rebound, these countries are likely to provide better growth prospects when a global recovery materialises. By contrast, countries such as the US, UK and Spain, with large deleveraging processes under way, may face larger stumbling blocks to return to healthy levels of growth."

The natural conclusion here is that those countries with a structural debt problem will suffer weak demand and low productivity since it will take longer for firms and individuals alike to deleverage. And while house prices are still falling in places like the UK there will be a natural pressure on people like myself to save more of their income.

Broda identifies three key reasons why high debt will probably lead to low growth:

- As the financial crisis (and impending regulation) implies a lower equilibrium level of household debt, consumers' deleveraging requires higher savings over time.

- Debt "overhang" is likely to lead to lower investment by firms.

- "Zombie" firms can reduce medium-term growth.

If the first two reasons are largely self-explanatory, the idea of "zombie" firms holding us back needs some further explanation. The term heralds, of course, from the experience of Japan during the 1990s, when Japanese banks were effectively incentivised to keep unprofitable companies alive, since if the firms went under the banks themselves would face the threat of insolvency.

Naturally enough, keeping these unprofitable firms going produces its own distortions of the economy, reducing overall growth.

Now, it should quickly be added here that in the US, UK and certain other parts of Europe, the threat now comes not from zombie companies, but from zombie individuals. The over-leveraging problem is centred on housing and consumer-debt like credit cards. But the effects are similar. Further precipitous falls in house prices, coupled with sharply rising rates of unemployment threaten spiralling default rates and, subsequently, huge losses for the banks.

So, if countries such as the US, UK and Spain, with structural debt problems and housing busts, are likely to have a longer period of low growth than countries with (mainly) cyclical vulnerabilities such as Brazil, China and Germany, we must assume that the latter group will rebound faster. As the Barclays economist puts it, the short term cycle in growth is not the trend.

For those like myself, living in an environment where levels of personal debt were allowed to get so badly out of control, the threat now is that we will be on zombie-watch for some time to come.



- The writer is an Associate Editor with the Financial Times

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