I recently came across an interesting paper (from the author of slackwire) on Fisher Debt dynamics of private debt. The basic idea is that, just like public debt dynamics calculations, private liabilities as percentage of income are not only the outcome of savings but a more complicated function of the primary balance (net borrowing – interest payments), income growth, inflation and interest payments. Changes in these factors, limits such as an inflation target or the zero level bound on interest rates play a significant role on the long-term path of the private debt burden (liabilities to income), in this case household liabilities.
The authors used flow of funds data for the US in order to examine these factors more extensively. An initial finding is the fact that savings data cannot be used to gauge on the primary balance. Since savings can be defined as ‘savings = primary surplus + tangible investment + net acquisition of financial assets – interest payments’, debt related factors play a central role, something which is evident in the following graph:
In order to examine debt dynamics the law of motion of government debt is used for private liabilities:
in a reduced linear form:
d is the primary deficit to disposable income (net borrowing – interest payments), i the effective interest rate (interest payments / debt of previous year), growth is the nominal growth in disposable income, π the inflation rate and b private liabilities of the previous year / disposable income. Using this (almost accounting) equation, the contributions of each components can be examined for a period starting during the Great Depression:
*pi is inflation rate
The relevant conclusions are:
- The Volcker shock is quite evident in the data, with the effective interest rate contribution remaining very high ever since 1980.
- The 70’s inflation shock was actually instrumental in managing to keep the debt growth in mostly negative territory.
- Households actually moved to a primary surplus during most of 1980 – late 1990’s. Positive debt movements were the result of high effective interest rates and the disinflation project since 1980.
- The unsustainable increase in primary deficit during the 2000 – 2007 is very clear. The magnitude of the sustained deficit (the integral in mathematical terms) is almost unprecedented in the data.
- The tremendous shift of almost 15% in the primary balance after 2007 is impressive. Nevertheless, interest rate and income growth dynamics made the actual debt decrease much lower.
A counterfactual scenario is examined were the primary deficits remain the same as the actual data, but growth, interest and inflation rates are the same as the 1945 – 1980 period. This results in a a totally different debt path, which shows that since 1980 the debt path was mainly driven by ‘Fisher dynamics’ and not profligate households:
The obvious exercise is to perform a corresponding examination of Greek household data. Unfortunately, flow of funds data such as interest payments are not that easy to find, while a reclassification of loan data happened during 2010 which breaks the debt series somewhat. I ‘ve used Bank of Greece data on interest rates and loan amounts in order to proxy the effective interest rate. During 2006 – 2009 households incurred loan liabilities to the RoW, most probably a result of loans in foreign currencies (such as swiss franc) so I do not consider the effective interest rate calculation absolutely accurate. Still, the calculated change is very close to the actual one of debt to income. Due to data availability, only the 2003 – 2009 period will be examined:
The interplay between the relevant factors is more evident in the following graph:
The household primary deficit was very large during the 2003 – 2007 period, around 8 – 9% of income, while income growth was much lower, driving a debt financed consumption. Tight ECB inflation policy meant that inflation was not a significant balancing factor, while the large increase in debt made the effective interest rate contribution larger, even though the nominal interest rate was on a downward trajectory.
Since 2008, the primary deficit moved to surplus (a change of almost 9% of income) Nevertheless, debt change was still positive (5% in 2008 and 0,4% in 2009) because of two factors: The large increase in saving lowered the income growth rate to almost a standstill, while the effective interest rate contribution only dropped by 0,7%. A positive development was the fact that inflation remained positive and was actually quite high during 2008 (due to the oil price shock). As a result, debt to income only stabilized without any actual drop.
In order to better account for the fisher dynamics on debt, one can examine a counterfactual scenario on Greek household debt for 2010 – 2015. As a result of lower ‘debt carrying capacity’ households decide to move into a ‘permanent’ primary surplus of 1% of income in order to pay down liabilities. The effective interest rate is assumed to go on a downward path with the inflation rate stable at a level of 3% (a rather high rate given low internal demand). Income growth is assumed at 2% for 2010/2011 and 3% afterwards since the primary surplus will be a drag on economic growth. This results on a drop of the debt ratio by only 14 points from 70,85% to 56,50%:
Debt dynamics make the drop in the debt ratio very hard and slow resulting in a stagnant and long-lasting balance sheet recession. It is also clear that an increase of the income growth rate from 2 to 3% results in an almost equal increase in the Δdebt. The basic method to espace from a balance sheet recession is higher income growth, growth which can only come from other autonomous sources (government and exports) in this scenario.