Good Debt, Bad Debt

We’ve had a lot of questions about TOP’s position on debt. On one level debt is a pretty simple concept; borrowing money to invest is pretty normal. If as a business or household you can borrow money to buy something that makes your life easier, better or more productive, at least enough to pay the loan back, then it is a good thing. This is how investment, economic growth and the financial system interact. Lenders are in the business of assessing risk and measuring collateral (the assets that back the loan). 

If on the other hand you are borrowing to pay the grocery bill, alarm bells are more likely to ring – primarily because in the event your ability to pay it back comes into question there is no collateral (or security) for the lender to call on. That’s why unsecured loans for that sort of stuff incur much higher interest rates than mortgages, which have a house to back it up.

So to really simplify it down if you go to a Harvey Norman sale and get a dishwasher that allows you to spend more time working or doing the things you love, and makes the repayments worthwhile, all well and good. If you get sucked in by Harvey Norman into impulse buying something you don’t need on hire purchase, probably it is not so good. Such is the importance of financial literacy.

Let’s just say if things are done right, loans and debt are the oil that lubricates the machinery of capitalism.

 On another level debt is a pretty complex topic with lots of moving parts, and causes a lot of confusion amongst commentators:

• net debt (debt minus financial assets) vs gross debt (total)
• public sector (central government and local government) vs private (households and businesses)
• foreign debt (that we owe to other countries) v domestic (that we owe to each other)

 Who Owes What to Who?

To save getting into detail, we will focus only on the issues that are key to debt’s role in our economy.

First up, public sector debt is pretty low in New Zealand. Sure it has been growing in recent years post the Global Financial Crisis (which is what you’d expect), but gross public debt is still pretty low at under 40% of GDP and falling. Compare this with the USA at 100%, Greece at 160% and Japan at 230%. Our good position is largely thanks to the frugality of previous Finance Ministers Bill English and Michael Cullen.

Source: Infometrics

 Far more worrying is private sector debt; gross private debt is 160% of GDP. So that is like owing Harvey Norman more than one and a half times your total annual income.

Source: Infometrics

And what about debt we owe to foreigners? This is how much of the money we owe to overseas Harvey Normans. This is the one that the Reserve Bank keeps warning us about because we are reliant on exports in order to pay that debt off. In other words if interest rates rise or our exports dry up for whatever reason, we can’t pay the hire purchase bills. New Zealand’s net external debt is high by international standards. This is a risky position to be in – just look at our company at this end of the scale – Ireland and Spain – both have had problems meeting their repayments.

Should we lose sleep over this debt? 

Some people contacting us fret about NZ’s debt and the proportion of our taxes that go to servicing it. Most of NZ's debt is private, not public sector, so relatively little taxation is spent servicing that.

On the other hand there are certainly problems with the housing market and our reliance on overseas debt (raised mainly through the banks) to fund mortgage lending. Our private sector debt is relatively high by international standards, particularly when you look at the share of it that is owed overseas. As we can see in the chart below, household debt has surpassed the previous peak before the Global Financial Crisis. the only reason we can make the repayments is because interest rates are at record lows.

That poses a risk to our economy. To pay back foreign debt we need foreign money, so we need to export stuff. We haven’t exactly done a great job of increasing our exports in recent years.

So, if interest rates rise, which they are starting to, or our exports falter, we could struggle to meet our repayments. If we can’t meet our repayments, the foreign Harvey Normans would want their dishwashers back. The implications of credit downgrades on the ability of the economy to grow are significant.

So what should we do? At TOP we don’t think we should get rid of debt entirely.

This reliance on foreign borrowing to feed our housing addiction is addressed with our flagship policy that closes the tax loophole around property. By ending the tax advantages for property ownership, we would borrow less and save more as a nation, and would have more money available for investment in our own businesses. This would increase exports and reduce the risk posed by owing money to foreigners.

People often ask why we can’t afford to process our own milk, or trees or fish. Well here is the reason; New Zealanders don’t save. We prefer to borrow and speculate on housing.

• * for full details, http://www.treasury.govt.nz/publications/research-policy/wp/2013/13-04/11.htm

Should we be so worried about government deficits?

Probably not as much as we are. Public debt is quite low in New Zealand as mentioned above. At times like these, when interest rates are so low, one could argue that National’s laser focus on getting into surplus has been a little one dimensional. Yet for some reason Labour and the Greens have bought into the same approach with their budget responsibility rules!

Of course, it depends on what you are spending the money on. As we noted above if you are borrowing money to buy groceries and keep the lights on, we should be worried. But would it be worth running a deficit to invest more in ensuring our poorest kids grow up healthier and better educated, so they can make a greater contribution in the future? Maybe. It depends on the business case.

Of course the other side to the coin is what future issues we face – our off balance sheet, contingent liabilities. The big problem in New Zealand is that Establishment Parties have written future cheques for baby boomers that we currently can’t cash. Health and superannuation will weigh heavily on our country in the years to come. Should we be preparing for this by running surpluses and investing the money ala the Cullen Fund? Or would we be better investing in our poorest citizens as discussed above? Or should we act to reduce these future liabilities and invest in future generations at the same time as TOP is advocating in our Thriving Families policy?

What about the evil banks creating money?

There is a growing discontent with the ability of banks to create money, which has been a feature of our monetary system for some time. In fact, Harvey Norman also creates money when they give you a dishwasher on hire purchase. They magically create an asset on their books, which is your debt to them.

Still, the feeling amongst some is that banks shouldn’t create money, governments should – by authorising themselves an overdraft at the Reserve Bank and and using the funds for investment. This would both stimulate the economy and properly directed, increase our productive capacity. It was done big time in the 1930’s to build infrastructure.

Of course printing money (aka; “Quantitative Easing”) has been seen overseas lately with the bank bailouts, relieving the banks of the consequences from their sloppy lending and financial market investments.

The right to print money as a last resort underwrites every sovereign currency. Some countries in Europe are currently looking at the possibility of printing money to overcome stagnant demand. Where there is spare capacity in the economy, printing money may not be inflationary. One idea is using the money to fund an Unconditional Basic Income. The big question is how to keep politicians out of the decision making, as in the past they have abused the right to print money for their own political ends.

There is no free lunch with printing money - inflation, a falling dollar and even undermining of confidence will eventuate if that route is taken too far (the 1970’s taught us that). At TOP we don't rule it out, and it may be appropriate in the future if the circumstances are right but there is no free lunch to be had there.

Printing money doesn’t mean unlimited free money for everyone. Debt is a market like any other, and interest is like the price in the market. If the price (interest rate) drops to zero, then demand for debt would skyrocket. Interest isn’t the only consideration of course, you do have to pay it back some time and what if some event impairs your ability to do so? But the government couldn’t issue unlimited money without inflation so there would have to be credit limits. If you aren’t using interest rates to ration the credit, you’ll get credit rationing like we had in the 70s. This in turn leads to a black market for borrowing where the “true” interest rate is revealed.

Some argue that the government should have the first rights to any money created without having to pay for the interest costs. But remember there is a limit on the credit in the economy and if you accept we need interest rates to temper demand for credit then the more free money government gets that means higher interest rates for you. Happy with that? No free lunch remember.

Questioning the right of banks to create money is now a popular pastime for some. The major quibble people have with banks creating money is the profit they make, particularly with that profit going overseas. TOP also has some concerns about the lax competition policy in New Zealand, but the answer isn’t to nationalise banks.

In the first instance, TOP wants to correct the structural imbalance in the housing market - and that has to do with income tax reform as well as prudential policy from the Reserve Bank. Changes to competition policy may also force a re-think of our ‘too big to fail’ banks.

Contrary to popular perception, the role of banks to create money is not unlimited, it is regulated by the Reserve Bank through capital reserve requirements to ensure they don't take inappropriate risks. There have been problems with excessive and imprudent lending (particularly on housing) in the past but since the GFC, Reserve Banks have clamped down, and are far more inclined to subject the banking sector’s portfolio to stress tests as a way of identifying and quantifying risks. 

Many people around the world are discussing monetary policy reform but the reasons why are unclear let alone any consensus emerging on the way forward. The reality is the central banks have already taken steps to avert a repeat of 2007. TOP monitors that space and we are interested in the work that many economists are doing on shifting the inflation target to nominal GDP. Other countries are facing issues now that we might well face in a few years time, so we can learn off their experience and make changes early to avoid their fate.

Our immediate priority is to fix the taxation system we have and thereby remove the artificial demand for property assets, boost savings, release funds for business investment, and drive the creation of more, better paid jobs. 

TOP wants to give our financial system a chance to work properly, instead of throwing the baby out with the bathwater and starting again.