Activity 4g Debt and economic activity
- Higher debt levels have been linked to:
- Deregulation of financial markets around the world where government intervention to control the volume and types of loans has been reduced.
- Lower interest rates increase the ability of borrowers to service debt so they have tended to borrow larger sums.
- Foreign countries like China have a large pool of funds that can be lent to other countries. With an increasingly integrated world economy it is much easier for financial institutions to access these funds and then lend them to their customers.
- When consumers have access to cheap money their ability and willingness to borrow. The lower interest rates tend to lower the opportunity cost of spending and may influence some consumers to increase their consumption spending and reduce their savings. This increases injections into the circular flow model and led to a greater level of economic activity. Leakages from the circular flow are likely to be reduced.
- Cheap credit is another way of saying that interest rates are low. This reduces the cost of borrowing and therefore acts as an incentive for households to increase spending on a host of goods and services, including houses. In particular, very low interest rates will increase the incentive to borrow larger sums (which are needed for the purchase of houses) because the ability to service higher debts is possible when interest rates are low. This increases the demand for houses and therefore exerts upward pressure on the price of houses (which contributes to a booming property market).
- Higher debt levels could, in the short term increase the ability of households to access goods and services. Households may be able to bring forward purchases and this enables them to enjoy a standard of living that they may not be able to afford (if they had to rely primarily on their savings for example). However, the accumulation of debt creates a liability for borrowers and this may have negative effects on material and non-material living standards in the future. Households, for example, may have to devote a larger portion of their income to debt repayment and this will become increasingly difficult should interest rates increase. The accumulation of debt also increases the vulnerability of households and businesses and could be associated with increased stress levels and anxiety. In addition, if excessive sums are borrowed in the early part of one’s life, then a greater percentage of income will need to be allocated to servicing that debt. This means that a portion of future income must be sacrificed, which reduces the households’ ability to purchase goods and services. This situation will be made worse if interest rates return to their long term average.
- If a government already has a high debt commitment then it makes it more difficult to attract the funds needed in times of economic crisis. Potential lenders may require a risk premium for lending to the government and this raises the interest payable on such loans. If the government is already running deficits, people may fear that the government may not be able to pay the debt back and therefore they may be less willing to purchase the bonds that the government issues to raise the funds needed to fund any deficit.
- The events of 2020, including the closure of borders and the lack of immigration (which ordinarily adds to the demand for houses), as well as the losses of income experienced by many Australians already facing high levels of debt will tend to reduce the demand for houses, exerting downward pressure on house prices. In addition, the supply of houses is also likely to increase as many property owners will be forced to sell (as repayment holidays by banks end) and the financial positions of households generally becomes more precarious. Overall, the lower demand and higher supply is expected to reduce house prices.