Wealth ,Debt and Snowballs

In the past week the Central Bank published its latest figures on the balance sheet of Irish households, covering the third quarter of last year, while the Department of Finance produced its annual thoughts on Government debt. The latter tends to generate more column inches, raising the question of whether the level of debt owed by the State is too high or in some way represents a major problem, while the ongoing extraordinary shift in household debt and wealth receives less attention.

On the latter Irish households are continuing the process of deleveraging which started in 2009 with debt of just over €200bn, equivalent to 210% of disposable income at the time. Since then the economy has recovered and then boomed, moving to full employment in 2019, while interest rates have fallen sharply , including mortgage rates which are currently at all-time lows, yet household debt has continued to fall in cash terms, declining to €130bn on the latest figures. The change in term of disposable income is more pronounced still, with the ratio at 107%, back to the range last seen twenty years ago.

Housing is the main asset on the other side of the balance sheet, and the property crash was the main driver of a collapse in net household wealth (i.e, assets minus debt); from 2008 to 2012 if fell from over €700bn to a low of €430bn. Since then the recovery in the housing market has been a big driver of the rise in household net wealth, which reached a new high of €831bn in q3. The long rally in equity markets has also helped boost pension assets while the past year has also seen a significant increase in holdings of liquid assets in the form of cash and bank deposits. This had started before Lockdowns but in effect households have become forced savers given the reduced options to spend.

As a result households now hold €163bn in cash and deposits which exceeds debt owed by €33bn, a far cry from 2008 when debt exceed deposits by €85bn. Of course these are aggregate figures and some households have few or no assets and a lot of debt while the reverse is also true. The change has been bad news for Irish banks, which have seen assets fall and deposits surge in relation to shrinking loan books.

The path of Government debt has been very different. Gross debt soared in response to the financial crash, reaching €215bn or 120% of GDP in 2015. From there it fell a little in cash terms but very significantly relative to GDP given the growth of the Irish economy, declining to 57.2% in 2019, one of the lowest ratios in the EA and below the 60% figure required under the Stability and Growth pact. The Irish Government responded to the Covid pandemic by significantly increasing transfer payments to households and firms, as elsewhere, and the debt figure ended last year at some €220bn, albeit still with a low debt ratio of around 61% given that Irish GDP probably grew.

Government Debt is potential problematical for two reasons. One is the annual cost of servicing it, which means Government spending diverted from other areas. That cost will in turn depend upon the debt stock and the average interest rate on that debt and thanks to the ECB the latter has tumbled; the average cost of Irish debt is now under 2% , less than half the rate in 2013, because Ireland can refinance maturing debt at a rate close to zero and even below for shorter dated borrowing. As a result debt payments costs the Government under 5% of total revenue, versus 17% five years ago.

Governments rarely run large budget surpluses for any period of time so debt is generally simply rolled over rather than repaid out of revenue i.e. if €15bn is due to mature in a given year the authorities will issue €15bn to fund it, plus any additional borrowing if there is a fiscal deficit. That raises the second issue for Debt- can the Government readily refinance maturing bonds. That depends on investor appetite and in general is affected by who owns the debt and expectations about repayment, with the debt ratio playing a key role in that expectation.

Japan has a debt ratio of 240% but few expect a default, in large part because most of the debt is held internally, by banks, the Central Bank, insurance companies and pension funds. So Japan owes the debt to itself and these holders are also far less likely to sell it before maturity. That example also highlights that expressing the debt relative to the population is not meaningful, as it ignores the ownership issue. In Ireland’s case domestic ownership is actually not high but over €40bn of the total is owed to the EU on very long maturities and of the €140bn of bonds at issue over €50bn is held by the Central Bank and the ECB .These bonds have to be repaid of course but the interest is largely recycled back to the Exchequer and the large holdings under QE and PEPP means less bonds available to investors who might sell before maturity, perhaps precipitating a spike in bond yields and hence raising issues about refinancing, as happened in 2010.

On the debt ratio itself, its evolution over time depends largely on two factors ( ignoring one-off impacts like asset sales) – the fiscal balance excluding debt interest (the primary balance ) and the difference between the rate of interest on the debt and the growth rate of GDP. In Ireland’s case, and indeed in many developed economies in recent years, the interest rate (r) is now well below the growth rate (g) and this ‘snowball effect, as it is known, has been a big factor in the fall in the debt ratio. So, let’s say,. Irish GDP grew at 5% a year over the next five years with the interest rate at 2%, the debt ratio would fall by around 3% a year, assuming a primary budget balance, down to 53% from the current 61%. By extension, given that snowball effect the Irish Government could actually run a primary fiscal deficit of around 3% per annum and maintain the existing debt ratio.

The fact r<g in many economies has been a big factor in changing attitudes to debt, with the IMF, for one, completely changing tack from its pro-austerity stance of recent years, now arguing for large fiscal stimulus. Of course rates may rise in the future and QE may one day end but that is likely to be some way off. So as it stands Ireland does not have a debt problem given the debt ratio , the interest rate and the ownership of that debt. Why then are some concerned? One answer is that it is argued GDP is not a good measure of Irish income and as such a better denominator to use is modified national income, a specifically Irish concept which adjusts GDP for various multinational related flows. On that metric the ratio is thought to be around 107% in 2020, a lot higher than 61% but still not excessive by EU standards. In this writer’s view the concept is not useful anyway and was an overreaction by the CSO to the 2016 GDP figures (the release precipitating the ‘leprechaun’ saga). No other statistical agency recognises the concept, it is impossible to forecast and in any event appears to have a very similar tax elasticity to GDP anyway (indeed Corporation tax is more closely related to GDP).