In a column published on March 24 I had explained why despite all the money printed by the central banks of the world over the last six and a half years, we haven’t seen much conventional inflation. The central banks have printed money (or rather created it digitally through a computer entry) and used it to buy government and private bonds
By buying bonds, central banks pumped the printed money into the financial system. This was done primarily to ensure that with so much money floating around, the interest rates would continue to remain low. At low interest rates people would borrow and spend. This would help businesses grow and in turn help the moribund economies of the developed countries.
But money printing should have led to inflation as a greater amount of money chased the same amount of goods and services. Nevertheless, inflation continues to remain very low in most of the developed world.
This, as I had explained, is primarily because of the fact that the world is in midst of a balance-sheet recession (a term coined by Japanese economist Richard Koo). Between 2000 and 2007, people in the developed world had taken on huge loans to buy homes in the hope that prices would continue to go up forever.
A recent report titled Debt and (not much) deleveraging brought out by the McKinsey Global Institute explores this point in great detail. As the report points out: “Between 2000 and 2007, household debt relative to income rose by 35 percentage points in the United States, reaching 125 percent of disposable income…In the United Kingdom, household debt rose by 51 percentage points, to 150 percent of income.” Other parts of the developed world also saw similar sort of increases in their household debt.
Much of this increase in household debt came from people taking on more and more home loans (or mortgage) to buy property. “In the United States, for example, household debt grew from just 16 percent of disposable income in 1945 to 125 percent at the peak in 2007, with mortgage debt accounting for 78 percent of the growth. Mortgage debt represents the majority of household debt growth in other countries as well. Our data show that mortgages now account for 74 percent of household debt in advanced economies,” the McKinsey report points out.
What is interesting is that this increase in home loans (or mortgage debt) in particular and overall household debt in general, was not accompanied by an increase in home-ownership rates. “In the United States, for instance, the rate of homeownership rose from 67.5 percent in 2000 to 69 percent at the peak of the market in early 2007, while household debt rose from 89 percent of disposable income to 125 percent. In the United Kingdom, the homeownership rate rose by 1.3 percentage points from 2001 to 2007, while the household debt ratio rose from 106 percent of income to 150 percent,” the McKinsey report points out.
As home loans were easily available at low rates of interest, more and more money was borrowed to buy homes. This pushed up home prices in most of the developed world. Between 2000 and 2007, home prices rose by 138 percent in Spain, 108 percent in Ireland, 98% in United Kingdom, 89%in Canada and 55% in the United States (on a slightly different note, real estate prices in India during the same period would have risen at a much faster rate. But we are talking about developed economies here where home-ownership rates are high and populations are stable or declining).
As home prices went up, this meant that the newer individuals wanting to buy homes had to take on a larger amount of home loan. This pushed up total household debt.
The correlation between rising home prices and increase in household debt to income ratio is very strong across countries. What also encouraged people to take on home loans was the fact that interest rates were very low, which meant that monthly EMIs required to pay off home loans were low as well. Hence, people could borrow much more than they would otherwise have.
Also, as home prices went up, people borrowed and bought homes not to live in them, but to just speculate, hoping that prices will continue to go up forever. A survey of home buyers carried out in Los Angeles in 2005, found that the prevailing belief was that prices would keep growing at the rate of 22 percent every year over the next 10 years. This meant that a house, which cost a million dollars in 2005, would cost around $7.3 million by 2015. So strong was the belief that home prices will continue to go up.
But that wasn’t to be. Once the bubble burst, housing prices crashed. This meant the asset (i.e., homes) people had bought by taking on loans had lost value, but the value of the loans continued to remain the same. Hence, people needed to repair their individual balance sheets by increasing savings and paying back debt.
Further, many of these loans had been issued at low interest rates. Once these interest rates started to go up, the EMIs also went up. As the McKinsey report points out: “In countries where many households have variable rate mortgages [home loans], such as the United Kingdom (and more recently Denmark), households are exposed to interest rate risk. When rates rise and monthly debt service charges are adjusted upward, some households may find they cannot afford their mortgages. This occurred in the United States prior to 2007, when households took out variable-rate mortgages with low “teaser rates,” but had trouble keeping up after a few years when the teaser rates expired.”
As EMIs went up and home prices crashed, more and more income was used to service the home loans. This had an impact on consumption. As the McKinsey report points out: “This dynamic is seen clearly across US states…A similar pattern can be seen across countries: the largest increases in household debt to income ratios occurred in Ireland (125 percentage points) and Spain (59 points), which also had the largest drops in consumption.”
As the accompanying table(from the McKinsey report) shows, households in many countries have been deleveraging since 2008, after the start of the financial crisis.
What this tells us clearly is that people are using more and more of their income to pay off their existing loans. Hence, even though central banks have ensured that low interest rates continue to prevail, people are no longer interested in borrowing and spending money. They are more interested in paying off their existing loans.
And that explains why all the money printing hasn’t led to conventional inflation though there has been a lot of asset price inflation. Investors have borrowed money at low interest rates from developed countries and invested them in financial markets all over the world, leading to stock markets rallying.
The column originally appeared on The Daily Reckoning on April 2, 2015