Macro 101 - Private Sector Credit Impacts

In a previous post I talked about the sectoral balance equation which is fundamental to understanding how an economy functions at a macro level. The function is also useful to understand the likely high-level economic outcomes of monetary and fiscal policy changes made by a government.

If a government is running a surplus budget then they are taxing more than they are spending. This means that the private sector will be paying more money to the government than they are receiving. Unless the export sector is providing the offsetting value ( a positive trade balance ) then the private sector will be getting poorer and will have to take on debt to maintain the same standard of living in the absence of price deflation.

That debt is what I want to talk about in this post.

Private sector debt is something that seems to be ignored by many economists. I have no idea why because it is an important measure of a number of things at a macroeconomic level. As I said above, using the sectoral equation approach you can see that it can tell you when government taxation/spending levels are not appropriate to support maintaining a standard of living given the terms of trade of the economy. From a financial stability perspective debt can be an early warning that the private sector is overly investing in a non-productive asset class which may require changes in the economic policy framework to counteract.

One of the major issues with a high private sector debt burden is that it reduces the private sectors ability to invest and therefore contribute to an increase in the productive capacity of the economy. If the debt associated with non-productive investments is allowed to grow unabated then the productivity of the economy will decline as the capital available for productive investment diminishes.

In Australia the private debt level has become so large that the banks can no longer fund it domestically within the regulatory framework. This now leaves the economy open to a foreign funding liquidity risk, something that flared up during the GFC and may occur again at some time in the future. 

However what is less understood by most economists is the effect of the rate of change of debt issuance on the economy. Loans create deposits, not the other way around, which can be used to pay down existing debt or used to purchase goods and services. When they are used to purchase goods and services they add to the overall economy by creating economic activity (resource utilisation). This has a flow-on effect of creating jobs and creating economic growth.

But make no mistake, continual debt issuance is unsustainable without offsetting productive economic improvements. So if that credit is being invested in non-productive enterprises then there will come a time when the private sector simply cannot and/or will not take on additional credit because the underlying real economy cannot support it.

When this occurs then the effects we mentioned above works in reverse. The fall in credit issuance creates less deposits, which drives less economic activity. This has a flow-on effect of destroying jobs and making the economy weaker.