My third point is that, for every financial debt there is obviously a corresponding financial asset, owned either by domestic residents or foreigners. There is a lender for every borrower. Net indebtedness, in this sense, is zero by definition. What matters, therefore, is how the debt and assets are matched and how the debt is distributed across the population. If debt is concentrated in households with low liquid financial assets, and high marginal propensities to consume, that is a more vulnerable scenario than if debt is more evenly distributed across the population. I’ll also return to this issue below. Financial cycle And the idea itself of a “financial cycle” is perhaps the best place to start. We are not here talking about the business or economic cycle – that is, the regular “ups and downs” in economic activity we observe in indicators like employment and GDP. By contrast, financial cycles are the persistent and possibly self-reinforcing build up of leverage, increases in asset prices and loosening of credit conditions over time. They don’t always end in tears. But they often do: the peaks of financial cycles tend to be closely associated with financial crises and the possibility of “serious distress and dislocations”.3  2  Although an increase in credit intensity (credit to GDP) is a key part of economic development some studies have found evidence that beyond certain levels of credit to GDP countries experience lower growth. See Cecchetti et al (2011) and Arcand et al (2012). 3  See Borio (2012).
And indeed, recent work in the Bank of England suggests that much of that fall could well be due to persistent structural factors (Chart 5).7 These factors include a slowing in the underlying global economic growth rate, the rise in saving due to demographic forces, lower desired investment given a lower relative price of capital, changes in the income distribution, excess saving in emerging markets and declining public investment. 7  4  Rachel and Smith (2015) attempt to decompose the substantial fall in real rates over the past 30 years. Although acknowledging significant uncertainty, they account for around 400 basis points of that fall, the majority of which they attribute to structural factors. In another piece of Bank of England work, Waldron and Zampolli (2010) calibrate a model of the UK household sector to examine the behaviour of household debt between 1987 and 2006 – their model can explain most of the rise in debt and house prices if households expected lower real interest rates to persist. BIS central bankers’ speeches  However, not all of these factors will support a higher level of debt. In particular a fall in the potential growth rate of the economy will lower the long-term real interest rate. But it will also lower long-term income so the overall impact on house values and debt sustainability is likely to be neutral.