February 25^th was Debt Freedom Day for 2007: the day Australia had earned enough income to fund the annual interest on its loans.

The good news is that the day has finally arrived. The bad news is that it has been so long in coming. Except for a brief fall in 2000, when official interest rates were cut as the GST was introduced, the date of debt freedom has been steadily receding since 1997. Then, Debt Freedom Day was January 30th. Now Australia spends an extra three weeks of the year working for the bank. And that’s without making a dint in the debt itself.

While Debt Freedom Day is just a hypothetical point in the financial calendar (in reality of course our interest payments are spread out over the year), it is a good barometer of the pressure that private debt puts upon the Australian economy. Interest rates by themselves don’t tell the whole story; multiplying interest rates by the level of debt does. In the Debt Freedom Day Report 2007 three ratios are calculated to indicate the Debt Freedom Day for households, business, and the economy as a whole:

Download the full Debt Freedom Day Report 2007

Households have to wait longer for Debt Freedom than ever before

The real debt story today lies with households. They have never had to work so hard in the past to meet their interest payments – and this is just the average figure. There are many more households that are stretched well beyond the average, and are on the slippery slope towards bankruptcy.

Households have borrowed up big in the last fifteen years, so the burden on household disposable income is much higher now than when interest rates were twice what they are today. Even when interest rates were at their peak in 1990, it only took a month for the average household to pay its interest bills. By 2004 – the year a significant chunk of Australia’s population voted to ‘keep interest rates low’ – Debt Freedom Day was February 9^th. Just 3 years later it takes the average Australian household an extra two weeks to earn enough income to pay the interest on its loans.

This seemed like a good deal while the motivation for that borrowing – the belief that “investment properties” would continue to increase in price – was fulfilled. But house prices in Sydney and Melbourne stopped rising in 2004, and many households have never had to cope with anything like this level of debt before: we are in uncharted and dangerous waters here. If the 1990 crisis is anything to go by, then a debt-induced downturn appears inevitable – particularly since mortgage debt is still rising.

The 1990 recession showed what can happen when the business sector is pushed over the brink by debt. With the overall debt burden just shy of the 1990 level today, we may soon find out what it’s like when households are pushed off the same precipice.

In all likelihood, the result will be similar to 1990: a recession as households, voluntarily or otherwise, repair their financial balance sheets. However the pressure on businesses in 1990 was obviously far more extreme than the pressure on households today, and that pressure directly impacted on investment. This implies that the forthcoming decline could be less extreme, and also that it could take a higher aggregate debt servicing to income ratio to bring about a widespread crisis.

On the other hand, households have far less capacity to repair their balance sheets when in financial distress. Businesses can sack employees, and curtail investment – as obviously occurred during the 1990s recession. They can also go bankrupt, and be permanently removed from the Australian corporate scene. Households cannot sack family members, nor can they cut back substantially on consumption, or even the “human capital” investments they make in educating children. They also do not disappear from the population when driven into bankruptcy.

This implies that when the crunch comes – as it must do some day, since this trend is clearly unsustainable – the recovery will be more drawn out than it was in the 1990s.

What can be done?

There is no quick fix to the problem of excessive debt. To be effective, policy responses to this problem must bring about significant shifts in Australian institutions and attitudes – not simply tinker with macroeconomic settings such as interest rates.

As Hyman Minsky put it, the best policy is to build ‘a ‘good financial society’ in which the tendency by businesses and bankers to engage in speculative finance is constrained’. Deregulation has clearly failed here, as credit standards have been eroded by lenders competing to play in Australia’s favourite casino – the real estate market. Smaller deposits have been allowed, larger income multiples used, and multiple income earners counted. At the time it was argued that this would enable greater access to home ownership; but the outcome has been asset price inflation, backed by inflated levels of debt. We need to restore credit standards in lending, by regulation where feasible, and by making lenders carry the risk of lax lending where not.

But no matter what a federal government does now, we’re not going to get out of this situation without economic pain. Like a cartoon character who has stepped off a cliff, there is only so long we can keep peddling in the air before we hit the ground. Ultimately the debt growth rate must fall to no more than the GDP growth rate. Given the magnitude of overall private debt (now 152 per cent of GDP), and the contribution that increases in debt have made to spending, that implies a substantial cut to aggregate demand in Australia – of the order of ten per cent.

When this happens, the government will have to abandon its obsession with accumulating surpluses. A government surplus means that tax receipts exceed government transfers to individuals and purchases from firms. By definition, this means a net transfer from individuals and firms to the government, which they can finance either by reducing their own spending, or by borrowing themselves. Clearly, Australian households have been doing the latter for the past one and a half decades. They cannot continue to do so.