Financial Notes: A dangerous form of debt addiction

DURING THE past 30 years, the Western world has developed an unduly relaxed attitude to the assumption of private and public debts and these excesses have begun to pose a threat to the stability of the global financial system.

Debt can be considered as a short cut to a desirable destination. It facilitates the immediate satisfaction of a want or need without regard to current resources. In poorer countries, international loans fund irrigation and sanitation programmes, saving lives and improving public health, long before the host country could otherwise afford them. There is still plenty of scope for the debt, whether bonds or loans, to go bad, but at least the connections between debt and the desirable destination are well defined.

There is a fundamental connection between the increased absorption of debt in an economy and the expected expansion of incomes and outputs. Why else would the lender be willing to enter into the debt contract in the first place? Yet, in most developed countries and some developing ones, the growth of debt has taken on a life of its own. It is seemingly disconnected to any reliable stream of future incomes. Borrowers appear to have lost sight of the desirable destination and lenders (investors) have ceased to take a proper interest in the way that their funds are deployed.

The key to this perplexing state of affairs lies in the radical transformation of the global financial system during the last 15 years. From the early 1970s until the mid-1980s, commercial and savings banks were the principal financial intermediaries in the system. At the close of the 1990s, it is the global fund managers who rule the roost. Commercial banks remain leading players in financial markets largely because they have reinvented themselves as eager capital market participants.

The central banks have played a pivotal role in manoeuvring the global financial system away from conventional banking arrangements towards market finance (principally bonds and equities). Central banks currently enjoy near-universal acclaim in the financial world for the success of their anti-inflationary remedies. But the policies advocated by the central banks in the 1980s and implemented by governments have had dangerous side effects in the financial system. Central banks diverted credit creation from within the monetary system to outside it.

Since 1985, governments throughout the developed world have financed the substantial part of their budget deficits by issuing Treasury securities. Only recently has this flood begun to abate. However, as national and international bond markets have matured in size and depth, they have become more attractive to corporations and financial institutions as well as government agencies. The outcome is that global net issuance of debt securities is still on an upward trend.

The failure of central banks to address the excessive rate of debt accumulation, whether by the private or public sectors, has resulted in a global financial system in which banks would rather operate off balance sheet as investors than on balance sheet as lenders. While the world-wide expansion of debt instruments continues to be much faster than the rate of price inflation, there is unusually slow growth of the global money supply in the hands of consumers. The one trend feeds off the other.

Excessive debt growth - a form of debt addiction, if you like, is destructive in itself. Indeed, stripped of its socially unacceptable association with inflation, debt growth is even more dangerous.

What can be done? Most encouraging would be if individual savers and investors woke up one day and realised how much financial risk has been imputed to them by an over-extended credit system. Their eagerness to liquidate substantial quantities of financial market investments and to repay debt would go a long way to re-balancing the system without any change in economic policy or financial regulation. Enlightened self-interest has a fine pedigree in the resolution of anomalies.

Peter Warburton is the author of `Debt and Delusion' (Penguin, pounds 18.99)