The notion of debt is something very common, whether it is for households or government. Households borrow to finance purchase of houses, vehicles, education, etc. The government borrows to finance its programs like building infrastructure and implementing various social programs while companies borrow to finance their operations.
Debt is necessary for households to build assets and improve human capital while for the government, it facilitates government investment in the society. Debt helps companies to grow and develop. However, excessive debt held by households, companies or the government may create potential financial or economic instability.
In Canada, the combined debt of households, companies and governments is 288 per cent of gross domestic product. At $4.4 trillion in the first quarter of 2015, the combined debt is almost three times the size of the Canadian economy. Compared to other G-7 countries, Canada's government debt is the lowest. However, Canadian household debt crossed 100 per cent of GDP in September 2015.
This may be putting excessive strain on the economy while making it vulnerable to shocks. Households have been taking advantage of record low interest rates to purchase real estate, which has led to increase in house prices, especially in cities like Toronto and Vancouver. The runaway prices of real estate in these cities may not be viable and may pave the way for a correction in the housing market in the future, which can lead to contagion effects in the economy.
Also, the potential rise of interest rates may put households in a tight spot in terms of higher monthly payments on their debt. If this leads to wide-scale default among indebted households, it can lead to instability in the wider economy.
In the US, debt securities and loans of all sectors stood at US $62.5 trillion in the first quarter of 2015. Again, US national debt is more than US $19 trillion. A high level of national debt which means higher level of government borrowing can crowd out private sector borrowing, which may lead to lower investment. More importantly, a high level of debt can lead to potential instability in the economy.
Also, it can impose excessive burden on future generations as they have to service the national debt and eventually pay it back. It must be mentioned that a significant part of US national debt is held by US citizens while other countries like China and Japan account for the rest. While domestic ownership of national debt makes it less vulnerable to financial or economic chaos, any sudden and major changes in foreign ownership can create problems in the financial sector, which can lead to further problems in the economy.
The second-largest economy in the world, China, also has high level of debt. While public debt stood at 55 per cent of gross domestic product in 2015, total credit excluding equity raising, was close to 200 per cent of GDP in 2015. The high level of debt can create potential instabilities in the economy that can create contagion effects in the Chinese economy, which may lead to financial chaos and unemployment in China. Also, any problems in the Chinese economy may have spillover effects on the global economy.
Many developed countries have high debt-GDP ratio; sometimes, household debt is a bigger concern than government debt. However, as in the case of Japan, most of the debt is held by the citizens of the country. This makes Japan less susceptible to sudden outflow of funds due to foreign investors reducing their holdings of Japanese financial assets. This in turn makes Japan less susceptible to financial and economic instability. Even though public debt was incurred to reinvigorate the Japanese economy, its impact was quite limited while it led to high level of debt-GDP ratio.
Debt is important in a modern economy to both the public and private sector. Public sector debt imposes a burden on the current and future citizens of the country. However, it is important to understand the reason that public debt is incurred.
If the public debt is incurred to finance infrastructure spending, expenditure on retraining of unemployed workers, increased public education or increased public health care, then, they are all investments that the citizens and country can benefit from, in the short-run to the long-run. Therefore, in evaluating public debt, it is important to understand the reason for public debt and its potential costs and benefits to the citizens and the country from the short-run to the long-run.
The same is true for private sector debt. When the private sector is borrowing to invest and establish companies that create employment and grow the economy, it is beneficial for the country. Again, when households borrow to finance their education or purchase a residential property to live in, it is a desirable policy.
However, when household debt increase exponentially to finance housing debt that lead to spiraling housing prices that in turn fuel further housing debt, it can become a vicious cycle that will only lead to a housing market crash that may further lead to a contagion effect on the financial and economic sector of the country. Therefore, policies to cool a hot housing market with regulations for higher down payments, stricter mortgage eligibility and curbing foreign buyers' appetite for purchasing domestic property may stem the disproportionate rise of housing prices and housing debt.
This will reduce the probability of a housing bubble that may lead to financial or economic instability. Therefore, the type of household debt is important when evaluating its potential problems. However, spiralling household debt would obviously be a concern for policy makers.
Governments, central banks and policy makers need to be vigilant of too much public or private sector debt and a too high debt-GDP ratio. When evaluating the potential implication of debt, the reason for debt needs to be taken into account as well. Unsustainable levels of debt need to be curbed so that they do not cause potential financial or economic instability.
Follow HuffPost Canada Blogs on Facebook
Follow Salman Sakir on Twitter: www.twitter.com/SalmanSakir