This come from contributor PazzoMundo at the PazzoMundo Blog:

From John Hussman – Zen lessons in market analysis:

…economic expansions have historically always been paced by rapid expansion in debt-financed classes of expenditure such as housing, capital spending, and sustained (not just one-off cash for clunkers) demand for automobiles. In prior recoveries, debt-financed expenditures have turned up quickly and have typically led other classes of expenditure by nearly a year.

The grandmaster is talking about the US but the message is the same for the Australian economy – certainly over my investing lifetime, the response of the RBA to every economic downturn has been to make money cheap, thereby encouraging debt financed spending and speculation.

Steve Keen makes this same observation in his Debtwatch blog – Every recession has involved a fall in debt-driven demand, and every recovery has involved a return to debt rising faster than income – accompanied by a chart of Private Debt to GDP:

I can see the logic in an argument that says this is an unsustainable trend – after all, GDP is the final arbiter of incomes and, at some yet to be defined limit, a neophyte is likely to suggest that ever rising debt to income is vaguely reminiscent of a ponzi scheme.

To look at this same trend from a slightly different perspective following is the debt to assets ratio (left hand side) and assets to disposable income (right hand side) ratio of Australian households (from the RBA).

How do assets values rise faster than disposable income?

Well, you can always borrow more against the assets in the process of buying them (this is the Christopher Skase model of asset management that was recently embraced by the likes of Babcock et al).  Given the debt to assets ratio has been rising until recently, it might be reasonable to conclude that as a country we have adopted this approach.

You can also borrow more against your disposable income – something that also seems to have become a time honoured trend considering the following chart of debt to disposable income (left hand side) and interest to disposable income (right hand side).

The recent rate cuts by the RBA (in concert with its global peers) had the desired effect of reducing the interest burden of Australian households.  The change in tack as rates start to rise will have the proportionate effect on the way up.  It will be informative to note how our trading banks lending practices adapt in an environment where there isn’t the same steadfast belief in asset price inflation and where interest chews up more and more disposable income.

But as we noted at the start of this article, we set out to explore the prospects of a debt fuelled recovery – and it isn’t looking too flash on these measures.

Perhaps Australia can sustain a higher debt level than its developed world peers.  With population growth of anywhere from 1.5% to 2.5% per annum (or more if illegimate children and hangers on are included), there is a reasonable argument for higher debt levels given a relatively younger population.

But even if that is the case, the question is by how much?  It’s beyond the scope of today’s exercise to explore this much further but my sense is that on a longer term scale we are approaching the debt-funded spending peak.  It’s the Minsky speculative stage just painted on a larger canvas.  Just as the US and the UK have begun the rebalancing process, so too Australia will follow their lead in time.  Our immigration fueled population growth may lead us down a different path – but that maximum debt asymptote stands tall and steadfast before us.