In 2019, Australia’s economy was stalling. House prices were declining even though mortgage rates were only about 3.25 per cent. Policymakers, who seemed to act in the belief they could outwit the business cycle forever, responded as they had for the past three decades. They doubled-down on the country’s consumer-debt-driven economic model.

The specifics were that Australia’s banking regulator eased the ‘stress test’ on new loans. To enable people to secure bigger mortgages, the Australian Prudential Regulatory Authority relaxed the test to 2.5 percentage points above the lending rate, from a previous test of 7 per cent.

Then the virus invaded. Amid the policymaker panic in the era of ‘magic money’, the Reserve Bank of Australia cut the cash to a record low of 0.1 per cent, capped the yield on three-year Treasury bonds at 0.25 per cent initially then 0.1 per cent, and gave banks $188 billion to lend. To encourage the public to borrow, the RBA said low rates would last ‘until 2024 at the earliest’.

People took advantage of mortgage rates below 2 per cent, which meant banks only need stress test their creditworthiness at a rate of 4.5 per cent. Sadly for these borrowers, they are among the third of Australian households with mortgages who need to be crushed financially to quell the inflation triggered by lockdowns and pandemic stimulus. Since May, the RBA has raised the cash rate in 10 steps to 3.6 per cent, an 11-year high. More increases can’t be ruled out because inflation at 6.8 per cent in the year to February is still too high.

The threat from higher mortgage rates is magnified because consumers have borrowed too much. Household debt to output now stands at a near-record high of 120 per cent of (nominal) gross domestic product, one of the world’s highest ratios. For context, this ratio was only 50 per cent at the time of Australia’s last recession in 1990-91.

Today’s threat from higher mortgages can be seen as coming in two forms. The first is that in coming months at least 800,000 households will come off the low-rate mortgage repayments that were fixed for two years in 2021. Brief fixed-term mortgages are normal in Australia’s oligopolistic banking system because banks have the muscle to shove interest-rate risk onto borrowers. In more competitive Europe and the US, people can fix mortgages for up to 30 years and the banks wear the rate risk.

The households moving off fixed mortgages will cop a variable rate of about 6 per cent. Such a sting from 2 per cent adds about $1,320 to the monthly repayments of a 25-year loan of $600,000, which is the size of the average Australian home loan. Absorbing that blow when many household essentials (electricity) are climbing suggests radical reductions in spending on other items. Holidays will be abandoned, kids pulled from private schools, and such like. Ending gym memberships and limited café visits won’t be enough.

The other threat are the people already on variable rates. RBA analysis in 2022 showed that a cash rate at 3.6 per cent – today’s level – would trouble about 50 per cent of borrowers. These households would see spare cash flow plunge by more than 20 per cent. About 15 per cent of owner-occupiers could suffer negative cash flow. If they were to lack savings, they might default, be forced to sell their homes, or have to renegotiate (extend) their loans.

Household consumption forms about 55 per cent of GDP. This means consumer spending is the main driver of economic growth and employment prospects. That house prices are tumbling as interest rates climb only adds to the doubts about the economy. Sliding house prices reverse the ‘wealth effect’ boost to consumption bestowed by rising home values. In any downturn, the newly jobless would swell those in debt distress. Australian banks could be vulnerable if bad debts mount. Most of their borrowers were stress tested at well below prevailing mortgage rates. (The stress test today would be 9 per cent. APRA in 2021 raised the test to 3 percentage points above the lending rate.)

Due to excessive consumer debt, and even when interest rates are low by historic standards, the Grattan Institute warns mortgage rates of 7 per cent could be as damaging as those approaching 20 per cent were in the early 1990s (when the RBA raised the cash rate to a record 17.5 per cent). The institute estimates a variable mortgage rate of 6 per cent today means the mortgage repayments would swallow about 11 per cent of Australian disposable household income, almost double the 6 per cent of disposable income that mortgages slurped in 1990 when variable rates topped 18 per cent.

The explanation for the jump is simply that rising house prices force the young to borrow more against their income than did their parents. The greater potency of increases in the cash rate these days makes it harder for the RBA to slow the economy enough to tame inflation without triggering a downturn.

Given the durability of inflation, it’s hard to see how Australia’s economy can avoid a recession in the coming 12 months or so. If the economy falters, blame the short-sighted policymakers who overlooked that an economic model built on consumer debt must expire one day.

To be sure, there’s nothing wrong with consumers borrowing or any set height at which it’s automatically excessive. Struggling homeowners are not the only threat to the economy. Commercial property, undermined by working from home, could soon pose a systemic threat. Loose monetary policy admittedly protected the economy from the virus (more accurately, from the lockdowns). The jobless rate is not expected to soar and wreak economic havoc – but that’s only a hope. A large immigrant intake could cover the shortfall in consumption. Higher commodity prices are supporting the economy. But that keeps inflation – thus interest rates – elevated. As would the wage increases that unions, backed by Labor governments, are seeking.

High consumer debt combined with higher rates make Australia’s economy vulnerable, even if the global environment was benign (which it isn’t). Prepare for a downward spiral that policymakers, with their spent macro tools, could struggle to arrest. Australia’s record of no recession since 1991 means there are three decades worth of excesses to purge. It’s an open question as to what economic model might arise from the wreckage.