Will record debt levels lead to disaster?

Back in 2008, there was a bit of a financial crisis. You may have heard about it.
Of course you did. To recap, the bursting of the American housing bubble helped lead to a liquidity crisis around the world,culminating in the collapse of Bear Stearns and Lehman Brothers, as well as the bailout of the entire U.S. banking system. As an interested market observer, those few months were absolutely riveting. There were legitimate concerns the whole financial system was going to collapse.
Essentially, the crisis was caused by liquidity, or a lack thereof. For those of you who need anexplanation, liquidity is a person (or business’s) ability to raise cash when they need it. The reason why so many personal finance bloggers stress the emergency fund so much is because it serves as liquidity during times of need. Since banks don’t make money on cash reserves, they typically don’t keep a lot of cash just kicking around. They lend it out, often using leverage to lend out their reserves many times over. When business is going well, this is an effective strategy for making money. When things aren’t going so well, these creditors refuse to lend the money needed. When liquidity dries up, disaster happens, and banks go under.

Record debt levels in Canada

Seemingly every quarter, Canadian households set a new record for indebtedness. In the 3rd quarter of this year, Canadians debt levels sat at 152.9 percent of their disposable income. In fact, according to Bank of Canada Governor Mark Carney, household debt is Canada’s greatest financial risk, at least domestically. One in ten Canadians are in serious danger of defaulting on their debts, meaning that greater than 40% of their income is being used to service their debt.
Considering how low interest rates are, this is an alarming development. Canadian debt to income levels have passed both the U.S. and U.K. record levels, which peaked in 2007, just a year before the big financial crisis. For many Canadians, just a few weeks without a steady paycheque would spell financial disaster. They just don’t have the liquidity required to weather any sort of financial storm.
If you combine record debt levels with record Canadian home prices, it seems Canadians are walking atreacherous financial tightrope. If interest rates ever go up in a significant way, many Canadians who are living on the edge may be knocked off that ledge.At least in this author’s opinion, this can’t end well.

European debt crisis

Meanwhile, we have a bit of a situation over in Europe. Greece, as we all know, is a fiscal disaster. The country has been bailed out by the wealthier members of the European Union several times, and they’re still not out of the boat. Spain, Portugal, and Italy are among the countries that have government debts exceeding 100% of GDP. The market is concerned about default, so it’s making it more and more expensive for these nations to issue debt, in the form of higher interest rates.
To make matters worse, there are beginning to be concerns about the rest of the European Union. I’ve heard rumblings that Belgium and France will be the next countries to run into debt problems. At what point does the European Central Bank admit defeat, and just let these countries default on their debt? Sure, it would mean the collapse of the Union, but they don’t have unlimited amounts of capital to bail everybody out anyway, unless they start printing the money. This would in turn create inflation, hence devaluing the Euro.
Unless the entire European union manages to get their government spending under control very quickly, this situation could end very badly. I’d avoid all investments in Europe, especially financials.

Meanwhile, there’s Japan

Many people mistakenly assume the country with the highest debt to GDP ratio is the United States. While the United States is high, Japan’s government actually owes more as a percentage of GDP.
Many smart economic minds aren’t concerned about Japan, since most of their government debt is held by its own citizens. (unlike the U.S., who actually lists Japan as one of its largest creditors) Since Japan has had a solid personal savings rate throughout the years, their citizens have the excess capital to buy government debt.
This is changing.
Japan is the oldest country in the world. They are slowly losing people, as more die than are replaced. Immigration into the country is practically non-existent. Soon, they’ll have more people collecting pension benefits than are contributing to the system. Since more and more people will start drawing from their savings, this will quickly turn the savings rate negative. Without their own people to buy the government debt, Japan will have to depend on foreign investment. Japan’s balance sheet is in worse shape than Italy’s or Spain’s. This foreign investment will be expensive, if it even happens.

What does this mean for you?

If a massive European or Japanese debt crisis happens, the pain will be felt all over the world. North American stock markets will take it on the chin. Investors will run to the exits, since defaults in general kind of make them nervous.
I’m not going to tell you what you should do with your money, because that’s ultimately up to you. I’m selling some winning positions, and sitting on a little more cash than usual. I think, a year from now, there will be a cheaper stock market out there. What do you think about the record debt levels? Will we see defaults in the near future? Or am I some sort of weird crazy guy?