The purpose of this essay is to put the latest crisis in the context of longer-term debt trends in the US and to attempt some predictions in respect to the US economy and financial markets.
Statistics are records of past events. Analyzing statistics means interpreting history, and this can only be done on the basis of theory. We must first have some theoretical notions to be able to render past events intelligible. Of course, historic data cannot be in conflict with the theory used, as that would put the validity of the latter in doubt. But we can neither use statistics to prove the correctness of a theory nor directly discover new theories (although history may give us ideas about potential theories). Before we look at the data I should give a brief outline of my theory, which readers of my book Paper Money Collapse will be familiar with.
The theory – short version
Paper Money Collapse challenges the prevailing consensus on money. This consensus holds that it is good to have something called ‘monetary policy’. Most mainstream economists today, while accepting the superiority of markets when it comes to allocating scarce resources to their most urgent uses, also maintain that in the field of money state involvement is desirable, and that a smoothly functioning economy requires a constantly expanding supply of state paper money and the guidance (manipulation) of certain market prices (interest rates) by a central bureaucracy, i.e. the central bank. More precisely, this bureaucracy should keep expanding the supply of money in such a way that money’s purchasing power declines continuously (moderate, controlled inflation) and that, whenever the economy is weak, it should use its powers to ‘stimulate’ the economy towards faster growth, usually through accelerated base money production and administratively lowered interest rates.
Paper Money Collapse argues that all these notions are erroneous and dangerous. Constant monetary expansion is not needed (not even in a growing economy) and is always highly disruptive. The continuous expansion of fiat money, naturally via financial markets, systematically distorts interest rates, which must lead to capital misallocations and other economic imbalances that will make recessionary corrections at a later stage inevitable. The recessions that ‘easy’ monetary policy is then supposed to shorten or ease are thus nothing but the result of previous monetary expansion.
Recessions can only be avoided by avoiding artificial booms through credit expansion. Once monetary expansion has led to sizable economic distortions the recession becomes unavoidable – and even necessary to cleanse the economy of dislocations. But to make matters worse, in our present system of unconstrained fiat money creation, recessions are – whenever they occur – countered by accelerated money creation (usually via new bank reserves from the central bank) and further cuts in interest rates. Imbalances are thus not being purged from the economy. Instead they accumulate over time making the financial system and the economy overall progressively more unstable. The system is moving towards a point of catharsis: either a complete purge is finally allowed to unfold (painful) or ever more fiat money is created until the public loses confidence in fiat money itself and a hyperinflationary currency collapse occurs (more painful).
I maintain that this theory is logically consistent and not in conflict with past events.
Clearly identifying, let alone quantifying, imbalances is exceedingly difficult if not impossible. It is usually during crises that imbalances become visible as such. Consequently, analyzing data requires a considerable degree of judgement. In the following I look at ‘excessive indebtedness’ as a major dislocation caused by fiat money expansion.
The present monetary system naturally encourages the excessive accumulation of debt, and discourages deleveraging and disinflation, although at certain points in time these may be difficult to avoid altogether. During the financial crisis deflationary and recessionary forces briefly gained the upper hand. To what extend have they purged the system of money-induced imbalances? Has a meaningful ‘cleansing’ of imbalances taken place? If so, has the economy ‘healed’?
I had a look at the Federal Reserve’s Flow of Funds data and the following picture emerges.
Over the 31 years from 1981 to the end of 2012, total debt outstanding in the US economy grew from $5,255 billion to $56,280 billion. The debt load has increased continuously from year to year – with only one single exception: 2009, when total debt declined by just 0.2%. Debt has grown faster than nominal GDP in 27 out of 31 years. The average growth rate in total debt was 8% per annum, compared to 5.4% for nominal GDP. In 1981, total debt outstanding was 168% of GDP, today it is 359% of GDP.
In 1981, total debt broke down as follows: household debt was about 48% of GDP; business debt was about 53% of GDP; the public sector owed about 38% of GDP and the financial sector 29% of GDP. Note that of the four major sectors, the public sector and the financial sector were the two smaller ones. Debt of the financial sector was only slightly more than half of corporate debt.
Things looked very different by the end of 2012: Household debt had ballooned to 82% of GDP and corporate debt to 81%. Public sector debt now stood at 93% of GDP and financial sector debt at 103% of GDP. The public and financial sector had become the largest debtors.
While corporate debt was about 7.5 times larger in absolute terms at the end of 2012 than at the end of 1981, financial sector debt was 17 times larger. Over the 26 years from 1981 to the eve of the current financial crisis in 2007, financial sector debt grew at an average clip of more than 12% per annum compared to about 6% for nominal GDP over the same period. When we entered the present financial crisis in 2007, financial sector debt stood at an all-time high for any sector in US financial history, at 131% of GDP.
I maintain that such a dramatic growth in overall indebtedness, as well as the specific breakdown of that growth by sector, is symptomatic of our unconstrained fiat money system with its constant money growth and lender-of-last-resort central banks that encourage debt accumulation and promote high-leverage strategies in the financial sector. That this has led to substantial economic instability is now self-evident.
Has the US economy deleveraged since 2007?
The two sectors that were most exposed in 2007 were households (via the residential mortgage market) and the financial sector. Both sectors have shed debt since 2007. Both have deleveraged. Households reduced their debt from a record $13,712 billion in 2007 to $12,831 billion at the end of 2012. These $881 billion mean a reduction of 6.4%. The financial sector was forced to cut debt even more: From 2007 to 2012, total outstanding debt of the financial sector was reduced by more than $2,100 billion, a reduction of 12%.
Such reductions in debt were unprecedented in the 31-year history we are looking at here. At no point before had household debt and financial sector debt declined on a year-over-year basis. In this respect, the events of the recent crisis were indeed unique. ‘Cleansing’ has occurred. But how meaningful are these reductions? In absolute terms – total amounts of debt outstanding –, both sectors are roughly back to where they were …..in Q3 of 2006, barely a year before the crisis started! Not much has happened in absolute terms. However, in recent years, the economy has continued to grow moderately, so as a percentage of GDP, household debt is today roughly where it was in 2002/3, and financial sector debt is about where it was in 2001/2. In relative terms, a decade of excess has thus been unwound.
Nevertheless, as mentioned above, the total debt load has continued to grow and stands at an all-time record today. The reason for this is mainly the explosion in public sector debt. While households and financial firms have cut debt by $3 trillion since 2007, the state has taken on an additional $6.6 trillion in new debt over the same period– almost all of it at the federal level! In fact, outstanding debt of the federal government has more than doubled since 2007!
The trend of ever-rising overall debt has thus continued. The deleveraging in the household and financial sector has, however, resulted in a reduced pace of debt accumulation overall, despite heavy borrowing from the federal government. In 2010, for the first time since 1992, the economy has grown faster than total debt, and this has continued in 2011 and in 2012, if at a slowing pace. Consequently, total debt stands at 359% of GDP today, slightly down from its peak of 381% in 2009. At 359% debt-to-GDP is back to where it was at in early 2007. Again, not much deleveraging has occurred in total.
Conclusion and outlook
I cannot see that the recent crisis has already brought about some kind of fundamental healing of the US economy, some much needed purge of monetary excesses. Yes, households and the financial industry have trimmed back and are now probably in better shape than a few years ago. Household debt numbers now seem to be stabilizing, meaning deleveraging could be coming to an end, while there is no sign yet that financial deleveraging has concluded. Of course, given the prevailing belief system, those who control the levers of the fiat money system are doing what they can to discourage further deleveraging. Zero interest rates and open-ended QE are hardly conducive to debt reduction.
Here are my present forecasts, and they are necessarily highly speculative:
- Super-easy monetary policy will continue as far as I can see. The Fed has declared that it wants to use monetary policy to boost employment (the hubris of the bureaucrat!). But deleveraging in the financial sector, if it persists, would be a problem for the Fed’s strategy. The financial sector is crucial in transmitting easy policy. The Fed can thus reasonably be expected to continue leaning against deleveraging with all its might. And if and when deleveraging turns into re-leveraging, the Fed will probably nurture it for some time.
- Public sector profligacy is not a crisis phenomenon but has been in full bloom since 2002 and is now in large part structural. A political solution looks unlikely any time soon. The state will thus continue to be the main driver behind the overall growth in debt. Funding this debt accumulation is not a problem with the Fed now the biggest marginal buyer of Treasury securities and the Fed unlikely to abandon super-easy policy anytime soon.
- The corporate sector has not been a major driver in this story so far. Recently, corporate debt has begun to expand again. It is not unreasonable to assume that this will continue.
- In aggregate, the picture could be the following: outstanding debt of the public sector will continue to grow rapidly, corporate debt mildly to maybe strongly; household indebtedness might stagnate. The wild card remains the financial sector. My guess is that what little overall deleveraging we experienced – measured as a modest decline in total debt in relation to the economy’s capacity for income-generation, i.e. GDP – is in the process of being reversed. The interventionists (i.e. the mainstream) will hail this as a success of policy. ‘Debt-deflation’ has been avoided – for now. A more realistic assessment is that the economy is as much on financial steroids as a few years ago, and –in aggregate – as fragile. Expanding debt levels further from here will require interest rates that are continuously depressed through policy and an even more activist and interventionist central bank. The Fed is fully on board with this.
- Deflation is very unlikely from here. The debasement of paper money continues. Inflation rates should begin to move higher.
Debt-GDP-ratios of 359% (now) or 381% (2009) are unusual historically. The ratio was below 200% at the start of the Great Depression and it peaked at a touch above 300% in 1933, when nominal GDP collapsed. The current debt load is unprecedented. But then, countries such as Japan and the UK have total debt in excess of 500 percent of GDP. Disaster still looks inevitable but maybe not imminent.
…a final word on the bond market.
It so happens that the start year of the above analysis – 1981 – also marked the peak in bond yields in the US. 10-year Treasury notes reached 15% back in 1981 and went on a downward path from there that lasts to this day. We have had an almost uninterrupted, 31-year bull market in bonds. Not only Treasuries but also corporate and mortgage debt are presently trading at or near historic lows in yield. Although the US economy never had to carry more debt – certainly never more in absolute terms and almost never more relative to GDP – the compensation that investors get for holding all this debt has never been lower!
Sure, inflation was still high in the early 1980s but the structural drop in inflation was over by 1992. CPI inflation has broadly moved sideways in a stable range since the early 1990s without any additional disinflationary momentum.
It seems that over the past three decades the debtors were encouraged to take out ever more debt because the lenders – the bond buyers – were happy to hold ever more debt at ever lower yields. A market in which demand for assets keeps rising at persistently rising prices (persistently falling yields) has all the ingredients of a bubble. I think the US bond market – and by extension, international bond markets – could be the greatest bubble in history.
The big question is when will this bubble pop?