DEBT HISTORY & SECULAR GDP
by Jas Jain
January 23, 2005
Note: This is an original work. Unlimited permission is granted to forward, publish, post, and use in personal work with full credit. Please feel free to forward to family, friends and coworkers. Thank you. J.J.
Since the Puritans arrived in North America, my fellow Americans, �You have come a long way, baby!� In jolly old England, during the heydays of Puritan influence in the government, soldiers were sent to homes to assure that there was no merriment on the Christmas Day. (Puritans were always a small minority in England but their influence, like in early American colonies, was way disproportionate to their numbers; Cromwell was a Puritan). Christmas was not supposed to be a Merry Christmas, a pagan practice, but a Somber Christmas. And the fear of soldiers was merely to remind the population of this truth. It has never been easy to keep people in line. Borrow-and-spend is as un-Puritan as it gets in economic behavior. I wonder what percent of the so-called Religious Right in America engaged in the pagan practice of Christmas celebration. And how many went into further debt to satisfy their �sinful� desires. One sin leads to others.
In their borrow-and-spend behavior, and we are not talking about borrowing to maintain moderate subsistence, Americans have adapted the Charvaka philosophy, one of many ancient Hindu philosophies of life, not unlike many of the ancient Greek philosophies of life (my translation from Sanskrit):
Live in pleasure.
Even if you must incur debt,
Keep drinking melted butter.
Have Americans been �drinking melted butter� with a vengeance or what? And it shows! BTW, �drinking melted butter� is a metaphor for a life of luxury and carnal pleasures including the pleasure of eating rich, or buttery, food that tastes good.
Debt plays a central role in any highly organized economy. Like many things in human affairs, it can be properly used or thoroughly ab-used. Debt is the single most important variable hanging on the neck of the US economy today and thereby on the world economy because of the world economy�s extreme dependence on the US economy. It is good enough for me that Warren Buffett and Bill Gross, two gents who are far more astute than Alan Greenspan when it comes to finances and other people's money, are very worried about debt. My focus on debt goes back to 1998 when I first understood that, historically, the stock market was a substitute very-high-risk debt market! In 1998 or 1999, commenting on the fate of the US stock market and the economy, I first used the phrase: It is the Debt, stupid!
Debt in the US is the biggest bubble and the mother of all the other bubbles. In this regard, Doug Noland�s weekly Credit Bubble Bulletin, for the past several years, is the best chronicle of the process that is headed straight to Greater Depression. (BTW, Greater Depression is a term that I coined after comparing the imbalances in the US economy in recent years with those during 1925-1934; the term has been picked up by few people who were on my e-mail list during 1998-2000, including James Davidson who wrote a piece with the title of �Greater Depression�).
The primary objective of this paper is to quantify what will happen to the US economy when the excessive private debt is corrected, one way or the other, i.e., by a combination of repayments and defaults, and to let you conclude on your own why I think that the Greater Depression is unavoidable. Higher that we climb up the debt ladder, deeper the US economy would fall during the coming Greater Depression.
Few Words On Methodology and Debt Components
All the raw data for the graphs are from official sources, e.g., Federal Reserve. Wherever there are discrepancies in various series from the same source, due to revisions, I have adjusted the data towards what I believe to be the later revision. Debt data from 1945 onwards are from the latest Federal Reserve revisions, with minor adjustments as appropriate, and data prior to 1945 are the best extrapolation from the available data. The emphasis is primarily on data after 1950; the data from 1929 to 1950 are primarily to understand the workings of the long-term economic cycle, i.e., the Longwave. For 2004Q4, I have assumed the same level of increase in the Household Debt, USG Debt and the GDP as 2004Q3.
The Household Debt data refers to consumption related debt, as individual debt for investments is excluded from it. There is a tiny component under the category of �other� included in the reported Household Debt. Yes, one�s residence is a consumption item; it is an expense like any other expense regardless of how one chooses to pay for it. If one borrows on his, or her, residence and spends on cars, motorcycles, vacations, or other consumption items, a common practice in the US these days, it is very much a part of the consumption debt.
The US Govt. (USG) Debt data is the actual debt that is outstanding. The book entry of Social Security Trust Fund and all other future obligations are not a part of the USG Debt outstanding, which is a contractual obligation, i.e., a non-payment as per the terms would result in default. The future obligations, including the Social Security payments, are NOT contractual, i.e., the terms, or the �formula,� can be changed at any time! The laws that made the future promises could be, and would be, changed when it becomes obvious that they simply couldn't be fulfilled without crushing the younger workers with a level of taxation that would leave very little incentive to work hard; and thereby crushing the economy.
Another important component of the Total Debt, and the largest, is Investment Debt, both individual, including partnerships, and corporate.
The debt owed by local governments (LG) is small in comparison to the Household Debt, the USG Debt and the Investment Debt. Its impact on the economy is local and over a shorter period of time because local governments are required to balance their budgets over a period of few years rather than decades. Recent events in California are good examples of this. The LG Debt is certainly not hanging on the neck of the US economy and the local govt. services would suffer as the local economies suffer. If things get really bad, LG Debt would default in many cases. If my scenario for the US economy pans out, two states that would suffer the most, relatively, would be California and New York, not necessarily in that order, and two localities that would suffer the most would be Silicon Valley and New York City. This would be due to the collapse of the financial economy and the stock market (yes, the stock market bubble has not burst yet, only popped slightly), both of which have a high component of chicanery, even fraud, in their boom. Those localities that live well by the fraud would suffer well by the fraud! (I know many honest and very intelligent people in Silicon Valley and NYC; it is the few Crooks who spoil for the rest kind of situation there).
Central Role of Debt In Capitalist Economies
Level of debt, in relation to production and incomes, plays a central role in a politico-economic system such as that of the US. The GDP is a good proxy for the production of goods and services and incomes; hence, the ratio of debt level to GDP is a good long-term forecaster of the economy. Unfortunately, the long-term could be too long for most people and they begin to believe that it would be different this time. Mr. Long-term, like the great Shogun, walks in confidently after all the resistance has been dissuaded, or spent, or obliterated.
Excessive debt creates many imbalances and distortions in the economy. Asset bubbles, e.g., stock market and residential real estate, are prime symptoms of excessive debt in the US in recent years. In the beginning, excessive debt feeds these asset bubbles and then the asset bubbles induce households and businesses to take on further debt, thereby creating an unstable condition, positive feedback loops, that always end in an economic downturn as the bubbles invariably burst.
ASSET BUBBLES ALSO DISTORT ECONOMIC VARIABLES LIKE INFLATION RATE AND PRODUCTIVITY. Excessive Investment Debt leads to over capacity and it is deflationary. At some point it leads to increased business bankruptcies and creates recessionary conditions for the economy. The over investment in technology during 1990s and the recession of 2001 are examples of this. Other things being equal, the increase in Household Debt exerts inflationary pressures while decline in Household debt exerts deflationary pressures. I hope that this is obvious. As the economy progresses thru the long-term cycle, other things are not equal in terms of inflation. But, our goal here is to look at how debt impacts various economic variables including the inflation at the consumer level.
Long-term, inflation rate has been falling in the US for some 24 years. At the end of 2003, the core inflation rate hits its low of 1.1% and is up by a percent since. Yet, this does not reflect change in the long-term trend. Deflationary, or disinflationary, pressures in the economy are very powerful. The most amazing thing is what it took to keep the inflation rate from falling � the biggest 5-year borrow-and-spend spree by households recorded in history anywhere that I am aware of.
Productivity reports in the US are a joke. How do you measure productivity of a financial, or an asset bubble, economy? If the same house by a homebuilder is sold for 2-3 times its price compared to six years ago, as has been the case in Southern California, is everyone involved, except for construction workers, at least twice as productive? Is the person who arranges the loan for 2-3 times the amount and gets his, or her, points, or commission, that is 2-3 times now that much more productive? Or, a realtor, who now earns 100-150% higher commissions by the sale of the same house that much more productive? Quarterly productivity gains at annualized rates of 8.2%, 1.5%, 2.7%, etc., etc., tell you some thing. Do actual productivity gains vary that much? How does one measure productivity of a lawyer? Or, a Harvard professor?! For the most part, in the US we get lot worse �education� for lot more money these days compared to the past. Do we measure the productivity of a highway patrolman by how many tickets he writes? Of course, how could I resist asking about the productivity measurement for Wall Streeters? I think that more and more of wrong kind of �productivity� is taking place. Anyway, we have a measurement problem. Let us examine the productivity numbers after all the bubbles have been fully burst. The productivity measured over the past 25 years is abysmal, but somehow the past 9 years have been wonderful. Maybe, bubbles do have some thing to do with that.
Role of Debt In Concentration of Wealth
One rarely known role that the debt plays is in concentration of wealth and the resulting inequality. THERE IS ALMOST ONE-TO-ONE CORRELATION BETWEEN THE INCREASE IN HOUSEHOLD DEBT AND THE INCREASE IN THE WEALTH OF VERY FEW AT THE TOP. I did not come to this insight on my own; I learned about it from an obscure book written in 1934 that I bought in a used-books store for $2, 7-8 years ago; later I was surprised when I was able to verify this from the facts in the recent years. It is amazing how powerful the propaganda machine in the US is in suppressing the knowledge that might harm the interests of the rich and powerful. LET US SEE, THE HOUSEHOLD DEBT INCREASED BY SOME 5 TRILLION DOLLARS OVER THE PAST EIGHT YEARS AND THE WEALTH OF THE VERY RICH AT THE TOP ALSO INCREASED BY A SIMILAR AMOUNT. COINCIDENCE?
The asset bubbles in stocks and housing have given households a false impression of their wealth, but what happens when these asset prices fall to where they were ten years ago, something that has happened several times in our lifetime? On the other hand, the very rich have no personal debt and have lot more of their assets outside of stocks and housing. Bill Gates and Paul Allen, Microsoft founders, have lot less in stocks today than they did eight years ago, have no personal debt, to my knowledge, and Gates has lot in US Treasuries. Households have lot more in stocks and lot more personal debt than they did 8 years ago. Twenty years ago, Gates had almost everything in stocks (he felt no need to diversify then or for the next ten years!) and households had very little in stocks. If the housing prices were to fall to where they were ten years ago, a large number of households would have negative equity in their homes! Forget about wealth that could disappear so easily, as the lovers of tech stocks found out few years ago.
Debt and Long-Term Economic Cycle
The attached Fig. 0, the only graph from an external source, has appeared in many articles over the past year and if history is any guide, and I don't know of any better guide, it portends an economic disaster far worse than the Great Depression in the US that lasted for some 20 years despite the huge economic activity during the WW II. BTW, at the end of 2004, the TOTAL DEBT is higher than 300% of the GDP.
What got the US out of the Great Depression was not the WW II but the normal working of the long-term cycle � the debt was washed out, as can be seen in Fig. 0, and the accumulated savings and the pent-up demand fueled the explosive growth during 1950-1965. In 1950, the private debt, Household Debt plus the Investment Debt, was merely 30-40% of the GDP and the US Govt. (USG) Debt, at 70%+ of the GDP, was being paid down very rapidly. And the GDP itself was below its long-term trend-line. The private debt, presently, is well in excess of 200% of the GDP, maybe close to 250%, as a result of over consumption (fueled by the Household Debt) and over investment (fueled by the Investment Debt). Excessive private debt leads to the Boom and the washing out of the excessive private debt leads to the Bust. It is that simple, ladies and gentlemen.
If you take a second look at Fig. 0 and focus on the two areas designated as �DEBT BUBBLE,� you will see a fit-and trim �person� on the left and a �half person� with huge middle and fat legs on the right. Sign of the times? :-)
Different Strokes (Resolutions) for Different Folks (Debts)
The three important components of the TOTAL DEBT � USG Debt, Household Debt, and Investment Debt � have different time horizons when it comes to their resolution if they are excessive, or unsustainable, by historical standards. Let us look at them one-by-one.
The USG Debt
Regardless of what people think, the USG has been extremely honest, or open, about its debt and has one of the best, if not the best, record of any entity, public or private, in history, of repayment as per the terms. The idea of the USG �Printing Money� to pay its debt, i.e., not by taxation and borrowing in the open market, is absurd and would not happen until after a financial catastrophe like the Greater Depression, or some other catastrophe like war in the case of Germany in 1920s. �Printing Money� would be suicidal for the USG and I don't expect the USG to commit suicide any time soon. Too many powerful people, in the US and around the world, have too much vested in the USG remaining alive and solvent. A Greater Depression is preferable to death of the USG, i.e., the politico-economic system, as it exists today; and it would be preferable to all concerned.
The USG Debt outstanding today is anything but excessive by historical, or any other, standards, as we shall see later when we focus on far more serious and immediate debt problem. The only time that the USG Debt has been excessive has been during wars and in very case the excessive part was paid off promptly. By looking at historical data, I believe that a USG Debt level up to 40-50% of the GDP is sustainable very long-term, i.e., hundreds of years. Any govt. that enjoys the highest debt rating, as do govt. of Japan and the US, can sustain much higher level of debt if the interest on that debt is a very small percent of the GDP, as is the case in Japan. The Japanese govt. has a huge debt outstanding and continues to run huge deficits to keep its best customer, the US, happy! (Otherwise, the US will accuse the Japanese govt. of not doing enough to spur growth of the economy; when Americans are in a deep dodo and in no position to tell the Japanese govt. what to do, the Japanese govt. will take care of the deficits by a combination of raising taxes and cut spending).
The only problem for the USG Debt is in the future beyond the next 10-15 years in terms of future obligations as those obligations are defined, or understood, today. Most Americans already believe that the unrealistic level of future promises, e.g., Social Security, would be lowered. When the time comes, whereby not lowering the promised benefits would hurt the economy and the younger workers, the laws that promised the benefits would be changed. The thing that matters the most for govt. debt is the interest payments as a percent of the GDP and that percentage in the case of the USG Debt, approx. 2%, has been declining for most of the past 10 years and still quite low. As we shall see, the USG is far more responsible compared with the American households. Also, the USG is lot more trustworthy than the bankers (more on this later)! Anyone who trusts Wall Street over the USG, for his retirement savings, needs to have his brain examined. Those Baby Boomers who are counting on their 401-Ks and not much on the Social Security for their retirement have a shock waiting for them.
Remember that ten years ago 4-6 trillion dollars of cumulative deficit was projected. Then, some 5 years ago, a 3-4 trillion dollars of cumulative surplus was projected. Greenspan had bought into the surplus scenario! Now, we are back to 3-5 trillion dollars of cumulative deficits. Looks like these projections should be taken with a big grain of salt.
The bottom line is that whatever the USG Debt problem is, it is at least ten years away and lot will happen to the US economy in those ten years. The focus on the USG debt is a diversion tactic to take the focus away from the real, more serious, and immediate debt problem. THE USG HAS HAD BUDGET SURPLUSES, AND PAID DOWN THE DEBT, SEVERAL TIMES IN OUR LIFETIME INCLUDING DURING 1998-2001; THE LAST TIME THAT THE US HOUSEHOLDS PAID DOWN THE DEBT, IN NOMINAL DOLLARS, WAS 1944! (In real dollars, the last time that the US households paid down debt was during the deep recession period of 1980-82). I would stand in a long line, if I have to, to loan to the USG and I would not be even seen anywhere close to a place where I could lend to a bank or an American household! I would not buy any bank stock for more than the price of a Subway sandwich; that is when the sandwich would cost $1.99.
The Investment Debt
Unless explicitly stated, I am not including the stock market as a debt substitute as a part of the Investment Debt. The Investment Debt is the largest component of the Total Debt and has the sharpest variations over time, especially, during the last phase of the Boom and thru the whole period of the Bust, which in the last cycle covers the period 1927-1951, approximately. (In the current cycle, it began approx. in 1996 and could last until 2030 because the bust period of the current cycle would be deeper and last longer). During the earlier cycle, the Investment Debt was as high as 185% of the GDP during 1935-36 and as low as 30% of the GDP soon after 1950. During the early 1950s, when the current Longwave cycle began, most of the corporate investment came from the income of businesses and most of the individual investment came from the savings. That is what 20 years of depression does to the psyche of investors! (What applied to business investment psychology also applied to the stock market, which made a very important low in 1949, the lowest-risk long-term entry point in the last 80 years; the risk at 1932 low was much higher).
Speculative investments are very common in the US. Thing about speculative investments, by corporations as well as individuals, is that they invariably lead to over-investment as everyone rushes to cash in what is believed, at the time, to be a great long-term investment driven by great demand, which is hyped. The rush into speculative investments is invariably facilitated by debt. At some point the debt becomes excessive. Generally, during a speculative period, 5-10 years worth of demand, or the capacity to meet the demand, is fulfilled in 2-4 years of time. Within 5 years, occasionally a bit longer, the reality of over-investment hits home. What promised to be highly profitable just a few years ago becomes a losing investment, especially, for those who came late to the party. Debt service makes the matters worse. The speculation ends but the consequences continue much longer because of the debt.
In a country as large as the US and the economy as diverse, there are several speculative episodes, many local and some nation-wide. However, there is a unique period during an economic Longwave, that lasts 50-80 years in duration, during which the speculative investments take on a whole new magnitude � a sustained period of falling inflation and interest rates! That period, in the Longwave parlance, is called the Fall season (Summer is the period of rising inflation and interest rates), which in the US began around 1981-82.
To someone who remembers 15%+ mortgage rate in early 1980s, a mortgage rate of 6% is like a kid in the candy store. He thinks that he can afford twice as big a home as he might have been able to earlier with the same real income. He doesn't recall that rates were even lower when his father bought the house and his father didn't buy twice as big a home because the rates were so low.
A similar psychology pervades businesses and investors of all stripes during the period of falling rates. Lower rates make more investments with borrowed money profitable in the beginning. Faster you borrow and invest in capacity farther ahead you are because otherwise your competition would beat you to it. The race is on. Lower the rates keep marching, more and more join the race. The field gets crowded and people start running into each other. At some point, lower rates become secondary to the process of borrow and invest. The race comes to an end, of exhaustion if nothing else. The exhausted participants find themselves left with the debt.
Poor investments that lose money, as well as speculative investments, don't continue for longer than five years, certainly not as a norm. For the most part, this applies to the stock market as well (the tech bubble of 1990s lasted slightly longer than 5 years) whereby there are major corrections after a big speculative move even during a much longer secular bull market. The average period for speculation is somewhere between 3 and 4 years. I expect this to be the case for the hot housing markets in the US where the speculative phase began some time during 2000-01 after the stock market bubble burst.
Based on the historical data on debt that is available, my best estimate is that Investment Debt somewhere in the range of 75-100% of the GDP is sustainable very long-term. Currently, the Investment Debt level of 150-175%, already in the process of correcting since 2000, except for residential real estate (not including homeowners), has lot further to go. Artificially low rates by the Fed would only prolong this process. During the investment boom, employment and incomes for household also boom. Conversely, during investment retrenchment, employment and incomes of the households suffer. This has been clearly the case in the US during 2001-2004.
However, investment boom in residential real estate, fed by artificially low rates, has countered some of the retrenchment in other areas. But, as I have noted above, this too will end and what happens when this feeds into the general investment retrenchment? I believe that when the housing boom ends, the real serious downturn in the US economy will begin.
Investment (please note that hiring people is very much a part of investment by businesses) retrenchment is the most likely, or common, trigger of a recession, or depression. What determines the depth and the length of a recession, or depression, is the end-user, i.e., consumer, demand. Therefore, out focus shifts to the future of consumer demand.
HOUSEHOLD DEBT IN THE US
Our discussion now progresses to what I believe to be the most worrisome component of the TOTAL DEBT in the US � Household Debt, i.e., consumption debt, because of its unprecedented level. Investment Debt may be good or bad for the economy�s future, as we have discussed above, depending upon its level, but Household Debt always hangs over the future consumption. This is because if you borrow to consume today, it must cut into your future consumption.
If you borrow more money to move into a bigger home, and assuming that your moving into a bigger home is not going to affect your future income, then it must have a negative impact on your future consumption of other items compared to had you not borrowed money and stayed in the smaller home. Remember: There is no free lunch! If you don't believe this, then you believe in Santa Claus, or tooth fairy. The idea that the home one lives in, or a vacation home, is an investment is a total nonsense. It is part of consumption. What may feel like an investment today might feel like a stone around one�s neck tomorrow, or the day after.
The Magnitude and the Growth of the US Household Debt
Fig. 1 shows the growth of the US Household Debt for the past 60 years. In case you have not seen an exponential curve, lately, this graph is pretty close. Please note that the past ten years in the US had low inflation; therefore, the recent exponential growth is not due to inflation. Let us put this growth in perspective.
Since 1940, from its low in 1942, the US stock market, as measured by S&P 500, at its peak in 2000, went up by a factor of 200 over a 58-year period; from its low in 1944, the US Household Debt has gone up by a factor of 400, over a period of 60 years, and it is still going strong. During the same 60 years, S&P 500 has gone up 100 fold and the GDP up 50 fold. If we were to reconstruct the Nasdaq index back to March 1940, then, in March of 2000, the graph of Nasdaq, going back 60 years, might have looked like the graph of the Household Debt except that the Nasdaq index would have lot more ups and downs along the way, but the end points would have matched closely.
As we have already stated, debt levels should be looked at relative to the GDP. Fig. 2 is the most informative synopsis of the two debts � one that most, including Greenspan, are worried about, i.e., the UDG Debt, and the other, the Household Debt, that I believe should be the real cause of worry for the next few years. The USG Debt during the WW II peaked around 120% of the GDP and was paid down at a very good pace. If we just look at the past 40 years, after most of the WW II debt was paid down, the current level of the debt is right in the middle. It is lower than what I believe is sustainable very long-term. Before we begin detailed examination of the Household Debt in Fig. 2, let us step back once more to get some historical perspective.
Household Debt During the Great Depression
Fig. 0 has poor time resolution, but if one examines it carefully the peak in Total Debt to GDP ratio occurred soon after the depth of the Great Depression and not during the bubble period of 1928-29. This was partly due to decrease in the GDP. The Household Debt, in nominal dollars, was actually declining, which did not exceed its 1929 level, on a consistent basis, until 1946, after the end of the WW II. The Household Debt as a percent of the GDP, prior to 1950, peaked in 1932 at 44% and bottomed at 12% during 1944-45, when people couldn't buy many things that they might have wanted to. After 1932, it was the Household Debt that kept the depression going for a very long time unlike the previous depressions, which were shorter and when Household Debt was negligible! (The farm debt, for the most part, was a business debt).
Households kept paying down the debt and those who had jobs and could borrow were unwilling to take more debt for consumption. It was not the level of debt, which was lot lower compared to today, but the self-chastisement and some remorse, I presume, that impacted people's psyche about borrow-and-spend. They started to save, which is the right thing for an individual to do in tough economic times. When people's psychology changes to caution, low rates, easy terms, and promotions don't have the same inducement. The situation was somewhat similar to Japan of the past 10-12 years.
The end of the war created depressionary business conditions because of cut down in defense spending, the major source of economic activity during the war. Consumers had lot of savings and hardly any debt, but after some of the pent-up consumer demand was met the business conditions weighed on people's minds. Total Debt was not increasing but the GDP was falling. It took 5-6 more years after the war to washout private debt to barebones level.
Frankie was singing love songs, lots of cute kid everywhere (the beginning of the Baby Boom), and people started to feel good about everything and started to spend more and even borrow more. Spring was in the air! I wish I was old enough (just a tiny baby in 1950), had money to invest, and understood the economic Longwave. I would have jumped into the stock market (no Scam Market back then) headfirst! Those were the days�
Household Debt Since 1950
Let us carefully examine the red graph in Fig.2. You can clearly delineate three periods � 1950-1964, when the Household Debt went from 25%-45% of the GDP; 1965-1983, when the Household Debt remained essentially flat in the range of 43-48%; and 1984-2004, when the debt as % of GDP kept going up, with minor rests, and accelerated growth during 2000-2004 and now stand at 86% of the GDP. When the Fed releases the next flow-of-funds data covering 2004Q4, the Household Debt would top the 10 trillion dollars mark. Any form of consumption debt, even if it is for a house, it is not only not an investment but a disinvestment! Higher-priced home means higher property taxes, higher maintenance costs, higher insurance, and usually, higher utility bills, etc.
For a moment, let us focus on the 19-year period, 1965-1983, during which the Household Debt as a % of the GDP was flat. This period covers the whole gamut of economic and political conditions � low inflation and interest rates, very high inflation and interest rates, severe recession, strong growth, historically high stock prices, low stock prices, Republican Presidents, Democrat Presidents, war, peace, domestic unrest, racial violence, political murders, etc., etc. Based on these facts I am of the opinion that a Household Debt level somewhere close to 45% of the GDP is sustainable, very long-term. Any level of Household Debt above 45% of the GDP is excessive and over long-term it would correct and fall below 45%; and in all likelihood quite a bit lower, because things always over-correct.
Regardless, the fundamental fact is that higher the level of borrowed consumption at any given time, it would negatively impact future consumption. Conversely, lower level of borrowed consumption today bodes well for the future consumption. Higher consumption leads to higher GDP and lower consumption leads to lower GDP. Essentially, borrowing and consuming today means borrowing the GDP growth from the future! Usually, with additional cost in the form of interest.
What Is Driving Excessive Household Debt?
There are so many causes of why this has taken place without any regard to its future consequences that it says a lot about the irresponsible behavior from the participants in our financial system from whom nothing but most responsible behavior is needed -- the bankers, both Central and private. I hope that super aggressive lending practices, especially, to consumers, are known to most of you who live in America.
The sad fact is that today the banking business, especially, lending money to households, has acquired the aggressive habits of any business pushing other consumer products and uses Madison Avenue just like consumer products companies. Lending money should not be the same as selling a consumer product.
And it ain�t nothin new!
Schumpeter, one of the greatest American economists, born in Austria, writing about our economic system, with reference to the period of Great Depression, also wrote: �One of the results of our historical sketch will, in fact, be that the failure of the banking community to function in a way required by the structure of the capitalist machine accounts for most of the events which the majority of observers would call �catastrophe.�� Earlier in that paragraph Schumpeter suggests that the standards to be a banker were such that a salesman could be a banker! He further said, ��intellectual and moral qualities not present in all people who take to the banking profession.� Is that an understatement or what.
Of course, he was talking about private bankers and not the Federal Reserve. It was the private bankers who more than anyone else were responsible, by being irresponsible!, for the Great Depression. Are private bankers more responsible today? N O, NO. Unfortunately, the bankers, Central and private, are short-term oriented on top of being irresponsible.
What �Debt Service Burden� Doktor Greenspan?
The �DEBT BUBBLE,� especially, the Household Debt, got lot of press and general awareness in the US during 2004. It would be very bad for the US economy�s performance if people became cautious and stopped borrowing more or, God forbid, started to pay down the debt that they already owe. It even reached the halls of the US Congress. Finally, the question was put to Doktor Greenspan during one of his Congressional testimonies, �Do American households have too much debt?� Greenspan replied that the �Debt Service Burden� was within historical range, i.e., it is not at an extreme level, and that it was �manageable.�
Doktor Greenspan outdid Goebbles in the propaganda department. American households, as a group, have negative �Debt Service Burden;� they are borrowing the part of payment that goes towards the principal, they are borrowing the interest payment, and they are borrowing some more for the good measure! American households are simply piling on debt without much thought, just as Schumpeter, writing about household debt in the late 1920s, said, �debt lightheartedly incurred.�
The data that your own Federal Reserve publishes every quarter, Doktor Greenspan, show clearly that American households, as a group, are NOT servicing their debt. Some are, but many are not and they are adding to their existing debt. But the net result is no �Debt Service Burden� for the group as a whole. We know that a debtor has a problem when he has to borrow the interest payment and borrows more on top of that. Haven�t you heard the expression, �Borrowing from Peter to pay Paul,� Doktor G? Come on, Doktor G., pay attention to Jane Shopper�s �clever� tricks.
A simple example would be that a person makes mortgage payments of $1,000 a month for two years, but at the end of two years she, or he, borrows $40,000 more on the house. Not to mention the fact that she buys a car with 0% interest rate and buys new furniture with no payments until 2008! She feels no �Debt Service Burden.� But, she does feel the debt burden, as evidenced by surveys. She wonders how long she can play the game of borrowing the payments.
The best proof that Greenspan was simply throwing wool at the eyes of the Congress comes from the facts that the household, or personal, bankruptcy rate in the US has no correlation with the �Debt Service Burden� but high correlation with the Household Debt as a % of the GDP with, probably, 2-4 years of time lag. The Personal Bankruptcy Filings rate is at the highest since the records have been kept. I am not aware of any nationwide records of bankruptcies for the period of Great Depression. It would be very interesting if such data can be extrapolated from what records are available. An honest answer from Doktor Greenspan would have been yes, but no one expects it. Truth from Greenspan could be fatal for leveraged players in the financial markets.
Detailed Picture Is Much Worse
The gross numbers, scary as they may be, that lump all households together, do not present the accurate picture. I am sure that you are aware of the fact that income distribution has gotten very skewed in recent years with more and more share of total income going to smaller and smaller percentage of the population. In my estimation, people with more than half the income have very little to no debt. Here I am not just talking about the rich, many of them are middleclass. I have no debt, my son has no debt (I am justly proud of that), most of my friends have little to no debt, and so on. But, my son�s coworkers and many of my friend�s friends are merrily engaged in borrow-and-spend. People who borrow-and-spend don't like me much, it seems.
There are Households in America whose debt is 3, 4, 5, even 6, times their gross income; that is when they have the job, or jobs. It is the horrifying distribution of the Household Debt that would trigger the depression when housing prices, the chief source of borrowing, fall even by 10-15%.
If you are persuaded that the Household Debt is excessive, based on 450%+ increase in number of Personal Bankruptcy Filings over the past 20 years and many other indicators of debt-distress among households, then the question arises: What will happen to the economy if the Household Debt could not be increased as the % of GDP and at some point it gets back to historical levels?
Another way to ask the above question would be: Where would the US GDP be today had the Household Debt, as % of the GDP, remained at the historically high level before the current run up? What if the GDP growth came from growth in the income of households and Household Debt growth that was at 45% of the growth in GDP? The primary reason that I picked the 45% number is that it is the average for 19 years, 1965-1983, and that after 1984 the Personal Bankruptcy Filings exploded. So, we are not talking about a case of no growth in Household Debt; we are simply talking about growth in household spending coming primarily from growth in incomes. Such a GDP would be a Secular GDP with organic growth. As some of you may know, growth in household incomes, in real terms, has been poor over the past 5 years (negative for the last twelve months). How long can debt be a substitute for growth in household spending when income growth is hard to come by?
To answer the questions posed in the above paragraph, I decided to recompute the GDP by assuming that the growth in Household Debt was at 45% of the growth in GDP. Further, I assumed that one dollar of additional Household Debt translates to additional dollar of GDP; this I believe to be a conservative number, because it could be closer to $1.5 of GDP growth for each additional dollar of increased Household Debt. Such a recomputed GDP I have termed Secular GDP. Fig. 3 shows graphs of Reported GDP and Secular GDP.
You will notice that during 1940s and 1950s the Secular GDP was above the Reported GDP, with peak difference at the end of the WW II. Longer term, the Secular GDP has the Pull Effect going forward. Also, you will notice that about half the time, notably 1955-1984, the two graphs are close to each other; this doesn't prove anything but lends some credence to the methodology employed in arriving at Secular GDP. During most of the Fall and early Winter of the economic Longwave, the red is expected to be above the blue line, but before the Winter could end the blue comes on the top decisively. It will happen again over the next twenty years.
The wide gulf that has opened up between the red and blue, especially, over the past 5 years, reminds one of the gulf between the Red States and the Blue States in America! Currently, the Secular GDP is 58% of the Reported GDP; this means that the US GDP would have to decline by 42%, in real terms, just to give back the borrowed growth from excessive borrow-and-spend by the households. And thing are likely to be worse than this because the red will fall significantly below the blue before it is fully resolved. This would be Greater Depression in all caps and would lead to massive dislocations of the economies and the governments all over the world.
What would happen if the Household Debt in the US stays the same, i.e., new borrowing by some equals pay down by others just for one year? The US economy would enter depression instantly! You do the math � in 2004, Household Debt is estimated to have INCREASED by $1,050B while the GDP is estimated to have increased by $700B (both numbers are in current dollars). But for the increase in Household Debt driven growth, the GDP would have declined at least 3% in nominal terms and 5% in real terms. The 2.2 million additional jobs would have been replaced by the loss of 9 million jobs in just one year. If you include secondary and tertiary effects, we are talking about lot worse than the immediate effects listed above. And what would it create in American minds? SHOCK AND AWE! Americans will become dumbstruck. I don't know the exact date of when this process would be triggered, but it will not be three more years. It is likely to be in quarters, in single digit.
Long-term Trend In the US Economy
All these numbers are annual rates. For 25 years, 1950-1974, the Reported GDP grew at 3.65% and Secular GDP by 3.04%. For the past 25 years, ending in 2004, the Reported GDP grew at 3.01% and Secular GDP by a meager 1.03%. Do you notice something interesting? The Secular GDP growth for the earlier 25 years equals the Reported GDP some 30 years later. The Secular GDP has the Pull Power. For the past 5 years, the Reported GDP grew at measly 2.15% while the Secular GDP has been falling at 2.56% rate. But for the excessive debt, the US would have been in depression since 2000.
Is the US Economy Suffering From ED?
If you look carefully at the Secular GDP (blue) graph in Fig. 3, you will notice that since 2000 it has been suffering from ED! An OD of Viagara, packaged with Household Debt, kept the US economy able to perform. Well, the US economy is anything but youthful; age has taken its toll. It needs prosthetics and pills on a regular basis. And who better to prescribe the blue pill, just for the asking, than Dr. G? You don't even have to ask; Dr. G�s banker friends have a debt-pusher in every econ-corner of America.
Just remember: The borrowed economic growth must be paid back. And with interest. There are no defaults or bankruptcies here; only heavy penalties for late payments. Let us see how long Americans can keep piling on consumption debt. At some point they will get buried in the pile.
Had the bankers, Central or private, kept a watchful eye on the level of debt in the economy, and set the interest rates accordingly, we wouldn�t have the booms and the busts and the wealth and income inequality that we do have. Keeping interest rates at artificially low level is the worst aspect of the Central Planning of the US economy in recent years and there will be hell to pay. The name of this hellish period in the US would be Greater Depression. Our bankers have baked this in the US E-Con cake. It is better to be safe now than be sorry later.
Wishing everyone the best,
© 2005 Jas Jain
Tehachapi, CA USA