Still Leveraging Up

The U.S. as a whole continues to dig itself deeper into debt, even though the composition of that debt is changing. The graph below (data from http://www.federalreserve.gov/releases/z1/current/default.htm) shows the total debt in the U.S. over time broken down by major sectors -- the Y axis is in billions of dollars.

The final bar of the graph is for the end of the first quarter of 2009, while all the others are year-end figures, which is important to keep in mind since the differences between the other bars represents a full year, and the difference between the last two represents only three months.

Total debt in the economy rose by 327.7 billion in the first quarter, but more than all of that ($359.9 billion) was due to increased federal debt (held by the public, excludes Social Security trust fund). The other sectors of the economy had essentially flat growth with relatively minor declines in the household and financial sectors, partially offset by minor increases in S&L debt and non financial corporate debt.

True, this is a slower pace of debt buildup than seen in the recent past. In 2008, total debt rose at an average of $654 billion per quarter, and in 2007 the pace was 1,149 billion a quarter. But the point is that we are still taking on debt, not deleveraging. What we have been doing is replacing private debt for public debt, and to some extent replacing State and Local debt for Federal debt.

There is a historical precedent for this. During the George Washington Administration, Treasury Secretary Alexander Hamilton persuaded Congress to pay off the Revolutionary War debts of not only the Continental Congress but of the States as well -- a move that greatly enriched speculators and formed the basis for the original U.S. banking oligarchy (sound familiar?). Hamilton was right about one thing, though -- the Federal Government is better able to shoulder the burden than are individuals, businesses or municipalities.

However, Federal debt is still a very small portion of overall debt, and there has to be a limit to how much of the total that can be shirted there.



While GDP has grown substantially over the years, it has not come close to matching the pace of debt growth, as seen in the second chart (from http://www.nakedcapitalism.com/2009/06/guest-post-what-de-leveraging.html). Since 1977, debt has grown from 160% of GDP to almost 375% of GDP. With GDP falling in the first quarter, this means that there has been no real slowdown in the growth rate of debt relative to GDP, even though the absolute rate of debt growth has slowed.

I doubt that we can continue to sustain ever-increasing debt relative to GDP. If the current pace continues, it will not be long before total debt is five times GDP, and in only a few decades it would be ten times GDP. I'm not sure what the limit is, but we have to be approaching it.

What does bringing down the total debt burden on the economy mean? Barring a dramatic and sustained acceleration in the rate of GDP growth to Chinese-type levels (not going to happen), it means that households and businesses are going to have to borrow less, save more and pay back the debt...or start defaulting on it. We got a taste of what it is like when households and businesses are not able to borrow last fall, and it is not any fun.

As a nation, we have been living large on the credit card for the last 30 years. Now we have to start paying the bill.

We are going to have to shift the entire economy away from consumption and towards investment in things that will produce future income that can pay off the debts. Either that or the current bankruptcies we are seeing in both the corporate and household sectors (and also foreclosures which can be seen as a partial bankruptcy by a homeowner) will continue to swell, as the problem is solved by default rather than repayment.

Given the number of states and localities that are in deep fiscal trouble (see California), this may extend to huge numbers of Chapter 9 bankruptcies (municipal) as well as Chapter 11 (corporate) and Chapter 13 (personal). This will not be good news for the financial sector -- most notably the banks, but not limited to them. Given its ownership of the printing press, the bankruptcy of the Federal government is not likely until long after the dollar loses its reserve currency status and the Federal government is forced to borrow in currencies other than the dollar.

However, the prospect of very high inflation down the road is real. It is not a current danger given the huge amount of slack in the system. With unemployment at 9.4% and rising, there is simply no way that the wage side of a wage-price spiral can take hold.  Thus for the time being, any inflation will simply serve as a method to reduce the real incomes of Americans.

The invisible hand of the market is going to force us to cut back on our consumption one way or the other. This means, among other things, that we will most likely never go back to an annual sales rate of 17 million for car sales. That is not good news over the long term for Ford (F - Analyst Report) or even Toyota (TM - Snapshot Report). It might, however, be good news for AutoZone (AZO - Analyst Report) since we will be patching up the old jalopy for much longer.

Dramatically lower consumption over time is not going to be good news for the vast majority of retailers or for the firms in the consumer discretionary sector. I'm not just talking about this year's revenues and earnings, but their revenues and earnings for the next decade (at least). On the corporate side, to reduce total debt companies are going to have to pay far less in dividends and not repurchase stock, and use retained earnings to increase equity relative to debt. State and Local governments will have to both raise taxes and cut services. This is going to seriously slow GDP growth, which will make it all the more difficult to reduce the level of debt relative to GDP.

Maybe I am wrong about the limit of indebtedness as a country being reached. Perhaps the can will be kicked down the road further and total debt will reach 500% or 1000% of GDP. There is nothing particularly magical about 375% of GDP, but as Nixon's chief economist Herbert Stein once pointed out, "if a trend cannot go on forever, it will stop." Well, debt cannot perpetually increase at a greater rate than GDP, so eventually it has to stop. My sense is that it has to happen sooner rather than later.

This mess has been a long time in the making, and will take a very long time to clean up.