by Fabius Maximus, FabiusMaximus.com
Summary: The effects of debt are among the most widely misunderstood factors of macroeconomics. The almost delusional writings of perma-bears and conservatives have demonized debt, while economists often regard high debt levels with complacency. Yet economists have learned much about dynamics of debt. This post looks at this cutting edge of economic theory, very relevant to us today — because the debt supercycle is the story of modern America, and it’s over.
“In final examinations {this economics} professor always posed the same questions. When he was asked how his students could possibly fail the test, he replied simply ‘Well it is true that the questions do not change, but the answers do.’ — From a speech by Fed Chairman William McChesney Martin Jr., 19 October 1955.
This is the effectiveness of debt in America.
Can you spot the when the post-WWII economic era ended?
The ratio of private sector debt to Gross Domestic Income rose steadily since WWII (after forced deleveraging during the Great Depression and WWII). This was one of the four big growth drivers — along with the increase in US government debt, the population boom (babies + immigration), and rising productivity.
This long expansion is the debt supercycle, first identified in the early 1960’s by Hamilton Bolton and Tony Boeckh of Bank Credit Analyst. Here is the BCA’s explanation. It’s the story of modern America.
“The Debt Supercycle is a description of the long-term decline in U.S. balance sheet liquidity and rise in indebtedness during the post-WWII period. Economic expansions have always been associated with a build-up of leverage. However, prior to the introduction of automatic stabilizers such as the welfare state and deposit insurance, balance sheet excesses tended to be fully unwound during economic downturns, albeit at the cost of severe declines in activity.
“Government policies to smooth out the business cycle were successful in preventing the frequent depressions that plagued the pre-WWII economy, but the downside was that the balance sheet imbalances and financial excesses built up during each expansion phase were never fully unwound.
“Periodic “cyclical” corrections to the buildup of debt and illiquidity occurred during recessions, but these were never enough to reverse the long-run trend. Although liquidity was rebuilt during a recession, it did not return to its previous cyclical high. Meanwhile, the liquidity rundown during the next expansion phase established new lows.
“These trends led to growing illiquidity, and vulnerability in the financial markets. The greater the degree of illiquidity in the economy, the greater is the threat of deflation. Thus, the bigger that balance sheet excesses become, the more painful the corrective process would be. So, the stakes have become higher in each cycle, putting ever-increasing pressure on the authorities to reflate demand, by whatever means are available. The Supercycle process is driven over time by the building tension between rising underlying deflationary risks in the economy, and the ability of policymakers to create inflation.
“The Supercycle reached an important inflection point in the recent economic and financial meltdown with the authorities reaching the limit of their ability to get consumers to take on more leverage. This forced the government to leverage itself up instead.”
The rise is best seen in terms of standard credit measures, such as debt to income. This graph shows the ratio of US private sector debt to national Gross Domestic Income. There were two steep rises: 1984 to 1986 (the Reagan expansion) and a larger rise starting in 1997 — ending in the 2007 crash. The large drop after the Great Recession was the first act of the new era that follows our 50-year-long party.
Monetary economist Melchior Palyi (1892-1970) took the next step towards understanding the macro effects of debt with his article “We are Prisoners of Our Debt Behemoth” in the 3 July 1969 issue of Commercial and Financial Chronicle. Palyi focused attention on the ratio of added GDP to added debt, aka the marginal productivity of debt or marginal elasticity of GDP with respect to debt. (See this WSJ article.)
Sometime in the mid-1980’s Maria Fiorini Ramirez, then with Drexel (now one of Wall Street’s top economists) made an insightful observation: over time the effectiveness of new debt was decreasing. That is, new debt provided less stimulus. She speculated that when the economy hit its maximum sustainable debt load then new debt would no longer create growth. That is, the debt elasticity of GDP goes close to zero. At that point the economy must deleverage, marking the end of the post-WWII economic regime in America.
This graph shows the ratio of the annual increase in private sector debt over growth in Gross Domestic Income (GDI). As with the above graph, note the breakout in 1997. As above the spike in 2007 marked the end of the post-WWII era.
What about debt of the Federal government?
America has moderate debt levels. The experience of other developed nations proves that government debt in one’s own currency becomes problematic only at far higher levels than ours — and then usually only during long downturns.
What’s wrong with too much private debt? What’s next for America?
“A thing long expected takes the form of the unexpected when at last it comes.”— From Mark Twain’s Notebooks
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The aggregate debt level of an economy is not a significant variable in Keynesian theory; attempts to integrate it were unsuccessful (e.g., by Hyman Minsky). I believe this might create a “crisis” in macroeconomics as described by Tomas Kuhn in The Structure of Scientific Revolutions
(a) “Household Debt and Business Cycles Worldwide” by Atif R. Mian, Amir Sufi, and Emil Verne, National Bureau of Economic Research, September 2015.
A rise in the household debt to GDP ratio predicts lower output growth and higher unemployment over the medium-run, contrary to standard macroeconomic models. GDP forecasts by the IMF and OECD underestimate the importance of a rise in household debt to GDP …
We also show that a rise in household debt to GDP is associated contemporaneously with a rising consumption share of output, a worsening of the current account balance, and a rise in the share of consumption goods within imports. This is followed by strong external adjustment when the economy slows as the current account reverses and net exports increase due to a sharp fall in imports. Finally, an increase in global household debt to GDP also predicts lower global output growth.
(b) “Falling off the supercycle“, The Economist, 10 January 2015 — “Trapped in a world of high debt, low rates and slow growth.”
(c) A positive note: “Debt supercycle, not secular stagnation” by Kenneth Rogoff (Prof Economics, Harvard), VOX, 22 April 2015. Excerpt …
“Weak, post-Crisis growth has been blamed on secular stagnation. This column argues that the debt super-cycle view provides a more accurate and useful framework for understanding what has transpired and what is likely to come next. The difference matters. Unlike secular stagnation, a debt super-cycle is not forever. After deleveraging and borrowing headwinds subside, expected growth trends might prove higher than simple extrapolations of recent performance might suggest.”
America’s private debt/income ratio has fallen slightly, to its level in 2004 (see the graph). It probably will drop far more during the next generation. Doing so by rapid economic growth seems unlikely (unless the Third Industrial Revolution kicks in soon). The only alternatives are deleveraging through fast defaults or slowly working it down. We might not get to choose. The path taken will help shape the history of the next generation.
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