Great U.S debt engine slips into reverse

December 12, 2008

John Kemp Great Debate— John Kemp is a Reuters columnist. The views expressed are his own —

After six decades of uninterrupted credit creation and an unprecedented era of consumption and prosperity, the credit process has come to an abrupt halt. If credit has been the locomotive of the modern economy, the third quarter of 2008 marked the point when the engine stalled and the economy began to roll back down the hill.

For decades, financial activities have grown much faster than the real economy. Between 1952 and 2007, U.S. nominal GDP grew by a factor of 39 times, while total credit market debt outstanding surged 101 times.

Finance has become even more dominant in the last 25 years, as subdued business cycles, improvements in technology and communications, deregulation and pension privatization have fueled a massive increase in the issuance of debt and other financial assets.

In 1952, the U.S. economy had just $1.28 of debt for every dollar of GDP, and as late as 1980 this figure was still as low as $1.61. But beginning in the 1980s, financial services underwent a revolution that saw credit instruments per dollar of GDP rise to $2.28 in 1990, $2.67 in 2000 and a staggering $3.55 by the end of 2007.

Increasing debt, much of it bought in recent years by China and oil-producing countries of the Middle East, has allowed the United States to have both guns and butter. It financed a huge expansion of consumption, home-building and business investment, while allowing the federal government to cut taxes and still fight two major wars in the Middle East.

But in the three months between July and September, the miracle of modern finance came crashing down.

Despite the turbulence, total debt rose another $585 billion, according to the Federal Reserve’s “Flow of Funds” report issued yesterday. But almost all the increase was government borrowing ($527 billion) to backstop the Federal Reserve and other rescue programs. The private sector borrowed just $58 billion.

Once seasonal adjustments are made, the total volume of debt owed by U.S. households fell for the first time since records began in 1952. While the shrinkage was marginal, at an annualized rate of just 0.8 percent, it stands in stark contract to the double-digit increases reported between 2002 and 2006.

For corporations, debt growth has slowed from almost 14 percent per year to 3.7 percent in the last twelve months.

Only the federal government remained an active borrower, with debt growing at rate of almost 40 percent in the three months ending in September.


Respected commentators, including the former chairman of the Federal Reserve, Alan Greenspan, have minimized the importance of the growing debt mountain by pointing out that household and corporate assets have grown even faster, and balance sheets are stronger than the debt figure alone implies.
Not any more.

Household wealth is evaporating as falling home prices and a plunging stock market wipe out a sizeable chunk of assets.

Households’ net worth (assets minus liabilities) has shrunk in each of the last four quarters. From a peak of $63.6 trillion at the end of Q3 2007, households’ net worth has fallen by a massive $7 trillion (11 percent) in the last twelve months to just $56.5 trillion.

The wealth that has vanished is equivalent to half the country’s annual output, and larger than the entire annual production of any other country on the planet.

In what is probably the largest disappearance of wealth in history outside war, falling home values have vaporized $4 trillion worth of homeowners’ net equity since the start of 2006. Net equity is down by a third from $12.5 trillion to $8.5 trillion.

In the past twelve months, there have been further losses from falling equity prices ($2.73 trillion), mutual fund valuations ($890 billion) and pension fund reserves ($1.65 trillion).

Until recently, corporations have been spared. But the net worth of nonfinancial businesses seems to have peaked at $16.2 trillion in Q2 and fell $52 billion during Q3. Further losses are inevitable as commercial real estate values go into freefall.


Perhaps the most significant changes, however, have come in transactions with foreigners. Desperate for cash, U.S. corporations, banks and investors and liquidated their overseas asset portfolio at a record rate during Q3.

U.S. residents liquidated their overseas portfolio at an annualized rate of almost $770 billion. There were record sales of bonds ($291 billion) and commercial paper ($273 billion), and a smaller but significant fall in overseas equities ($57 billion) and other miscellaneous assets ($277 billion).

On the other side of the ledger, foreigners continued to support the U.S. currency and balance of payments, despite the implosion of the U.S. banking system, making net purchases of U.S. assets at the surprisingly fast rate of $815 billion per year during the three months between July and September.

But the net purchases were entirely accounted for by ultra-safe U.S. Treasury bonds ($819 billion) and more than half of those purchases were by foreign governments and central banks ($464 billion).

Private investors also bought $355 billion worth of safe Treasuries. Both the private sector and governments shunned the agency market, selling at a rate of $240 billion per year, and corporate bonds, where holdings fell at a rate of $126 billion.


Capital repatriation explains much of the dollar’s recent surge against all the other major currencies except the yen.

Some commentators have suggested the dollar’s slide will resume once repatriation has run its course, and that a weak economy and damaged banking system will see a renewed substantial decline in the dollar’s value from early next year.

But as I noted in a recent column, the dollar’s behavior this decade has been inversely linked to the strength of the economy and the massive expansion of the financial system between 2002 and 2007.

Earlier in the decade, rapid U.S. growth sucked in imports faster than U.S. manufacturers could raise their exports, while some of the balance-sheet expansion leaked abroad in the form of net purchases of overseas assets by U.S. residents.

Since the United States could not fund all its imports, let alone asset purchases, from export earnings, the result was a steadily increasing net offer of U.S. financial assets to the rest of the world and persistent downward pressure on the currency.

Now the devaluation process has gone into reverse. Slower growth, and the liquidation rather than accumulation of overseas assets, have sharply reduced the U.S. external borrowing requirement during the last four quarters and resulted in strong dollar appreciation. (

Currencies are potent symbols of national identity, and it is a common mistake to conflate the strength of a country’s currency with the performance of its economy.

In fact, exchange rates have never been directly linked to economic performance. Japan’s lost decade in the 1990s coincided with, and was partly caused by, the strength of the yen. Much the same could be said of the underperformance of the British economy in the early 1990s and the French economy in the 1930s.

So there is no reason to expect next year’s forecast U.S. weakness to be expressed in a falling exchange rate.

Assuming activity and imports remain depressed throughout 2009, growth switches to Asia, and U.S. investors and corporations stabilize or continue to liquidate their overseas asset portfolios, rather than trying to add to them, the U.S. currency could remain surprisingly steady.

But that would be a sign of weakness, not strength.

For previous columns by John Kemp, click here.


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Wealth can not be vaporized short of a nuclear explosion.

Fiat wealth, fake wealth, fraudulent wealth, imaginary wealth, illusory wealth, delusional wealth may be vaporized by consequence of reality reasserting itself.

Posted by Patriot Henry | Report as abusive

People in America need to realize jus what got America in this shape…”cheap” yes so-call cheap items from a foreign land.

quote*Wal-Mart firmly believes in local procurement. We recognize that by purchasing quality products, we can generate more job opportunities, support local manufacturing and boost economic development. Over 95% of the merchandise in our stores in China is sourced locally. We have established partnerships with nearly 20,000 suppliers in China. *end quote!

Now! if there be 182 country’s making items for the world to buy and they have only 5% of the pie in China…duh! This company makes the nice people of China support their currency(yuan) by keeping it in their country working for the people there…. but with the “yuan” going up in value and the US dollar going down…all the foreign items that the American consumer buys thinking it is cheap has went up in price.

People…its all about the currency and to keep a currency strong you got to keep it floating around the country you live in so it can work for you. For the past 12 years all them US dollars are being shipped overseas to a foreign bank and with the American worker not making anything for the foreigner to buy the “we the people” have to turn to the “second” largest employer in America(Uncle Sam) to sell “we the people” debt in order to get all them dollars back!

50 years ago a foreigner would had given their left nut for a US dollar or a Hershey’s chocolate bar and today the same foreigner has got Uncle Sam and the American consumer by both all the while Hershey is moving the chocolate factory to Mexico. Wake up! America and think “MADE IN AMERICA.”

Posted by madmilker | Report as abusive

I totally agree with John’s article. Most people feel that we can continue growing through debt. Most folks feel that we can blindly pump funds into any project to stimulate the economy. We can pay a person $1 billion to dig a hole. Auto workers use the same sort of logic all the time. If they accept lower salaries, they cannot stimulate the economy. We can throw cash off buildings and borrow ourselves into oblivion to encourage growth. We can all run a bit of ponzi scheme with our own finances. We can borrow principal amounts. Then we can borrow to pay the interest on the principal. We can keep on borrowing and never pay it back. Then the lender at the very end loses everything, and everything collapses. Taxpayers and small-time investors have supported these systemic ponzi schemes for decades. But I’m game for more. If we are going to crash, crash bigtime. Let’s take taxpayers money and funnel it into businesses that are not financial viable with products that people don’t really want to buy. Like the auto industry, for instance.

Posted by Don | Report as abusive

1) Re a previous comment, with respect: ‘Wealth’, as much of existence, is illusory–or, at the least, slippery. It is ‘created’ and ‘destroyed’ all the time.
2) I am in agreement with the observation that the correlation between a nation’s currency’s relative value and its overall economy is tenuous at best. That said, I would note that in the course of the example offered, the Japanese ‘lost decade’ the Yen was positioned within a world which was, barring the occasional LTCM debacle, etc, essentially expansionary. That situation is not applicable to the US$’s future. It would seem to me that the present implosion is likely to result in the customary outcome of an ‘implosion device’, viz, a horrific, rapidly dissipating expansionary surge to follow.

Posted by Big Al | Report as abusive

Don’t think that all this debt stuff is bad. Think about this for a moment. I have a ton of debt and would like to weasel out of it by having those people who hold my debt buy worthless junk from me. So, I put together a whole mess of AAA Bonds on overpriced homes that I got real cheap and know will default and then sell this junk to them. They get this toxic junk and I get rid of a bunch of debt.You think they will figure this scam out? Could this have happened courtesy of Bush and company? JOHN

Posted by ginsengjohn | Report as abusive

Great article – puts things in perspective.

Posted by KidFromWinnetka | Report as abusive

The West were fools they taught the World how to manufacture by inviting them to their Universities and teaching the world all the hard earned knowledge for next to nothing. Now the world does not need the Wests brains any more only their consumers.

Posted by Tony | Report as abusive

Great article John,
Governments have allowed growth to be the only key to success over all other criteria.

Unfortunately the world financial system has failed to put in place the checks and balances needed to provide responsible governance of the system.

The penalty for this mismanagement is the hardship that people around the world will endure at all levels of our community

Posted by Bruce | Report as abusive

people do not want cheaper loan because of jobs scarecity. People wants to buy back from bankers of their ill asstes / instruments; people may have their own money. The own money will boost the spending capacity of public and faith in financial / banking system.

Posted by rajay kumar aggarwal | Report as abusive

excellent article John-well defined the side effects of so called consumer based economic model.

Posted by sanjay | Report as abusive

The only way forward , is forward” Brad. Read the article below and stop talking negative. Buffet didn’t become the wealthiest man on the planet by looking backwards, did he? I’ve said it before and I’ll say it again, the Electric Car is a winner in so many ways for the US. To name a few: Cheaper Fuel, Cleaner Fuel, New industry, Many new jobs in Detroit, New friends in the Global community for doing something constructive. It will leave the BIG 3 carmakers for dead. Time to move on Yankees. Many people have the money to buy the plug-in electric vehicle, we are just waiting for you to build it for an affordable price. Better hurry up or we wil have to buy Chinese (Again).Read Buffets story below:

Buffet Into Chinese Electric Future cars and Batteries
These finance guys always amaze me. Here is Warren Buffet, who of course is one of the richest men in the world, invests $230 in a Chinese future cars manufacturer. Of course, china is the up and coming industrial powerhouse, but still it takes a lot of guts because the economy there is extremely volatile.

In September, Warren Buffet invested $230 to by ten percent of BYD, a Chinese electric car and battery manufacturer. BYD could soon become a major leader in electric future cars and battery production. BYD is reportedly planning to start selling electric cars in America by the end of 2009

The electrical future car will present storage challenges which BYD may be able to answer. Our aging electric grid and our wall sockets are not equipped to deal with recharging car batteries should the electric car become mainstream. There will need to new developments such as swapping stations where cars can come in and swap batteries. Maybe this will be Buffet’s new line of investment.

– Posted by Brad

Posted by Brad | Report as abusive