Great U.S debt engine slips into reverse
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.
THE VAPORIZATION OF WEALTH
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.
DOLLAR REVALUATION SUSTAINED
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. (https://customers.reuters.com/d/graphics/US_EXTFIN1208.gif).
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.