-- John Kemp is a Reuters columnist. The opinions expressed are his own. –
The United States and the United Kingdom stand on the brink of the largest debt crisis in history.
While both governments experiment with quantitative easing, bad banks to absorb non-performing loans, and state guarantees to restart bank lending, the only real way out is some combination of widespread corporate default, debt write-downs and inflation to reduce the burden of debt to more manageable levels. Everything else is window-dressing.
To understand the scale of the problem, and why it leaves so few options for policymakers, take a look at Chart 1 (https://customers.reuters.com/d/graphics/USDEBT1.pdf), which shows the growth in the real economy (measured by nominal GDP) and the financial sector (measured by total credit market instruments outstanding) since 1952.
In 1952, the United States was emerging from the Second World War and the conflict in Korea with a strong economy, and fairly low debt, split between a relatively large government debt (amounting to 68 percent of GDP) and a relatively small private sector one (just 60 percent of GDP).
Over the next 23 years, the volume of debt increased, but the rise was broadly in line with growth in the rest of the economy, so the overall ratio of total debts to GDP changed little, from 128 percent in 1952 to 155 percent in 1975.
The only real change was in the composition. Private debts increased (7.8 times) more rapidly than public ones (1.5 times). As a result, there was a marked shift in the debt stock from public debt (just 37 percent of GDP in 1975) towards private sector obligations (117 percent). But this was not unusual. It should be seen as a return to more normal patterns of debt issuance after the wartime period in which the government commandeered resources for the war effort and rationed borrowing by the private sector.
From the 1970s onward, however, the economy has undergone two profound structural shifts. First, the economy as a whole has become much more indebted. Output rose eight times between 1975 and 2007. But the total volume of debt rose a staggering 20 times, more than twice as fast. The total debt-to-GDP ratio surged from 155 percent to 355 percent.
Second, almost all this extra debt has come from the private sector. Take a look at Chart 2 (https://customers.reuters.com/d/graphics/USDEBT2.pdf). Despite acres of newsprint devoted to the federal budget deficit over the last thirty years, public debt at all levels has risen only 11.5 times since 1975. This is slightly faster than the eight-fold increase in nominal GDP over the same period, but government debt has still only risen from 37 percent of GDP to 52 percent.
Instead, the real debt explosion has come from the private sector. Private debt outstanding has risen an enormous 22 times, three times faster than the economy as a whole, and fast enough to take the ratio of private debt to GDP from 117 percent to 303 percent in a little over thirty years.
For the most part, policymakers have been comfortable with rising private debt levels. Officials have cited a wide range of reasons why the economy can safely operate with much higher levels of debt than before, including improvements in macroeconomic management that have muted the business cycle and led to lower inflation and interest rates. But there is a suspicion that tolerance for private rather than public sector debt simply reflected an ideological preference.
THE DEBT MOUNTAIN
The data in Table 1 (https://customers.reuters.com/d/graphics/USDEBT3.pdf) makes clear the rise in private sector debt had become unsustainable. In the 1960s and 1970s, total debt was rising at roughly the same rate as nominal GDP. By 2000-2007, total debt was rising almost twice as fast as output, with the rapid issuance all coming from the private sector, as well as state and local governments.
This created a dangerous interdependence between GDP growth (which could only be sustained by massive borrowing and rapid increases in the volume of debt) and the debt stock (which could only be serviced if the economy continued its swift and uninterrupted expansion).
The resulting debt was only sustainable so long as economic conditions remained extremely favorable. The sheer volume of private-sector obligations the economy was carrying implied an increasing vulnerability to any shock that changed the terms on which financing was available, or altered the underlying GDP cash flows.
The proximate trigger of the debt crisis was the deterioration in lending standards and rise in default rates on subprime mortgage loans. But the widening divergence revealed in the charts suggests a crisis had become inevitable sooner or later. If not subprime lending, there would have been some other trigger.
WRONGHEADED POLICIES
The charts strongly suggest the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.
From this perspective, it is clear many of the existing policies being pursued in the United States and the United Kingdom will not resolve the crisis because they do not lower the debt ratio.
In particular, having governments buy distressed assets from the banks, or provide loan guarantees, is not an effective solution. It does not reduce the volume of debt, or force recognition of losses. It merely re-denominates private sector obligations to be met by households and firms as public ones to be met by the taxpayer.
This type of debt swap would make sense if the problem was liquidity rather than solvency. But in current circumstances, taxpayers are being asked to shoulder some or all of the cost of defaults, rather than provide a temporarily liquidity bridge.
In some ways, government is better placed to absorb losses than individual banks and investors, because it can spread them across a larger base of taxpayers. But in the current crisis, the volume of debts that potentially need to be refinanced is so large it will stretch even the tax and debt-raising resources of the state, and risks crowding out other spending.
Trying to cut debt by reducing consumption and investment, lowering wages, boosting saving and paying down debt out of current income is unlikely to be effective either. The resulting retrenchment would lead to sharp falls in both real output and the price level, depressing nominal GDP. Government retrenchment simply intensified the depression during the early 1930s. Private sector retrenchment and wage cuts will do the same in the 2000s.
BANKRUPTCY OR INFLATION
The solution must be some combination of policies to reduce the level of debt or raise nominal GDP. The simplest way to reduce debt is through bankruptcy, in which some or all of debts are deemed unrecoverable and are simply extinguished, ceasing to exist.
Bankruptcy would ensure the cost of resolving the debt crisis falls where it belongs. Investor portfolios and pension funds would take a severe but one-time hit. Healthy businesses would survive, minus the encumbrance of debt.
But widespread bankruptcies are probably socially and politically unacceptable. The alternative is some mechanism for refinancing debt on terms which are more favorable to borrowers (replacing short term debt at higher rates with longer-dated paper at lower ones).
The final option is to raise nominal GDP so it becomes easier to finance debt payments from augmented cashflow. But counter-cyclical policies to sustain GDP will not be enough. Governments in both the United States and the United Kingdom need to raise nominal GDP and debt-service capacity, not simply sustain it.
There is not much government can do to accelerate the real rate of growth. The remaining option is to tolerate, even encourage, a faster rate of inflation to improve debt-service capacity. Even more than debt nationalisation, inflation is the ultimate way to spread the costs of debt workout across the
widest possible section of the population.
The need to work down real debt and boost cash flow provides the motive, while the massive liquidity injections into the financial system provide the means. The stage is set for a long period of slow growth as debts are worked down and a rise in inflation in the medium term.
For previous columns by John Kemp, click here.
Lack of savings alone is not what created the problem in the first place. As the article states, its a combination of lack of savings and a huge increase in debt. If people didnt save, but also didnt increase their debt, the difference in GDP to debt would be negligible, and the GDP would arguably go up. But if people continue to increase debt, the GDP will stagnate or drop, as the debt spins continually out of control.
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There is a small but growing group of scientists and economists who believe that economic growth as been, and continues to be, closely associated with, and dependant upon, our use of energy. While there are many who argue that we have become more efficient in using energy, at least until 1984 the growth of the US economy had been very closely correlated with energy use. Since then the economy has been growing more rapidly than energy use, leading many to believe that we are becoming more efficient. In fact much of that growth has not occurred because of rigged official inflation estimates (see shadowstatistics) or, as you note, has been financed by debt, the energy cost of which has not yet been paid. Our research shows that, for example, the inflation-corrected Dow Jones index has tracked (snaked about) the total national energy use since 1915. The recent “corrections” are just returning to the energy index. Since US domestic energy production peaked in 1995 and total use in about 2004 there may be little opportunity for real growth in the future, leaving, according to this post, only inflation to settle the books. Yes we need a new economics, one based on biophysical reality and not on the absurd economic theories of neoclassical economics which violates many physical laws. The UK is in a particularly dangerous situation because the North Sea petroleum windfall (which is now almost gone) gave the country several decades of real growth and the expectation that this is normal (and Margaret Thatcher an undeserved reputation as financial wizard). The adjustment to the new reality will not be pretty. Remember: Mother nature holds the high cards.
Let me put it straight. There is no way out of the current crisis for the US without going into a controlled collapse. All these stimulus packages fancied by Obama and his friends will only end by burying the US economy under a pile of huge debts and deficits. In two years from now America will wake up to discover that the economy is still doing badly while the state coffers gone empty. At this point, a collapse of trust in dollar as a reserve currency of the world is bound to send a tzunami of dollars returning from all over the world to the US shores sweeping away the hapless country together with this semi messianic figure now posturing as its president.
Much like the victims of Bernie Madoff, so was the US Economy a victim of fraud.
In previous postings I compared the economy to an athlete on steroids and the impact of taking the steroids away. The de-leveraging of the US economy is just like taking an athlete off steroids, those stats were inflated and they are not coming back. It was and is fraud.
Much as the Madoff victims are dealing with a range of emotions and realizations, it is about time Congress and the Obama administration come to some of the same conclusions: It is gone, what do I do now with what I have left. Sorry, investors ~ it is gone and the US Government should not under any circumstance print new cash for you. Congress, do not give those that perpatrated the fraud anymore American taxpayer money, it is like giving Bernie taxpayer money in order to keep perpatrating his Ponzi scam.
President Obama, let us find what and where the real economy is and then live within the means of the real economy.
If Obama utters the phrase “Return to Gold Standard” we are saved. It is perception: When your money is backed by gold it holds more value to you then when your money is backed by the full faith of the government to replace it.
You’d also have to do a 25:1 conversion like a reverse stock split.
But i believe the root cause to be loss of perceived personal value of the dollar. You are told in business that your employees should act like they own the company. Why not the same mentality with money; with government; with monetary policy? They are talking about the money in your wallet. Americans need to make their voice heard outside of proxy.
Maybe on a household level we already have the beginnings of inflation. Maybe economists have their baselines and basis for their reports all wrong? Maybe we are seeing a new economy rise which invalidates everything they learned in college?
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The acceleration of debt without meaningful productivity is the problem. I agree, bankrupt the meaningless - complex contracts and derivatives like mulitply held insurance contracts on failure. Pumping blood into a bleeding body is not the right way to save a life. Stop the leaking.
It should be a great year for accountants.
[...] The last great empire builders - the UK and the USA appear to be on the brink disaster due to the collapse of debt financing. [...]
I’ve been saying they should refinance debts all along. Probably all of them (student loans, home loans, equity loans, business loans.)
This allows people to breathe easier, feel like they can loosen their belts a little now that their mortgage is $XXX less per month, now that their student loan is $XXX less per month, now that their business loan is $XXXX less per month, which will lead to… SPENDING! You got it. Remember, jobs are only there when companies think they can pay for them.
People will also feel like it is not such a burden to repay their debts; they will not feel like they can not afford the services this country runs on just because they need to eat.
We also need to educate people on credit/money usage. Yes, you really have to repay that money, it’s not just a joke because it’s all plastic and checks. Splurging should not be a daily attitude, more like a once-a-year attitude. (OK It could be more often, but you get the point - people should only ’splurge’ when they know they’ll be able to pay it off.)
I’m so sick of this purchasing of “toxic assets.” Why not just refinance these assets so they are no longer toxic? Go from ARM to fixed. Go from high risk to low risk. If they’ve only got a minimum wage job, then give them a minimum wage mortgage, even if it stretches out for 50 years. If you let those who can’t seem to get ahead in life feel like they have the chance to have something in their own name, they’re going to keep it. It’s something to be proud of.
Oh and what’s with these f’ing ridiculous car prices, anyway? Does it REALLY cost you 10k more to build X vehicle over Y vehicle? I really doubt it!
“Make life affordable.”
Excellent article!
Man created the money system as a simple means to represent fair exchange for goods. Since numbers are based on math we can easily create real problems as the system becomes more and more complex.
If we accumulated money “exchange power” without borrowing we would not have the problem we face and have faced before. Then again, borrowing has its place. When people borrowed for homes to live in, within their means this made sense. When businesses borrowed to build enterprises that create jobs, provide money to people and governements in the form of taxes…within limits this too made sense.
Years of increasing deficits on all ends, government, personal and corporate have lead to where we are today. The problem can be fixed by allowing the chips to fall where they may. Government does need to keep the flow going but without the excessive bailouts. Why not fix the price of oil for 2 years! Cut taxes, and let businesses that have made poor decisions fail. They will be replaced by stronger and better companies as their slack is picked up.
Simply put money is debt. The more debt the more money to actually the more we sign on the line to pay back a sum the more money is created into the system. Currently the fractional reserve banking system allows about a 9:1 ratio. ! dollar in 9 dollars out. This equals collapse period. Of course if we live in 1s and 0s it does not but because living in a finite world actually demands a sustainable practice that reflects actual value not a shifting of numbers and complex formula.
Man made law economic law all lose hands down to natural law.
A solution well that is easy. Simply turn our backs on the bankster overlords. They do nothing but take value in the form of real asset and give a imaginary paper value in return. Right now we will witness the collateralizing of many of our own natural places, national parks etc etc just to pay principal and then banks such as the ones in other countries whom loan us money to service our debt will own these assets when we declare bankruptcy.
This is not strange and it is not unplanned since the global banking system works in harmony and those who are the backbone of the central banks in different countries are ultimately the same people or their affiliates.
The question now is will we allow this to occur or what can we actually do about it now we have signed away our lives and our children’s lives into debt servitude?
This is not going to be solved by magic decree of a messiah it is not going to solved by a single solution. There is going to be conflict and there is going to be hostility but we can choose in smaller communities to just simply turn away from these powerful bankster interests and regain a sustainable form of value exchange.
Its gonna take guts and its gonna take fire.
I wish us all the courage and blessing that we will need int he days to come.
PC
Excellent article John. It seems that the penny is finally starting to drop that this is no ordinary recession–on which point, Microsoft’s Steve Bullmer’s excellent summary of what’s happening in the economy is well worth reading:
“We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy,” (see http://finance.yahoo.com/news/Microsoft- resorts-to-first-apf-14127574.html)
Modelling the dynamics of debt deflation is my academic research specialisation. A recent paper on this that supports your argument–that the debt mountain is simply too big to be overcome by adding government debt to private debt–is available at:
http://www.debtdeflation.com/blogs/wp-co ntent/uploads/papers/NotKeenOnBailoutsFi nal.pdf
Cheers, Steve Keen
This may have been said before, but its worth a mention.
It isnt only the U.S or U.K that are bankrupt, its actually the whole monetary system, that was built on fraud. Writing off worthless toxic junk which was known as junk by those that securitised anything and everything possible, is what should be done. Privately gains and abuse should not be publicised and the pain should be localised as the gains were. “City” of London created the monster, deal with it… and what a pleasant death to the Anglo/Dutch Financial Empire it is. We need to sever all its tenticles and start a new global financial system based on the US constitution as its the only true Sovereign nation in existence, in conjunction with China, Russia & India. The rest are economic colonies of the empire.
I have spent more time than I’d like to admit to reading both the article and many of the comments. Everyone is a [self-styled and often erudite] expert. And Mr. Kemp makes a lot of sense because he pragmatically lays out reality. However…
For anyone who’s interested, here is the real bottom line (yes, I suppose this makes me an ‘expert’ too): Kemp states, inter alia “…the necessary condition for resolving the debt crisis is a reduction in the outstanding volume of debt, an increase in nominal GDP, or some combination of the two, to reduce the debt-to-GDP ratio to a more sustainable level.” As for increasing nominal GDP, we need to create REAL value. You either capture it from the ground/air/sea, grow it, or make it; or some combination. That’s it. Massaging fiat currency is only economic masturbation.
The true underlying cause of today’s economic malaise is the personal, and I do mean personal, philosophy that we can live on the never-never. If you subscribe to that thinking personally, that means you subscribe to it as a buyer and seller.
Be more efficient in manufacturing. Capture margins otherwise relinquished to others by embracing better technologies that eliminate the costs you pay others to absorb (e.g., cheap labor), gaining competitive advantage and growing your business, creating more employment because you’re in a position to sell your products/services at a lower price while maintaining good margins to a broader universe of customers. Doesn’t this seem obvious?
And limit use of credit and OPM (Other People’s Money). We see these two as a panacea for reducing risk. Yes, it does, narrowly, but one never then develops a sense of careful pragmatism.
As for losses, suck it up, knuckle down and grab a shovel, pay attention to the suggestion box, reject hubris, stop passing the buck, change your MO in the ways above suggested, and spend money as if you earned it by the hour and had no credit.
I would argue that the debt doesn’t matter as much as the long term return on energy. When the price of energy starts climbing it limits our ability to deal with risk thus the credit markets start to come down. I think we could change our fate by bringing up Algae oil production to about 4 Million barrels a day as quickly as possible.
This all the fault of the Federal reserve. Printing money and increasing the money supply, thus forcing the rest of the world to maintain same levels of money supply.
When there is too much money in the system bubbles are created - ie housing adn shares
Banks/ Wall St are businesses that sell money (if there is no excess money to sell) they cant lend it.
If you leave lollies in a room with children then leave and come back to see teh mess, who do you blame the children or the irresponsible teacher
The Fed should have let the economy tank after the tech bubble, then we wouldn;t have been in this mess.
A recession is needed, its part of the system/economics, and must not tried to be stoppped.
Liek the junkie who has to go theough withdrawal to get clean, otherwise keeps getting more hits/drunk - just means the hangover is going to be worse
in the end.
Get out of debt
It is a wonderful article and sure to energise the neurons in our brain. What we are seeing currently is like nothing experienced by Economists ever. By the time we get to know how this pans out over the next few decades,we may need to rewrite the history of Economics. We can definitely understand that currently all Asset classes are Deflating. How long and how deep this Deflations runs its course, only God knows. Theoretically we have all learnt that cranking the Currency Printing presses means Inflation, sooner or later. Will this Deflation damage Asset values so badly as to drastically reduce the Wealth disparity between the filthy Rich and chronically Poor? I do not know.
The real nightmare of this Deflation for us folks will come about if after reducing our Assets to near about Zero, we get runaway Hyper Inflation. The young may be able to cope and rebuild but those of us on the wrong side of fifty could have their lives shattered. This can really test the Human Spirit.
May we find the strength to face and overcome the challenges.
God Bless !
One of the solutions proposed, and echoed by many commenters, is to reduce the overall debt as much as needed, by “letting inflation rip”. That was the solution employed by President Reagan in the ’80’s when the public debt burden was considered too high by his administration. The great injustice of this “solution”, in my view, is that those who created the problem are rescued and rewarded, while those who did not contribute to the problem, are severely penalized. Those who avoided excessive debt, met their financial obligations, lived within their means and saved some of their income and invested it, provided for their own support in their golden years instead of sponging off “the government”. It was their invested savings that provided the capital for businesses and individuals to borrow, so the economy could thrive. Due to the government-created raging inflation, people like me who retired in the early ’80’s had our savings cut in half in our first few years of retirement, reducing our “golden years” to poverty instead of the comfort we had legitimately earned. If this tactic is employed by the Federal Government again, we will sink from impoverished to destitute, all in order to keep irresponsible, unethical, and dishonest businesses and individuals from having to take any responsibility for their bad behavior. Could we please have a little fairness?
One of the comments hit on the real question, that is, “Where did all of the money go”. Most are all professing their solutions to a problem, but they have not really looked at and defined what created this problem. The proposals treat symptoms and not the disease. Mr. Urban came very close when he pointed out that most, if not all of the problem arises, not from the effects of capitalism, but from the effects of uncontrolled greed.
Much of the debt, aside from the stupidity of rampant over-appraisal of real estate and mortgage fraud, stems from corporations borrowing beyond reason and the ability to pay back their foolish and greed inspired borrowing. How many corporate buy-outs have you seen, read about or even provided participation, where one company would buy another to enter a new or expanded area of business. And worse yet are the buy-outs that were to purchase the competition to absorb or liquidate them. In many or most of these cases the purchasing company just borrowed the money to buy up the purchased company and assets. In most cases the purchasing company’s stock falls while the bought-out company stock is inflated because the sellers will be able to take the cash buy-out payments like money that vanishes and is replaced by new debt burdens upon the buyer. Eventually, in many cases, the buyer cannot support the increased debt burden and the company shrinks until bankruptcy looms as the only way out. Is this where our country is headed, as we make the same mistakes on a much grander scale?
Investment and the taking on of debt must be supported by the creation of income to retire the debt. One of the most foolish actions of our government was the taxpayer refunds of last year where money was handed out for no benefit other than to promote consumer spending. Unfortunately for the U.S., the consumers probably spent this little windfall upon items made in China or other Asian countries. Wouldn’t it have been wiser to have taken that same government money and used it to build needed infrastructure, creating jobs and promoting the purchasing of necessary items, more probably produced locally? Billions of dollars were handed out to the taxpayers, and now we have little or nothing to show for it, other than a blip on our balance of trade deficits.
I will admit to all that I am an engineer and not an economist, but then just look at how your ipod has gotten smaller and your computers keep getting more powerful and less expensive, and compare that to how well the economists are doing what they do right now. Perhaps we need some serious and careful economic engineering, and a little less calling for inflation and public debt without any design goals and test procedures to monitor progress and achieve a desired and measurable outcome. It could only be worse if the lawyers were trying to resolve this crisis, but just wait, soon they will be.
Replying to Mr. Kemp, I wrote a poem:
Ode to Obama’s Inauguration
(With apologies to Rudyard Kipling)
By: Cecil R. Williams
On the road to Zimbabwe
Where hubris rules o’er our day
and motors slow like dying men
as Robinhood strikes, today!
On the road to Zimbabwe
Obama arrives to say
‘Productiveness is not important
as need is op’word today’
Oh the road to Zimbabwe
as the Lemmings ‘lights out’ say
civilization dies in agony while
what might have been, Kipling say!
“Oh the road to Mandalay
Where the flyin’-fishes play
An’ the dawn comes up like thunder
…………………………………………”
The whole notion of insuring bad behavior is what has created this economic UNFIT: uncontrolled flight into terrain. Widespread bankruptcy will destroy the banks, while hyperinflation will destroy the taxpayers. The only solution is a gradual descent, as investors take their losses and debt holders shed their toxic assets over the next few years. Any government attempt to accelerate this process will only result in disaster. In two words: do nothing. In time, recovery will come.