Why private (non government) debt may be the real culprit

Last week, in response to a colleague's post, I suggested that concerns about America's debt may be premature. One of my reasons was that though high, the U.S. federal debt as a percent of GDP is less alarming when placed in historical context.  This ratio was 120% during the Second World War and 60% in the 1950s; furthermore, the federal debt has averaged about 40% since 1956 (the same level it reached in 2008, although it is expected to rise to or above 60% by 2010).

For some reason, the thought of considering US private debt (i.e., non-government debt) did not even cross my mind. This may have been partly the result of a naïve belief that other sectors would never match the government’s addiction to spending enormous amounts money it does not have and/or Freddie Mac and Fannie Mae's irresponsible use of explicit/implicit government guarantees to borrow excessive amounts of money from the financial markets in order to buy shoddy mortgages. Add to this the billions and potentially trillions of dollars the government is spending to bail out Fannie Mae and Freddie Mac, the banks, the Big Three, and any other entity deemed too big to fail and, my thinking was, there was no reason to worry about other sectors’ (non government) debt relative to public debt.

To validate my hunch, I went to the Federal Reserve Statistical Release website and looked at the most recent Flow of Funds Accounts of the United States (Dec. 2008). I was surprised to find that the federal government seemed to be a more prudent borrower (at least it borrowed less) relative to other sectors. In 2007, federal debt outstanding was about $5.1 trillion. Compare this to the following private debt outstanding that same year:

Household debt (mainly home mortgage & consumer credit) = $13.8 trillion

Mortgage debt alone, which in 1997 was nearly equal to the federal debt, more than doubled to $10.5 trillion dollars by 2007 (more than twice the federal debt outstanding in 2007).

Business Debt = $10.6 trillion (more than doubled from 1997 levels)

Domestic Financial Sector = $16.2 trillion (more than tripled from 1997 levels)

Total US Debt outstanding (public and private) = $48 trillion

The troubling thing about these figures is not that private debt is considerably larger than the debt levels of the federal government, or that federal debt is a relatively low percentage of the total. Theoretically, this should be a good thing. The main problem is that the massive increase in debt levels has not been followed by similar rises in income, proportionally speaking. This seems to point to a sad truth: that a major part of our past growth was fictitious, built on excessive private borrowing, which, enhanced via securitization and derivatives, created enormous amounts of wealth that fueled excessive spending with money that had not been earned. We borrowed more to spend more, deluding ourselves that this amounted to sustainable economic growth.

But the real shocker is that the total debt (public and private) mentioned above pales in comparison with the debt created by derivatives, a private sector invention. According to the Office of the Comptroller of the Currency, the notional value of derivatives held by commercial banks as of the third quarter of 2008 was $175 trillion. Other estimates suggest a much higher figure. If these derivatives go the wrong way, no bailout or stimulus will be large enough to get us out of this crisis.  The potential havoc that private sector debt is able to cause the economy – via derivatives or other innovative instruments designed in part to circumvent regulations – is, as we are seeing, astounding. The question is: what should we fear more, government debt or private sector debt? Right now, I am more afraid of what the latter has done than any policies supported by the former.

Comments

[Marty Basu]

What’s particularly troubling about the private debt issue is that system incentivizes the accumulation of private debt. A bank’s profitability is derived from its ability to attract as many borrowers as possible. Until recently, it learned that it does not even need to take on sound risk; borrowers of all risk were worth it to them, as long as they could bundle up the risk into enticing securitizations for other investors.

The only check we seem to have against the debt culture is what we are about to experience: a depression. Still, that only attacks the problem from the demand side, so to speak. A borrower might not be so ready to take on a subprime loan or invest in a house that is worth more than seven times his annual salary after living through a generation of defaults. Indeed, it took a few generations for people to get out of the Depression mindset and invest in funds other than T-bills.

The real question: are the banks going to change? A case can be made that a bank might not be so willing to dole out subprime mortgages either but perhaps the banking industry is just going to look at this as a failure to price risk correctly. Maybe in 20 years, they look back and say “Now I know how to price the real estate market and I won’t make the same mistake twice being overly optimistic.” It is not hard to imagine that in the future, we will again have a need for real estate and the banks will again see a need to get large amounts of cash to real estate developers. Maybe banks figure out that they can bundle enough “good” risk with “bad” risk that it could still come up with a safe security that might find investors.

In the end, there will always be someone willing to give you money and charge you an interest rate. One might think that a solution is to police individuals and prevent them from accumulating too much debt, putting an effective check against the growth of the economy, but people get pretty upset at the government telling people what to do and people might actually seriously consider moving to a country where they could do whatever they wanted with their money. More likely, we can just ride the waves of the free market economy and know that times will be better.

[Shoney Hixson]

Your research into private debt reminds me of the question Professor Henderson asked a few weeks ago about why the billions of dollars in bailout money that have been pumped into the economy haven’t caused inflation. If I remember correctly, one of our classmates actually suggested that he suspected there was no inflation because the “money” people had been spending wasn’t there to begin with. It seems as though your research has proven our classmate right. It boggles my mind that this can be the case. I honestly do not understand fiscal policy enough to comprehend how companies/individuals/banks/etc. can borrow/lend money that doesn’t exist. It’s just a little too metaphysical for me.

[Jeff Farkas]

Private debt accumulation has long been a severe problem Had it not been for the Greenspan Fed policy of easing monetary policy following 9/11, its likely the 2008 credit debacle and recession would have occured much earlier.

I would expand on the author's comment regarding "fictitious growth:" Its apparent that the value of our private wealth is largely fictitious as well, hence the Great Devaluation that has been occurring over the past several months.

[David]

There is an interesting new paper on this topic here:
http://www.voxeu.org/index.php?q=node/6328

Summary: Over the last three decades the US financial sector has grown six times faster than nominal GDP. This column argues that there comes a point when the financial sector has a negative effect on growth – that is, when credit to the private sector exceeds 110% of GDP. It shows that, of the advanced countries currently suffering in the fallout of the global crisis were all above this threshold.

[לימודי שוק ההון]

It is very challenging to suppose at some point, I will again have a need for property and the financial institutions will again see a need to get a lot of money to property designers.