Does Economic Data on Debt Support Medium-Term Bullishness?

Wednesday morning I again wanted to challenge my somewhat bullish medium-term outlook but bearish longer-term view on the US economy – this time by looking at the data on debt. What follows is going to be a very numbers-heavy post. So, I apologize in advance if you are not a numbers jockey like me. But, do bear with me; I think you will find the analysis useful.

Now, as I write this paragraph, I have compiled the data, but have not yet dissected it. So I approach this without any definitive conclusions at the outset (although I must admit the last time I saw the data last year, they supported my thesis). Let’s see if the data still support my beliefs .

The Asset Based Economy View of America

My pre-conceived thesis is as follows:

1. The U.S. has been living beyond its means for a generation as reflected in the increase of debt to GDP across a wide-spectrum of sectors of the economy.
2. This increase has not been worrying to policymakers because they have only been watching debt service burdens, to the degree they have been tracking debt.
3. Because of “the Great Moderation,” interest rates have fallen, permitting a secular increase in debt to GDP levels without increasing debt service burdens.
4. The Federal Reserve has a dual mandate to support economic growth (through full employment) while maintaining low consumer price inflation (through price stability). Cognizant that debt services burdens were not acute and consumer price inflation was low, the Federal Reserve was able to target asset prices through lowering the Fed Funds Rate as a mechanism for reviving the economy when cyclical downturns occurred.
5. As a result, the Federal Reserve under Sir Alan Greenspan followed an asymmetric monetary policy of only increasing interest rates slowly in the face of large levels of asset price inflation but reducing those rates very quickly to stem asset price declines.
6. The result has been a belief that the Fed would save the economy when it ran into trouble, the so-called Greenspan Put. This has increased the appetite for risk in the financial sector and, most crucially, has meant that debt levels always increased after a brief downturn. The heroic actions of the Bernanke Fed have only increased this belief in the Fed as economic savior, sowing the seeds of the next asset bubble.
7. This Asset-Based Economic Model can last through several business cycles – but will eventually collapse when debt service burdens become too large.

So, in sum, I believe that we are now poised to either a) collapse under the weight of debt only if debt service burdens are too much to bear or b) continue apace in the Asset-Based Economy until these burdens do eventually become crushing. I see a) as the more likely outcome during this cycle. Whether that crushing level of debt eventually comes as the result of a decline in incomes not matched by a decline in debt burdens (deflation) or via an increase in interest burdens not matched by an increase in incomes (inflation) is a question for another day.

What I want to look at here is the narrow issue of how debt burdens have moved at turns in the economic cycle. Specifically, I am about to examine the debt to GDP levels of specific sectors of the economy as presented by the Fed Flow of Funds right around recessions. And then I will compare these levels to the growth in nominal GDP and draw conclusions based on the data (debt cannot grow more than nominal GDP for long or it is a clear sign that growth is predicated not on sound investment and productivity but on leverage).

So, this is not an exercise in crunching the numbers to fit a conclusion, but rather a look-see at whether the data supports my thesis.

The Numbers: Federal Reserve Z1 Data Series

The Federal reserve releases a data series called Z1 every quarter. This is the basis of my analysis (link at the bottom). The Z1 series shows debt from the following sectors of the economy:

1. domestic nonfinancial sectors credit market instruments, excluding corporate equities liability
2. households and nonprofit organizations credit and equity market instruments liability
3. households and nonprofit organizations home mortgages liability
4. households and nonprofit organizations consumer credit liability
5. nonfinancial business credit market instruments, excluding corporate equities liability
6. nonfarm nonfinancial corporate business credit market instruments liability
7. state and local governments, excluding employee retirement funds credit market instruments liability
8. federal government credit market instruments liability
9. total finance credit market instruments, excluding corporate equities liability
10. rest of the world credit market instruments, excluding corporate equities liability

My pre-conception is that the sectors I want to key in on are the mortgage market (3), the household sector (4) and financial services sector (9).

Total Debt

What should be abundantly clear from the two charts below is that the U.S. has been growing in an unsustainable way since the recession of 1982. There was a brief period during the 1990-91 recession when the change in nominal GDP outstripped increases in debt levels, but that’s it (note, I use year-over-year change levels throughout). This is completely at odds with the preceding period in which every recession induced declines in debt to nominal GDP comparisons.

Debt levels at the end of Q2 2009 are 357% of GDP, a massive increase from the 160% that prevailed in 1982. The data clearly demonstrate that since 1982 the U.S. has relied on an increase in debt, even during recession, to avoid downturns. My thesis of policy asymmetry is, therefore, confirmed.

Government Debt

This chart is fairly benign when you look at aggregate levels as a percentage of GDP. Pundits forecasting an imminent increase in U.S. interest rates because of too much government debt have obviously not looked at these data. However, what is striking is the huge and unprecedented surge in debt as a percentage of GDP since the latest downturn hit. This discrepancy to nominal GDP cannot go on indefinitely. My general conclusion is that deficit spending can indeed continue for a long time without stoking an increase in interest rates given the low level of government debt as a percentage of GDP. This is bullish for U.S Treasuries in a muddle through economic scenario.

Household Debt

There is less here than I anticipated. One thing is clear: the household sector has breezed through the recessions in 1990-91 and 2001 without decreasing debt significantly. As a result, the increase in debt levels in the household sector are pretty astonishing. In 1952, it began at 24% of GDP, rising to around 40% by 1960, where it remained through the Ford presidency. Afterwards, it shot up again to its present 97%, four times the level a half-century ago.

Mortgage Debt

This pattern is largely the same as the previous one.

Consumer Credit Debt

Consumer Credit seems to be much more volatile than mortgage credit. You can see the fluctuations in comparison to nominal GDP are greater. And the absolute amounts are much less than in the mortgage market. The conclusion I draw from this is that, to the degree household debt levels have increased unsustainably, it is mortgage debt which is to blame.

Non-Financial Business Debt

There is a lot more volatility in capital spending as reflected in non-financial business debt levels as well. Nevertheless, there has been a secular increase in debt levels of the business sector, from 30% in 1952 to the present 78%. The one thing to notice on the chart on the right is how short business cycles were pre-1982. It is more striking in that chart because business debt levels always adjust during recession.

State and Local Government Debt

Since the 1960s, state and local government debt levels have been basically flat as a percentage of GDP. There is not much to say here except to note the huge spike in the mid-1980s relative to nominal GDP. Can someone explain this for me? I think that area circled in red is quite intriguing.

Federal Government Debt

This chart looks basically the same with the total government debt charts as Federal Government debt dominates. What you should notice is that debt levels are lower now than they were in the 1950s and have just passed the post 1950’s high-water mark in 1993 of 49%. Again, this does suggest there is ample room for deficit spending without an increase in interest rates. The data are more favorable for treasuries than I had anticipated.

Financial Services Debt

This is probably the key damning piece of data confirming the asset-based economy thesis. The data are much worse than I expected. Not only do Financial Sector debt levels rise from negligible to percentages well over 100% of GDP, but the entire post-1982 period sees zero decline compared to nominal GDP until last quarter.

What conclusions can one draw here?

1. The financial services sector is six times more important than in 1982 when its debt is measured as a percentage of GDP.
2. The financial sector protected the American economy since 1982 by increasing its debt burden relative to nominal GDP even during recession.
3. The financial services sector contracted in Q2 relative to GDP for the first time since 1982. If this is a rear-view mirror view, that means recovery could continue. However, if this is a canary in the coalmine, that is negative for the U.S. economy. This number bears watching.

Foreign Debt

There was an absolutely massive decrease in foreign debt relative to GDP when the economy was falling. Q4 2008 saw a gap of -12.4% between the change in foreign debt and the change in nominal GDP. The year-over-year differential has diminished as Q1 and Q2 2009 saw foreign debt increase, albeit to a level much lower than in Q3 2008.

Conclusions

Most of my basic beliefs regarding the asset-based economy are still intact. What now seems clear to me is the degree to which the post-1982 period is a departure from the one which preceded it. Moreover, the data on the financial services sector was surprisingly stark. I would go as far as to say that the US economy depends on leverage in the financial services sector to continue growing. I come out of this thinking it is the financial services sector more than the household sector dictating the course of events. And as the financial sector just began to really deleverage in Q2, it bears watching how this proceeds.

As for the household sector, aggregate debt levels are not decreasing substantially – not in mortgages or consumer credit. This may have changed in Q3 but given the fact that the worst of the recession was in Q4 2008 and Q1 2009, the data suggest that the consumer will not deleverage. If deleveraging doesn’t occur in the mortgage market, the household sector will not be the cause of a double dip. So, not having looked at debt service levels yet, I am not anticipating an imminent downturn in consumption demand or a further increase in savings – although this could change based on the data.

In the end, my somewhat more bullish medium-term outlook is justified by the data. Here, I am not talking about longer-term sustainability but the prospects of a multi-year recovery. Watch debt levels in the financial sector as a contrary indicator.

Source

Z1 Data Series – Federal Reserve

Comments

[Moon Kil Woong:]

Thans for your rather detailed view on debt in the US. The Federal debt is just the tip of the iceberg. Under it sits the unaccounted for debt caused by social security and other underfunded US liabilities. Although this can be explained away in the fact that people believe the US will simply curtail social security medicade etc. when the liabilities occur, politically this is questionable.

Regarding the broader economy, it is clear the US government wasn't the only one piling on unsustainable debt. A few years of austerity, although bad for GDP would go a long way at restoring some semblance of fiscal sanity to these charts.

Edward harrison is once again right that in a recession businesses and individuals need to unwind their debt levels, otherwise the correction does wring out inefficiencies out of the system and create a firm base for growth and prosperty going forward. This clearly has not taken place in the 2001 recession. The government should stop trying to prevent it from occuring this recession as well.

Oct 08 04:15 AM

[aussiereader4:]

Dear Ed,

You have performed the same exercise that i performed two years ago.

I made the following comment following John Lounsbury article on the 21st September which incidently did the same exercise but from the late 1990's..

'Interesting article, I did this same exercise about two years ago, i found that there would have been no growth in gdp without the debt expansion back to the time of Ronald Reagan. There was a brief respite in 1990's, which you have charted following the de-militarisation that followed the decline of the Soviet Union. The growth in the US economy has been an illusion for 30 years.'

Following the article 'its the debt stupid' I wrote the following

'It is my conviction that when external debt repayment requirements climbs above 30% of GDP, a country is in serious trouble.' It happened first in 1929.

The USA has been above this level since 1998, except for when interest rates are kept low by the Fed. The Fed is incapable of raising rates above about 3-4% without precipitating another decline.

This is why the US dollar will devalue and there will be inflation.
Do the same exercise with other economies. The UK is the worst.

You are right to be a long term bear.

Oct 08 04:53 AM

[chap08:]

A useful run thru the data, Edward. You say:

"My general conclusion is that deficit spending can indeed continue for a long time without stoking an increase in interest rates given the low level of government debt as a percentage of GDP. This is bullish for U.S Treasuries in a muddle through economic scenario."

I agree with you that deficit spending CAN continue in this way. That's not to say it should. Certainly Japan shows what's possible. They will reach a debt to gdp ratio of 200% next year and it hasn't done their govt bonds much harm. In fact there are several countries with more worrying ratios than ours. There is no evidence that the market will punish us for spending. In addition, there are good reasons for several of our backers to keep buying. Oil states and mercantilists will keep buying for their own reasons. They certainly won't be selling in any big way. Realistically, where else would they invest it?

But that doesn't add up to a "bullish" scenario for a number of reasons including:
1. The dollar will continue to fall, long term. This could easily lose you 5% pa against a balanced basket of global investments.
2. Treasuries are currently priced to perfection from an inflation perspective. That's unrealistic. 2-3% inflation is easily possible based on a lower dollar and oil staying high.
3. Long term the appetite for treasuries will decline. I see a lot of people making a case for treasuries as a short term refuge. I haven't seen anyone make a case for them as a good long term investment.

Oct 08 06:11 AM

[Edward Harr...:]

I'm not sure if anyone caught it here, but there is a typo where I say I see a) as the most likely scenario this cycle. I meant b). Perhaps it was a Freudian slip?

But Chap08, I wanted to address your view on Treasuries. What I was trying to say on Treasuries is that I see the case for low-to-moderate inflation in a muddle through (1-3% GDP growth) scenario. And given the low debt-to-GDP numbers, I don't see the canard of a huge deficit as a significant problem (over the medium-term).

As for the hidden liabilities of medicare and social security, that is another issue.


On Oct 08 06:11 AM chap08 wrote:

> A useful run thru the data, Edward. You say:
>
> "My general conclusion is that deficit spending can indeed continue
> for a long time without stoking an increase in interest rates given
> the low level of government debt as a percentage of GDP. This is
> bullish for U.S Treasuries in a muddle through economic scenario."
>
>
> I agree with you that deficit spending CAN continue in this way.
> That's not to say it should. Certainly Japan shows what's possible.
> They will reach a debt to gdp ratio of 200% next year and it hasn't
> done their govt bonds much harm. In fact there are several countries
> with more worrying ratios than ours. There is no evidence that the
> market will punish us for spending. In addition, there are good reasons
> for several of our backers to keep buying. Oil states and mercantilists
> will keep buying for their own reasons. They certainly won't be selling
> in any big way. Realistically, where else would they invest it?<br/>
>
> But that doesn't add up to a "bullish" scenario for a number of reasons
> including:
> 1. The dollar will continue to fall, long term. This could easily
> lose you 5% pa against a balanced basket of global investments.<br/>2.
> Treasuries are currently priced to perfection from an inflation perspective.
> That's unrealistic. 2-3% inflation is easily possible based on a
> lower dollar and oil staying high.
> 3. Long term the appetite for treasuries will decline. I see a lot
> of people making a case for treasuries as a short term refuge. I
> haven't seen anyone make a case for them as a good long term investment.

Oct 08 07:53 AM

[Living4Divi...:]

You put alot of work into this article. Alot of detailed charts. Terrific article

Oct 08 10:06 AM

[gato:]

Thank you Mr Harrison,
The detailed analysis has (in my opinion) one major flaw, that is you like all economist are using data supplied by the FED..you said:

"The Federal reserve releases a data series called Z1 every quarter. This is the basis of my analysis"

Since this is corrupted data (through their teeth) in mind boggling detail, to legitimize it, your hard work is of little value and should be viewed with as such...never the less it's thought provoking article.
Thanks!
gato

Oct 08 11:28 AM

[chap08:]

Agreed in the sense that, in the short to medium term, treasuries may not be much worse than most other investments.

Also, forgot to say - another great article! You have done some great stuff recently. This type of well thought out, facts based analysis is what I value most.


On Oct 08 07:53 AM Edward Harrison wrote:

> I'm not sure if anyone caught it here, but there is a typo where
> I say I see a) as the most likely scenario this cycle. I meant b).
> Perhaps it was a Freudian slip?
>
> But Chap08, I wanted to address your view on Treasuries. What I was
> trying to say on Treasuries is that I see the case for low-to-moderate
> inflation in a muddle through (1-3% GDP growth) scenario. And given
> the low debt-to-GDP numbers, I don't see the canard of a huge deficit
> as a significant problem (over the medium-term).
>
> As for the hidden liabilities of medicare and social security, that
> is another issue.

Oct 08 12:02 PM

[AU:]

To build a thesis on finance JUST using debt (liabilities) is bias by design and can lead to wrong conclusions.

All things financial break down into 4 & only 4 pieces.
1.) Obligations
2.) Responsibilities
3.) Liabilities
4.) Cash

The more of the first 3 you have the less cash going forward (for perceived growth).
The less of the first 3 you have the more cash going forward (again for perceived growth).

It doesn't matter if you’re a 12 yr. old on a paper route, small / large business, local, state or federal government (any country).

You have done an excellent job with the data you have (debt) but it's not enough to draw any conclusions from.

Oct 08 12:09 PM

[fotokemist:]

Thanks for a great deal of effort.

Oct 08 01:46 PM

[Hunter the ...:]

I am curious about eliminations among the debt components of the charts. For example, household debt should consolidate mortgage and credit card debt, but financial sector debt will also include mortgage debt - ie to some extent they are levering the holding of the consumer obligation. So inherently, the total amount of debt funding the mortgage will have some degree (albeit not perfect) of elimination vis-a-vis debt funding the financial institution. If this debt is entirely domestic then the leverage at the financial institution is held by an unlevered investor and theoretically doesn't add leverage to the currency. If it is held by a foreign investor then it adds to the capital account deficit and inherently pressures the currency when/as leverage cannot be serviced.

So I guess what would be interesting would be a consolidation of the charts up to the first chart, so as to see more about what the real driver is. Of course I cannot do this but would find it interesting to have somebody else give it a try.

Hunter the Punter

Oct 08 01:55 PM

[Ichabod:]

Thanks for a thorough, careful analysis.

You mention that leverage in the financial sector is what has driven US growth since the 1980's. The clout of that sector is reflected in the enormous percentage it holds in stock market capitalization - not only here, but across the world.

Imagine if those two trends could continue at an ever-increasing pace: the world will stop making useful things and supplying helpful services; people will merely pass around pieces of funny paper, bidding up prices toward infinity, using debt whose collateral is more debt (as the banking system does now).

We have become grasshoppers.

Oct 08 02:40 PM

[Thomas J. G...:]

Good article. Seeing all the different kinds of debt broken out is interesting. Looking at debt to gdp tells a lot but this detailed breakout is really helpful. The word needs to get out to the voters that maybe we've been living beyond our means for the last 10-15 years. Otherwise some terrible decisions are going to get made at the ballot box. Maybe people don't care and will vote for whoever promises to keep them at their standard of living of the recent past. But we have to hope for rationality. I guess the other interesting question is why were we able to borrow so much. I guess other countries were lending to us. If you are the world's economic and military super power you can borrow a lot of money and people don't ask whether you will pay them back. If the u.s. was Zimbabwe, we couldn't have borrowed like that.

Oct 08 04:27 PM