If you are overweight or obese, there are two ways to get fit, healthy and back to the right weight. You can do more exercise and you can eat less. Most scientific surveys show that the latter is does the trick more than the former, but you need both.
What’s true for the human body is also true for the body economic. The American capitalist economy is struggling to recover from the biggest slump it has experienced since the Great Depression of the 1930s. Humans cannot run faster if they remain fat and America’s economy won’t grow fast enough to create jobs in an economy where 17% of the labour force are unemployed or underemployed unless it can remove the excessive weight of debt bearing down on it.
In a previous post (The overhang of debt, 1 March 20101) I argued that the huge increase in private sector credit that fuelled the property boom of the 2000s was really what Marx called fictitious capital. It was not an accumulation of assets with real value like factories, technology or skilled labour, but assets that had fictitious value, like company shares or property.
Eventually, any slowdown in the growth of real values would expose the hollow nature of this fictitious capital. And indeed, the buyers of all that debt in mortgages and other forms of borrowing, found that the asset prices held as collateral started to collapse and homeowners defaulted and banks went bust. The credit crunch and the Great Recession ensued.
Until that mountain debt can be cut back by bankruptcies, write-offs and payments, the profitability of new investments will be curbed and so will capitalist economic growth. American capitalism has to go on a debt diet.
But dieting that works takes time and discipline. If history is any guide, deleveraging usually takes several years – at least four and often as much as seven, according to studies by the McKinsey Institute and Reinhart and Rogoff. This time will be no different. In the meantime, real GDP and consumer spending growth will stay below trend.
The increase in debt experienced by the major developed capitalist economies, particularly between 2001 and 2008 was unprecedented. Between 2000 and 2008, the compound annual growth in public and private sector debt was 8-10%. Overall debt outstanding in the major economies rose 58%, led by a 66% increase in household and financial sector debt. Such increases would suggest that the process of deleveraging will be longer and more painful than it has been after previous crises.
So how far has debt dieting gone? According to the latest Federal Reserve bank statistics, the short answer is not very far. Total US debt (public and private) is now higher than it was at the end of 2007, although it has been falling since Q1’09. The main reason that the US economy is deeper in debt than before the financial crisis began is the rise in public sector borrowing. In effect, more debt has been piled on existing debt – apparently the answer to obesity is to eat more. Since end-2007, government debt (including the now state-owned mortgage lenders Fannie Mae and Freddie Mac – so-called GSEs) is up 72%, while financial sector debt is down 9% and households have reduced their debt by nearly 3%. The non-financial business sector has raised its debt by 2.6%.
Dieting has gone the furthest in the financial sector. The big debt reductions have been in the writing-off or redemptions of mortgage-backed and other asset-backed securities. The value of these securities and the debt they represent has dropped $5.2trn, or over 60%. The debt securitisation market has died.
The largest sector in the economy and the one which drives consumption and corporate sales, the household sector, has reduced its debt by $380bn, or 3% since end-2007. Indeed, households went on adding to their debt right through most of 2008 before borrowing peaked at $14.6trn. Household debt now stands at $13.9trn, down 6% from its peak. That is the biggest fall in household debt in modern times.
But more is needed. Household debt may be down $650bn from its peak, but the value of household assets (both real estate and financial assets) is down 20 times more, namely $12.4trn, or 16% from its peak in Q3’07! As a result, the ratio of household liabilities relative to assets jumped from 17.7% in Q3-07 to an all-time record of 22% by the beginning of 2009 and is still above 20%, as opposed to the trend average of about 17.5%. In that sense, the debt burden of American households is worse, not better.
The drop in asset value has been repeated in the business sector, if not quite to the same degree. US Inc is flush with cash. Corporate cash levels are up from $580bn at end-2007 to $920bn. But the value of non-liquid tangible assets has fallen by more than six times as much. Commercial real estate values have fallen by one-third from $9.3trn at end-2007 to $6.5trn now. The overall fall in corporate business assets is $2.2trn, while debt has risen by nearly $1trn, as companies issued paper to finance their businesses. As a result, the business sector debt to assets ratio has reached a level not seen since the recession of the early 1990s.
That’s not good news to sustain a rise in profitability. In the last significant recession of the early 1990s, the business debt-asset ratio also rose sharply – it’s a function of recessions. But then the ratio soon improved because there was a sharp recovery in corporate asset values. Indeed, corporate debt continued to rise – so there was no dieting at all. But this time it will be different. In this crisis, corporate asset values have plunged to such an extent that any recovery in asset values will be insufficient to restore healthy balance sheets that will encourage businesses to sustain new investment. This time debt will have to be reduced as well.
Deleveraging in the private sector has been small so far because the cost of servicing that debt has fallen. US mortgage rates are at record lows. Personal interest payments as share of personal disposable income are also at record lows. In that sense, the economic recession and Fed monetary policy has enabled the body economic to avoid dieting too much. But the debt (excess fat) remains.