US Borrowing, Debt and Growth Part 1

Below is a picture (Chart 1), for the last three decades, of the total amount of money Americans borrow each year.  The credit is provided, primarily by American banks for

1. American households, 
2. American businesses, 
3. American banks, 
4. Various branches of American government.

By far the majority of credit is provided to the "private" that is the "non government" sector, which are the first three sectors above.

Contrary to much of Main Stream Media and politician noise, private borrowing and private debt has been our primary borrowing and debt problem.  It has not been government borrowing and government debt.

It was only in the last couple of years (since Q4 2008) that the Bush administration, with the complete agreement of the incoming Obama administration, and the Federal Reserve, that the US federal government (USG) bailed out the private banking system, and thus took on the responsibility for redeeming private debt.

Thus did we middle class Americans have the excretions of bankers and conniving politicians dropped on our unwitting heads.

The USG got involved because the world credit "suddenly" froze and bank lending ceased.

In less than two years, Americans changed from borrowing about $4.5trillion per year to borrowing less than nothing -- whatever that means.  (More on that in later posts).

What does that signify?  Sound and Fury Signifying Nothing?  Just a Bump in the Road of  Perpetual Economic Growth?  A Harbinger of Economic Doom?

You will find my answer at the end of this piece.

This post is the first of a bunch of wonkish, but hopefully commonsense and easily understandable posts on the subjects of American borrowing, American debt and American economic growth (US GDP).

Chart 1.  Total US annual borrowing.  Data from the Fed Flow of Funds Table D2
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I will start with a series of charts and brief explanations of their significance.  After I have presented data in chart form I plan to begin, in future posts, a somewhat philosophical data based discussion about the implications of these debt and borrowing data on future US GDP growth.  I think best in pictures. So...

Chart 1 tells me that something extraordinarily dramatic happened in the period 2008 through 2009. 

• In the previous three years US banks lent and Americans borrowed an average of approximately $3.5trillion a year, peaking in 2007 at $4.5trillion.  This tradition of borrowing had been in style for at least the last three decades.
• In 2008 in a sudden reversal, US banks issued loans of only about $2.5trillion and in 2009 they actually reversed course and "sucked in" (wrote off or were paid off) about $0.5trillion.  As the chart shows, this "negative lending" was a unique event in the last nearly four decades.

We know from his book that President Bush's Treasury Secretary Hank Paulson, in  2008, was terrified of a complete breakdown of the US banking system.  He went down on his knees  to Nancy Pelosi begging her to get Congress to pass TARP, a bank bail out package which was passed in late 2008.  "I didn't know you were a Catholic Hank", Pelosi is reputed to have said.

As a result of passing the TARP "Wall Street" bailout in 2008, and the ARRA "Main Street" stimulus in 2009, the federal government (Treasury) had to increase its borrowing to meet the federal government's new commitments.  The borrowing necessary was increased by reduced tax receipts caused by the crash influenced recession.

Chart 2 focuses on the more recent period and shows the annualized quarterly borrowing for the period 2004 through 2009 for total US credit market borrowing and for US federal government credit market borrowing. 

It is clear that federal government borrowing prior to the crash was a very small portion of total borrowing by Americans.

As the chart shows, it is only when total private borrowing crashed, that the federal government stepped in.  The rescue operation almost immediately tripled the federal deficit. (Note: Federal government borrowing is included in total borrowing. As I explained here federal government credit market borrowing is another name for "the federal deficit", with allowances made for fiscal and calendar year differences).

Chart 2:  US and Federal Government borrowing
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In chart 2 Federal government borrowing increases by nearly $2trillion annually in the government's attempt to compensate for the collapse of private loans.  But total US borrowing has fallen from a rate of about $5trillion/year since Q2 2007, so other sectors must have experienced even larger decreases in borrowing.  I will discuss sector debt data in later posts.

But first a little common sense macro economics:

1. GDP and Borrowing and Total Debt:  GDP is a measure of the size of a nation's annual consumption -- it is a measure of the size of a nation's economy.  We know that static or shrinking economies cause grave national and international problems. A growing economy requires a certain level of continuous borrowing if it is to continue to grow.  As long as the total debt remains a "reasonable" percentage of GDP, whatever that means, and as long as the new borrowings which increase the debt are invested in productive projects, increasing debt is virtuous, the new borrowings improve productivity, and, theoretically, the economy grows at a maintainable rate, and the resulting debt can be serviced.  Borrowing in those circumstances is "a good thing".  Government deficits as long as they are wisely invested and not "too large" are desirable. 
2. GDP Growth Targets: Over the course of capitalist history, experience has taught us to keep our economic growth within certain limits.  We seem to accept that real annual economic growth (real GDP growth) between about 2.5% and 4% "is a good thing".  Much above 4% leads "developed" nations to experience economic bubbles of boom and bust.  Much less than 2.5% leads to misery and social unrest.   The range between 2.5% annual growth and 4% annual growth leads to a doubling of GDP (consumption, economic growth, call it what you will) between about 18 years (4%) and  about 28 years (2.5%).  "Developed" nations appear to be able to handle, and to need, these kinds of limits on growth rates.  During the last century "Central Banks" (the US Fed, the Bank of England, the ECB...) have been given the responsibility to fiddle with interest rates and money supplies to keep growth within roughly these bounds while maintaining "full employment". 
3. Employment Targets:  We also seem to have accepted that reducing unemployment to much less than about 4% to 6% of the "employable population" (depending on how it is measured) is almost impossible and that a "just" society must plan and provide for about 5% of it's employable citizens to be unemployed.  
4. Debt and Borrowing Targets:  Since we seem to have accepted a compound annual growth rate (CAGR) of GDP of about 2.5%-4% as a target, it is reasonable to expect that debt CAGR, expressed as a percentage of GDP, to be in line with, or somewhat greater than GDP CAGR.  This is just another way of saying that borrowing as a percentage of GDP should be in the region of the GDP growth rate, or maybe just a shade more, depending on current crises and future confidence.   There are no accepted rules of thumb I am aware of which recommend absolute limits of debt as percentages of GDP.  Professors Rogoff and Rinehardt have done a lot of historical research on "public debt" (government debt) limits, but their conclusions are quite controversial.
5. In summary then, if debt is at a reasonable level to begin with, meaning that the debt in each sector of society can be easily serviced, then in a healthy economy debt, as a % of GDP, should grow at about the same rate as GDP, or maybe a little faster if we want to "borrow from the future".  It also means that borrowing, measured in dollars, should be about the same as GDP growth in dollars, or maybe a shade more.  So if GDP is growing at say 5%/year, and if we are confident about future growth, perhaps we can convince our selves to increase our borrowing at perhaps twice that rate (10%, or 110% of GDP), with an occasional few years at a higher rate.  So borrowing at the rate of 120% of GDP growth or even higher may be permissible for short emergencies like war.  
6. Consistently borrowing and planning to borrow at any rate much greater than about 150% of GDP growth should set off all kinds of alarm bells in the halls of government.  For the last three decades Americans have been borrowing at rates in the region of 400% to 800% of GDP.  A large portion of this excess borrowing has been completely unproductive.  The borrowing has been used to finance the banking industry's experiments with financial engineering, the military's increasing investments in larger higher tech killing machines and wars, and the American consumer's attempt to maintain or aspire to a life style she had been promised.
7. Public Debt:  Absolute maximum values of public (government) debt, expressed as a percentage of GDP, which should not be exceeded are not known.  Neither are the consequences of exceeding an as yet unknown maximum value of government debt, particularly in a country which prints its own (and currently the world's) currency.  
8. Private Debt:  Clearly in a well regulated economy which prides itself on its devotion to free market principles, too much private debt should bankrupt the debtor, so no particular rules should be needed to control private debt --presumably it is self-regulating. Unless!..Unless!..Unless!
9. Yes, unless the private institution is allowed to create credit and debt at the press of a computer keyboard button, to enrich its executives and owners by the amount of credit and debt it creates, and to then be deemed too big to be allowed to fail.  Which is, of course, precisely what American banks are licensed to do. American banks are permitted and encouraged to create debt ex nihilo, subject to certain government regulations.
10. During the period beginning in the early 1970s, with President Nixon's creation of the "fiat dollar" and delinking from gold, the only limitation on the creation of credit (and debt) were Glass-Stegall like regulations, and "fractional reserve banking" limits inherited from the days of the gold standard.  With the elections of Margaret Thatcher in the UK and Ronald Reagan in the US, "government regulations" were deemed to be diabolical.  They were gradually removed, in the US under Presidents Reagan, Bush I, Clinton and Bush II.

 Behold the results:

Chart 3.  Annual Borrowing and GDP Growth in Dollars
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Chart 3 shows a nation gone wild.

• GDP Growth:  Beginning in 1975 GDP growth and total borrowing were relatively close at about $200billion a year.  The chart shows a slowly rising GDP growth of less than half a trillion dollars per year every year, until the late 1990s.  In 2001 GDP growth begins to oscillate, in 2005 GDP growth plateaus, begins to fall in 2007 and contracts in 2009.
• Total Borrowing:  Total Borrowing, on the other hand, begins to increase at a much faster rate than GDP as early as the 1980s.  By 1985 America is borrowing more than a $1trillion a year while GDP is growing at about $0.2trillion a year -- a ratio of 500% of borrowing to GDP growth.
• Beginning in the early 1990s under President Clinton, lending by American banks and borrowing by American citizens begins to skyrocket.  
• Lending, and therefore borrowing begins a moonshot in 2000 under President Bush, reaches 800% of GDP in 2007 and then crashes and burns in 2008.  
• During the entire period of this apparently insane amount of borrowing by Americans from each other and from foreigners, Alan Greenspan was Chairman of the Fed (1987-2006), and the man most responsible for prudent monetary policies.  Malfeasance should be his middle name.
• Federal government borrowing remains relatively well behaved until 2000.  In fact federal debt begins to be paid off, under Clinton, in 1998, 1999 and 2000.  Federal government borrowing begins to increase rapidly in 2000 (Bush tax reductions and war), and again in 2008.  The 2008 increase is the result of the government attempt to replace private credit in the crash of 2008.

In the rest of this post I will examine total debt and GDP, and the ratio of total debt to  GDP and the ratio of debt growth (borrowing) to GDP growth.  Because it took me a while to absorb the importance of these data, I will spend what may appear to be an inordinate of amount of time dissecting them.
Borrowing and GDP:

Chart 4: Ratio of Total Borrowing (FOF Z1 Table D2) divided by nominal GDP Growth (BEA Nominal GDP).  Red dashed line is Excel generated exponential trend line, green line is five year moving average.
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 Chart 4 is the result of dividing the dollars borrowed every year,  by the dollar growth in GDP every year and multiplying the fraction by 100. Here is the tale it tells:

• In 1975 Americans borrowed about one and a half times as many dollars as the amount the US GDP grew in dollars, that is 150%.  (Black line)
• This ratio stayed below 200% through the rest of the 70s.  
• In the early 1980s through 1990 the ratio started oscillating violently between 250% and 500% of GDP.  Remember that this ratio should be perhaps about 150% even in times of extended crisis.   
• The five year average of the ratio (green line) went from a ratio of about 180%  to about 380% in the decade of the 80s.
• In the late 1980s and early 1990s the average fell from just under 400% to just under 300%.  
• In   the late 1990s the average ratio started rising again, reaching a peak in 2008 when Americans borrowed 850% of GDP.  Using a five year average, in 2008 Americans had to borrow $6 for every $1 increase in GDP.
• A target of 3% annual real GDP growth implies today (US GDP~$14.5trillion) an increase in GDP of about $450billion.  According to the data charted in Chart 4, if the trend of the last two decades is followed, unless systemic change is forced on us, we  Americans would have to borrow more than $3trillion to force GDP to grow by $450billion.
• Unless the American political and economic system is radically re formed, there is no reason to believe US GDP can increase without Americans continuing to borrow about $7 or more for every increase of $1 in US GDP.

Conclusion:  There is no reason to believe that American banks can continue to create debt at the rate of $3trillion or more a year.  Private debt is already too high, and too many Americans are unemployed.  Without writing off debt and reforming the US financial system it is folly to plan on a "rapid" return to BAU of about 3% CAGR.  Yet that is precisely what the federal government budget is planning.

 Total Debt and GDP

 Let's now look at the medium and very long term history of US total debt and US GDP, and the ratio of the two.  Total US debt is, of course the accumulation of annual borrowing in the credit market,

 Chart 5.  Total Credit Market Debt and GDP from Fed Flow of Funds and BEA
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 Chart 5 is a relatively simple chart showing the historical growth of US GDP and US debt.  As we would expect, because the annually borrowed dollars have consistently been much greater than the increase in GDP dollars, the debt runs away from GDP.

In 1978 debt was $3.8trillion and GDP was $2.3trillion for a difference of $1.5trillion.  In 2008 debt was $52.5trillion and GDP was $14.3trillion, for a difference of $38trillion.  So the difference now is about 3 years worth of GDP, versus less than a years worth of GDP in 1978, and debt is 350% of GDP in 2008 versus about 160% in 1978.

 Chart 6.  Ratio of Chart 5 Debt and GDP numbers multiplied by 100.
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Chart 6 merely emphasizes and illustrates the increasing ratio of US debt to US GDP during the last three decades.

As I said earlier in this post, there are no "experiential" or theoretical numbers about how large total debt can be before a country finds itself in difficulty.  However it would be interesting to look at data over a very long time horizon.  Chart 7 is just such a chart, showing the US debt to GDP ratio for approximately 140 years.  (I have seen this and similar chart in various credible sites on the 'net.  I have not yet found all the original source data.)

 Chart 7:  Ratio of Total Credit Market Debt to GDP in Percent (100*Debt/GDP)
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In summary:

• Until 1980, the total debt to GDP ratio excluding the three decades between 1916 and about 1945 (WWI, Depression, WWII) was usually well below 180%.  In the 1950s it was well below 160%.
•  Beginning in about 1952, the debt to GDP ratio began increasing relatively slowly taking about 30 years to get back to 180% -- an increase of about 40 points in three decades.
• In 1980 the ratio began increasing much more rapidly as a result of  Reagan tax cuts and increased military spending.
• By 1990 the ratio had reached 240% -- an increase of about 60 points in a decade.
• In the next decade (1990s) the ratio increased to about 270 in the year 2000, an increase of about 30 points -- Clinton had managed to reduce the rate of increase, but not the absolute numbers.
• In the next eight years -- (2001-2008) the ratio increased to 358, an increase of about 90 points in just 8 years -- Bush GWOT, Tax Reductions 
• In 2009 the system self destructed.

The 100 year summary by decade is in Chart 8.  The values prior to 1975 are "scraped off" Chart 7

Chart 8.  Summary Debt/GDP*100 Ratio
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Conclusion:
We are operating the US economic system with debt to GDP ratios never seen in the history of the nation.  Private debt is too high.  Unemployment cannot be reduced and consistent growth will not resume without debt reduction (write downs) and financial system reform.

I do not believe writing down debt and re-forming the financial system, by themselves, will be sufficient to resume consistent economic growth.  They are necessary but not sufficient conditions.  There are fundamental structural problems in the US economic system which need to be addressed.  Debt write off and financial reform are the  necessary precursors.