Til Debt Us Do Part

Here is an interesting article by Martin Wolf in the Financial Times. What surprises me is that debt peaked in the Great Depression and it has peaked again. The key difference? The greatest increase in debt was by financial institutions!

How much debt is too much? Nobody knows. But the governments of highly indebted high-income economies – such as the US and UK – think they know the answer: more than today. They want even more credit to flow to their struggling private sectors. Is that an attainable ambition and, if so, how might it be achieved?

Let us start with some facts. The ratio of US public and private debt to gross domestic product reached 358 per cent in the third quarter of 2008. This was much the highest in US history (see charts). The previous peak of 300 per cent was reached in 1933, during the Great Depression.

Nearly all of this debt is private. That reached an all-time high of 294 per cent of GDP in 2007, a rise of 105 percentage points over the previous decade. The same thing happened to the UK, on a yet more impressive scale. This has been a gigantic debt and credit expansion.

Particularly remarkable is the composition of the increased debt. In the early 1930s, most US private debt was owed by non-financial companies: so balance-sheet deflation occurred in companies, as was also the case in Japan in the 1990s. This time, however, the big increase in debt was in the financial and household sectors.

Over the past three decades the debt of the US financial sector grew six times faster than nominal GDP. The consequent increases in its scale and leverage explain why, at the peak, the financial sector allegedly generated 40 per cent of US corporate profits. Something decidedly unhealthy was going on: instead of being a servant, finance had become the economy’s master. ...

What do such rises in indebtedness portend? The answer might be: nothing. After all, over the world, debt nets to zero. In principle, the ability to transfer purchasing power from lenders to borrowers is highly desirable: as a British advertising campaign once claimed, credit “takes the waiting out of wanting”. Yet people can also make big mistakes, particularly if they confuse bubbles with permanently high prices. The financial sector is particularly prone to such blunders. As Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard comment: “Systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike”.

Once such asset bubbles burst, it becomes hard to find borrowers and lenders who are either willing or creditworthy. The over-indebted start paying down their debts, instead, as now. Desired savings also soar. Realised savings may not rise, however: incomes may collapse, instead. This is what John Maynard Keynes called “the paradox of thrift”. The result will be a slump caused by balance sheet collapse rather than attempts to control high inflation.

What then might be done?

Some recommend a “liquidation”. A chain of bankruptcy would indeed eliminate a debt overhang, as happened in the 1930s. But, with much of the economy enmeshed in bankruptcy and the financial sector imploding, a depression would result. To choose that option must be insane.

Go read the full article and look at the graphs which lets you see for yourself the facts behind this story.