The Post-Credit Economy - Looking Backwards

(partial draft) Even though I was aware of the housing bubble quite early (by 2005), I only recently grasped that it was a subset of a larger credit bubble. The pieces were there in front of me, and I even occasionally tried to wade through "The Credit Bubble Bulletin" (which is usually a rather tedious data dump). Only now have I put them together, meaning I lost out on months of great shorting opportunities. Alas. So here we are, at the start of the biggest recession since the Great Depression. But how did we get here? Well, by borrowing too much, obviously. Far too much. How much is that? A lot. Now, the actual dollar figures don't really matter when examining issues like this. Instead, it is the ratio of whatever metric to GDP. The past 33 years of debt to GDP ratios look like this:

As we can see (click for a much larger graph) debt for the two sectors has gone up dramatically. Financial sector borrowing is mostly re-lent, thus the two sectors aren't totaled up to avoid double-counting (I think - I haven't found a plain-English explanation). However, that financial debt has grown so much is a symptom of the expansion of the "shadow banking system". These businesses borrowed directly in the various debt markets to fund lending instead of using deposits as banks have traditionally done.

As noted before, the "shadow banking system" borrowed directly in various debt markets, and that growth can be seen in this graph.

From this graph we can see that the household sector has grown the most. State and local governments held their debt fairly level. Federal government publicly-held debt grew under the Reagan/Bush regime, then declined under Clinton, and went back up slightly under Bush. (This data set does not include 2008, which will show a dramatic spike for this sector.) Business borrowing has varied more than the other sectors, but it too has turned up recently.

This graph shows that households have grown their share of non-financial debt at the expense of all other categories.

Now at this point you might be wondering, "Where are the federal intragovernmental holdings?!?" Well, over the next few years they don't really matter. They don't have to be serviced and won't be redeemed, so their immediate impact on the debt markets is negligible. Starting in 2018-2020 they will matter, which is why the nation's various financial problems needed to be fixed yesterday. Yesterday? Wasn't Bush running deficits during the growth phase of the business cycle, making future budget problems much worse? Why, yes, he was and here's the results:

The ratios using the total Federal debt aren't too different

The composition doesn't change much here either.

Here the intragovernmental debt does show up.

And here.

This graph shows the percentage change of each non-financial sector along with the percentage change in GDP. Because the data is not adjusted for inflation all of the increases are significant.

The ratio of the percentage changes shows about the same thing. Note that 1 is the reference line.

And finally, the raw dollar numbers for domestic non-financial debt. The reason for using other measures is plain to see.

Before we go any further we should take minute to remember that not all debt is bad. Incurring debt in order to invest in something that increases future productivity can be a smart thing to do. Taking out a loan to build a factory which will make more widgets with less inputs is an obvious example. Taking out a loan to build a new road that cuts travel time in half is another. But incurring debt to increase current consumption is bad. If cashflow is sufficient to pay off the loan, it makes more sense to save until the consumption can be paid for in full. A 50" LCD might be neat to have right now, but it is quite unlikely to increase future productivity - probably the opposite. Similarly, taking out a loan to pay for repainting the stripes on the new road every year would be a bad decision.

People have learned to use debt in much more sophisticated ways than the simplistic examples above. And frequently the investment in question will increase productivity only by the smallest of margins. There are also plenty of cases where an investment at one price is productive and isn't at a higher price, but the crossover is hard to determine. Nonetheless, the standard should still be applied every time a company issues a bond or a consumer reaches for the credit card. Unfortunately, the standard has been frequently forgotten of late, to delayed but spectacular effect.