Deleveraging Has Not Yet Run Its Course

We’ve argued for some time that the process of deleveraging has yet to run its course. The aggregate level of debt in our economy currently stands at a record high, even though many pundits continue to say that debt levels are much more manageable now as compared to the pre-crisis days. In our view, the disconnect can be attributed to ultra-low (and artificially low) interest rates, which have lowered debt-service burdens even though the absolute level of debt continues to grow. But we cannot depend on interest rates staying this low forever. Ultimately, rising rates will take a dramatic toll on the economy’s ability to service such high levels of debt. Prudence would dictate a more definitive solution to our problem of too much debt.

The first chart below shows the absolute level of total US debt, to include: consumer debt (including mortgage debt), non-financial business debt, state & local government debt, federal government debt, and financial-sector debt. You will see that the total (as of the end of the 3Q) is about $54.5 trillion – a record. Had we included the federal government’s borrowings from the Social Security trust, this figure would be about $5 trillion higher.
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The second chart shows total debt as a percentage of GDP. While this figure has come down a bit from close to 350% in 2008-2009, it is still about 311% – well above historical averages. The ratio has come down only because the denominator (GDP) has increased dramatically since the financial crisis.
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The third chart is the point we continue to emphasize to you in our weekly Market Commentaries. While the absolute level of total consumer debt has indeed come down slightly since the highs in 2007-2008, the decrease has been dwarfed by a massive increase in federal government debt. The combination of the two now stands at about $26 trillion – well above the pre-financial crisis level of about $18-$19 trillion. In other words, debt has simply been transferred from the consumer to the federal government (and then some!).
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And finally, the last chart shows the trends in business debt. While financial sector debt has come down significantly from a high of over $17 trillion to about $14 trillion (as of the end of the 3Q), non-financial business debt has risen rather sharply over the past five years from $10 trillion in 2010 to about $11.7 trillion at the end of the 3Q – an increase of about 17%. The increase can largely be attributed to companies issuing low-rate debt so they can buy back stock. Stock buybacks have been a major driver of EPS growth over the past few years. Many are beginning to speculate that the big increases in debt levels at US companies cannot continue, eliminating a major source of EPS growth.
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As you can see, the economy is not deleveraging the way it should following a financial crisis. The federal government has effectively assumed much of the consumer debt through massive increases in transfer payments (Social Security, Medicare, Medicaid, veteran benefits, unemployment insurance, food stamps, disability, etc.). The Fed, for its part, has simply encouraged more borrowing through the suppression of interest rates in an effort to drive higher rates of consumption and investment. In the process, asset prices (stocks, bonds, and housing) have skyrocketed as investors have sought higher returns on their money.

Furthermore, federal government debt has grown immensely, which wouldn’t be as big of a problem if the government had used the low-rate environment to extend the duration of its debt. Eventually, interest rates will rise and so will the debt service burden for the federal government (and consumers as well). And all this will happen when more and more baby boomers start retiring, causing entitlement payments to increase dramatically.

Moral of the story: The answer to the problem of too much debt is not the encouragement of more debt.

Peace,

Michael