Grand Super Cycle National Bankruptcies

Part VII

The Great Credit Bubble

 

By

 

Joseph M. Miller

jmiller585@mchsi.com

 

Daan Joubert

daanj@kingsley.co.za

 

Marion Butler

juneb01@msn.com

 

 

 

Introduction

 

Much like some of humanity’s other inventions, such as the use of fire, and gunpowder with all its clones, credit has its uses, but these do not come without risk. Fire that gets out of control or arson, and the use of explosive materials for purposes of destruction or war, bring devastation and ruin and death. We will see when credit gets out of control it does not destroy the material fabric of our existence, nor directly cause our lives to end, but for many people enveloped in a credit trap these differences may not really matter.

 

Consider a barter economy where we have two farmers, both of whose wives have just broken an earthenware pot that is essential to the running of the household. They both go to the potter to order a replacement. One farmer still has grain saved from the previous harvest and can deliver payment when his replacement pot has been completed. The other has already traded away what reserves he had had and he now has only enough grain for his own needs; which means he has to promise payment when the next harvest is in.

 

One can imagine that such might have been the initial uses of credit in an early society with functional specialisation; where there are specialised, potters, skin workers, farmers, hunters and so on, so that there has to be in order to obtain all the household needs. Then, when credit is advanced, it enables one to obtain immediate satisfaction of what is needed or wanted, in exchange for a promise to pay later.

 

As this example illustrates, when one gets down to the nitty gritty of it, the use of credit is a means to ‘cheat’ on time; instant gratification, instead of having to wait until one has accumulated enough savings to purchase the desired item or service. In the example, to take on debt was the means to obtain a necessity for the household; however, today debt is used far too often for more frivolous reasons as a solution of those who do not have the discipline to save for non-essentials.

 

Through the years, ‘cheating’ has become habit, for many a way of life, and, as is true of other habits, many people and societies have become addicted to the instant gratification it offers, without concern for the consequences. It is the latter that will concern us – the consequences when the credit system gets out of control. Credit has changed from being a straightforward loan between two parties into a vast web of inter-related obligations and counter obligations that has grown out of all proportion to the economy that supports it. Like all top-heavy structures it is becoming more unstable, more susceptible of collapsing with even a small nudge or trigger.

 

A barter economy that exists between individuals, as in the above example, is unlikely to allow credit to grow to unmanageable size. A potter who wants to trade grain and skins and stone tools and have a new house constructed, all on credit, for, say, a total quantity of 10 000 pots, will be laughed out of the market. Who ever heard of a potter who can make 10 000 pots in his life time, let alone in the short period over which the credit will run! A silly example, one will say, but it so happens that today a situation very similar to that is no longer thought to be strange.

 

The changes that have taken place with respect to credit – from early agricultural times to today – that enabled the Credit Bubble to develop, lie firstly in the fiat money system and secondly in the fact that credit has become indistinguishable from money.

 

As we will see, the first major change in the way credit is perceived occurred with the transition from a barter economy to a money economy. The second change was a little more subtle, but it was much more pernicious. That was when ‘money’ itself changed its nature, from being hard coin to paper fiat, and other paper surrogates for money.

 

A third, more recent change and the final nails in the credit structure, occurred when the lender no longer needed to assume responsibility for repayment by the borrower. When one can extend credit to a customer and then pass on the risk of default on the debt to a third, unrelated, party, the sound of hammers becomes louder and louder.

 

Do we have a Credit Bubble?

 

Without a positive answer to this question one may think that this essay is superfluous. A good number of most influential economists see no reason to believe there is a bubble. We do not want to argue the point, despite the fact we believe there is ample evidence, of different kinds, to more than just suggest that the world, the US in particular, is trapped in the greatest Credit Bubble of all time.

 

Rather than to get trapped ourselves in an argument based on subjective interpretation, since there is no absolute measure that differentiates between much debt and the bubble that arises out of too much debt, we will look at the trends in credit – firstly the changing face of credit through the ages, then secondly at recent trends in the US economy that, if sustained long enough, inevitably will evolve into a Credit Bubble of truly magnificent proportions, evident even to the most sanguine of observers. If it had not already done so.

 

The reader can decide for him or herself at what particular stage, historically or perhaps in days still to come, the Credit Bubble actually manifested itself. Because a Credit Bubble either already exists or will do so. When that bubble is pricked, it will be a real financial catastrophe – and the latter term is selected deliberately, in preference to synonyms such as ‘calamity’ or ‘disaster’ or ‘melt-down’, that sound rather tame by comparison.

 

 

Credit, money and collateral

Firstly, credit is a term with different meanings. We all know the word ‘cattle’ and what it means. We also know there are different kinds of cattle, each with unique features of its own that would enable a knowledgeable person to distinguish between them. The same is true of credit and we shortly will examine some of the different forms of credit.

 

For a long time, beginning right from early civilisation, the giving of credit and the taking on board of debt involved two people in their personal capacities. This is the most simple type of credit and can involve any object or commodity or service. As in our example, a farmer might assume the debt of grain, to be delivered when the harvest is in, while the potter, whose production is less tied to the seasons, has just bartered some earthenware to the farmer in exchange for grain to be delivered later, thus advancing him credit.

 

In due course, it became clear that some commodities were more often involved in credit transactions than others; because of this, these commodities became ‘standards’, in that traders and other people ‘in the market’ would know the relative value of other frequently traded commodities in terms of one of these ‘standards’. A good hint of this development can be found in the written sign for ‘credit’ in ancient Sumerian, which is the same as the sign for ‘cattle’. Quite interestingly, and probably an indication of early practice, the sign the Sumerians used for ‘interest earned’ is exactly the same as that for ‘calves’.

 

In a sense this implies that in Sumerian times cattle may have come to fill at least one of the roles of money, namely that of a common measure of value. Whatever is taken to be money in a society can do so in various roles –

 

·        it acts as the measure of value in that the prices or values of other commodities and services are expressed in terms of whatever is accepted as standard ‘money’

·        it can be used as the unit of account, in which the profit and loss of a trading activity over a period of time is recorded, and also for the compilation of a balance sheet, to determine the material wealth of a person

·        it is the standard medium of exchange that enable people to trade the fruits of their labour for whatever else they need or want, with ease and with minimal haggling over relative values of commodities and services

·        money is used as a store of value – as the means of saving whatever proceeds of one’s labour are not immediately spent, so that one can build a reserve for a rainy day, or even for when one can no longer work

 

There are other roles, but these are the more important.

 

Over time it became clear that, ideally, whatever is used as money should be of uniform quality, have a high value density, be easily divisible into smaller sizes or units and be able to last without deterioration due to aging or decomposition.

 

From very early on, various metals came to be used in one or more of the classical roles of money, mainly because metals shared some or most of these ideal qualities. Copper, in all probability the first metal to be used, has the liability in that it corrodes in time; gold and silver, however, meets all the requirements.

 

For much of early history, metals used as money were in bar form and the value of a bar was determined by its mass or weight and its fineness – and a high ethical premium was placed on accurate scales and weights! Later, beginning from the 8^th century BC, coins were struck to serve as money; the main objective of this practice was to establish a standard medium of exchange, for internal use and for trade, which was flourishing at that time. Its ease of use meant it also came to serve as the standard in terms of the other roles of money, as we understand these today.

 

Archaeologists have unearthed a large volume of clay tablets in the middle east that have been deciphered and found to be contracts describing credit transactions. It seems that giving credit or making loans was widely prevalent from as early as the Sumerian period. It is widely accepted that writing was developed to keep books of account, to record taxes paid and to provide ‘hard copy’ of trade and credit agreements. It is notable that the latter typically made firm provision for collateral that could be claimed in case of default. The lender carried risk and wanted to be sure that the loan would be repaid, and, if not, that contractually there would be alternative means to recover the outlay.

 

Since the common man in those early times did not accumulate much wealth in the form of material possessions – land generally belonged to the king and was only used by the farmer or occupant, i.e. leasehold not freehold – collateral was a problem when making a loan or assuming other debt. Life was simple, compared to modern society of today, and personal ownership for the average man was mostly limited to individual adornments and clothing. Households would have counted the cattle, sheep or goats they owned as their primary store of their wealth, but if they had these, they would probably not need to make a loan, so that most borrowers had a problem with collateral.

 

Apart from material possessions, the only thing of value that people had was their capacity for labour, or that of members of their households. Almost invariably, according to the clay tablets, people who had to seek out credit were obliged to post themselves personally or their children or other members of the household as collateral for the loan. This meant in the case of default they became slaves or, at best, indentured workers, for a specified number of years.

 

One can imagine that this threat meant that borrowers were well motivated to pay off the loan according to the agreement! It probably also acted as a most effective deterrent to making an inordinate amount of debt that could not easily be repaid. This practice does however represent an early and very literal example where one generation was able to enjoy all the advantages of making debt and then call on the next generation to settle the obligation! In modern times and at the level of the state we have refined this principle to an exquisite degree.

 

If only life had remained as simple as this, we would hardly have a climate in which too much credit would become a risk to all of society, not only to imprudent individuals. However, as people submitted more and more to the temptation of using credit to ‘cheat on time’, the whole matter of credit became increasingly institutionalised, the norm as in “But everyone does it”, and with it the nature of credit came to change and thereby came steeply increased risk, firstly for the household and finally for society at large.

 

Even at the time of the Sumerians, credit had developed to where it was no longer a simple matter between two individuals who want to exchange the fruits of their labour, but who were subject to timing differences between the respective products they wanted to barter. Even that early, there already were what could be called money lenders or financiers, people who made a living by providing loans, rather than traders who merely extended credit to their clients or counter parties in trade or barter.

 

By the time the words ‘cattle’ and ‘calves’ also came to stand for ‘credit’ and ‘interest’ in the Sumerian language, it is clear that credit had become an integral and quite common practice in Sumerian society. It was also about this time when remarkably fair laws, even  to a modern observer, were first introduced to protect the debtor against all manner of usurious practices by money lenders – another indication that credit was big business!.

 

 

Different views of the desirability of credit

Today, and probably throughout history, society’s views on credit cover a wide spectrum – from the fundamental view that credit is inherently bad for the economy, if not outright sinful, to the belief that credit is what makes the wheels of commerce and industry turn at a good speed. This view is very prevalent in western economies, credit being seen as the grease that keeps the wheels of our economies from slowing down, or even grinding to a halt. This view is widely held by most proponents of sustained growth, with the US as the premier voice in support of this point of view.

 

Yet one can muster substantial evidence in support of views that credit is a moral hazard.

 

On the one hand an account of conditions in Newgate prison in England, home to many bankrupt debtors during the 1700’s and 1800’s, tells the sad story of how many people are unable to handle the freedom to make choices that is supported by credit. It is so easy to succumb to the temptation to cheat on time, even when it is to obtain the necessities of life by using credit, as was common in those days, because incomes were too small.

 

However, when one continuously has to use credit because of lack of income, it means sooner or later one will no longer able to service one’s debt, let alone think of repayment.

 

Since in those years gin was considered essential to existence, and not only among the lower classes, an ability to add more debt often meant that the ability to earn a living was thereby impaired; for many concerned citizens it would seem that the two public evils of drink and debt combined to add substantially to the Newgate population. In certain circles in England, and in due course the colonies as well, debt was therefore viewed with great suspicion if not absolute distrust. 

 

Proponents of free and easy credit look at what has happened to the growth rate in the US economy over the past 100 years or so, the more widely credit was being used by people from all walks of life. Apart from enjoyment of an improved standard of living by people who employed credit to purchase the amenities of life they would otherwise have had to scrimp and save for a long time, it is believed that purchases on credit boosted growth in the early manufacturing sector to quickly reach economies of scale. The Ford motor car company – among the leaders of the use of credit – and manufacturers of other capital goods enjoyed rapid growth, which, apart from being of great benefit to the US economy, also raised the standard of living of many households who found work in these factories.

 

So which view should prevail?

 

Perhaps the proper view of credit is that there is some middle road, not necessarily quite well defined, where credit has advantages, yet without the potential liabilities. Like fire and gunpowder, civilisation is better off with prudent use of these inventions; however, when they are abused and no longer under the control of moderate men, they bring much pain and sorrow in their wake.

 

As always, too much of a good thing leads to a hangover of some sort, the severity of which is commensurate to the excesses that were enjoyed not so long before. Moderation and careful use are the watch words.

 

 

When does ‘much’ become ‘too much’?

Having enough of a good thing is a blessing. However, when desire for something good feeds on itself – or proliferates through a belief that when something is good then ‘more’ has to be better, a belief that manifests itself as ‘greed’ – to the stage where there is ‘too much’, the blessing invariably turns into a curse.

 

Sometimes the ‘too much’ immediately and acutely results in distress, but this is rare; more often it is difficult and contentious to try and determine, “Exactly when has ‘much’ become ‘too much’”

 

How can one know, preferably in advance, just when does a blessing become a liability and a cause of real problems. And what really will happen when there is ‘far too much’?

 

With respect to household and even other forms of credit, the glib answer today is that credit does not pose significant risk as long as the debtor is not financially strained by the need to service the debt. What is generally left out of the picture is that the ability to pay the interest and other service fees on one’s debt is strongly influenced by circumstances.

 

In the current climate (at time of writing during the first half of 2003) of low interest rates, some economists are inspired to proclaim there is no potential problem in terms of the amount of debt carried by households, because they still have slack in their disposable incomes. It is not uncommon to read of American consumers being exhorted to take on even more debt; the economy needs it and government will do all it can to ensure that the climate of low interest and high liquidity in the housing market will remain intact for them to do so. The consumer has become the spender of last resort, the main pillar of the US economy; and has to take on even more debt to play this role to the full.

 

While on the one hand many people think debt is wrong; on the other hand, many believe that debt is good and more debt is better.

 

Perhaps the way out of this dilemma is to look at how credit is used. As discussed earlier, credit is a way to ‘cheat on time’, as an alternative of saving beforehand. Yet credit can also be considered a way of saving ‘after the fact’. If, after one has cheated on time, the debt is repaid as soon as possible, it can be viewed as ‘saving after the fact’. A good example of this is a mortgage; given a choice between saving first until enough capital has been accumulated to buy a home, or going the mortgage route, practically everyone will say that a mortgage is justified, partly on the basis of how long it would take to save enough money and partly because of the continually rising prices of property, which turns the home into a long term investment.

 

While payments on a mortgage initially are mostly interest, with a relatively small capital component, at least there has to be discipline to ensure that the mortgage is repaid within the stated time frame. In the same way, one could even justify the use of credit for an overseas holiday, frivolous as that may be viewed by some, provided the loan is being repaid on schedule and before other purchases on credit are made.

 

This discipline implies that the consumer has some slack in his or her disposable income that can be used to repay loans, and that is saved when no debt is outstanding. Purchases on credit only occur when the amount needed exceed savings and then they are repaid as soon as possible afterwards.

 

In this disciplined way of dealing with debt, the amount of debt never proliferates to the stage where it becomes a threat to the financial survival of the household. And the same applies to the corporation and the country.

 

In this scenario, ‘too much’ credit is a matter of life style rather than how much debt one has taken on. Then the question, “When does ‘much’ become ‘too much’?” is irrelevant.

 

As soon as one consistently lives beyond one’s means or income, the only question that is relevant is at when the crisis will strike. The critical factor to consider is the trend; while the amount of debt increases faster than income, a crisis is certain; it is only the timing and the magnitude that will be influenced by circumstances. Circumstances nevertheless do change, sometimes dramatically so in a short space of time. A condition of relatively low risk could snap into a crisis overnight, if a contingency materialises.

 

For the household, sudden illness, an accident, theft, the weather and many other factors can scramble all of one’s calculations of how much can be spent on living the good life and thereby change the household budget drastically. Then debt previously seen as quite comfortable becomes an intolerable burden to place the financial future of the household at risk. A household with slack in their budget and some savings might be able to survive a financial setback with less impact on his living standards than the household that had been stretched closer to its limit. The latter might even fall into bankruptcy.

 

Common sense requires one to take contingency into consideration when thinking of taking on more debt. Over and apart from not letting debt accumulate to uncomfortable levels, prudence requires one to have a nest egg, something that can act as a buffer to prevent contingency becoming disaster.

 

As an aside, the reader should note that the two words, ‘credit’ and ‘debt’, are really the same thing, seen from two different perspectives – a ‘dollar’ bill is always a ‘dollar’, from whichever side it is viewed. However, the media have long ago discovered that in the minds of readers or viewers the two words ‘sound’ very different. Having received credit is fine; it shows one is a man of the world, enjoying life to the full. On the other hand, being in debt is believed not to be such a good thing; it brings home images of the household goods coming under the hammer on a sale of execution or, at best, wide eyed children staring at the truck from the finance company being loaded with their furniture and their bicycles. Which is why we often read or hear of consumer credit, and far less often of consumer debt.

 

To conclude, the proper answer to the question of ‘too much’ is that adding more and more debt, at a rate faster than the increase in one’s income, is a recipe for disaster. One cannot say in advance when disaster will strike or what its magnitude will be; only that the longer this trend is maintained the greater will be the calamity. This applies to equally to households, corporations and countries.

 

 

Opportunity cost

The debate on how much debt is too much should also take into regard that cheating on time has a price, the opportunity cost. This comes into play because each transaction that adds to the load of debt does two things: it firstly reduces the ability to obtain more credit for whatever other purpose, thereby limiting additional or future spending. At the same time, additional cost of servicing the increased debt reduces the amount of income that can be freely spent. Secondly, since the debt has to be repaid at some future point in time, perhaps as part of the cost of servicing the debt, repayment of the capital of the loan means that future spending is reduced by the amount of the debt.

 

Apologists for higher use of debt claim that if one considers the full picture there is no real opportunity cost. More spending now, using debt, provides a spurt of growth to the economy that multiplies over time. The higher rate of growth provides a wealth effect in which the borrower partakes and that makes it easy to both service the debt and to repay the capital and still have more cash to spend than before. These people believe one can have one’s cake and eat it too!

 

This view assumes sustained growth over a relatively long period of time, with no period of down scaling in the economy. The fallacy of that argument is therefore only revealed over time. For as long as the assumption holds true and while economic growth makes it easier to carry a given load of debt, households are exhorted to make even more use of debt in order to keep the economy on track. “Just look at how easy it is to deal with your debt of $X-thousand three years ago. Now you can take on another $Y-thousand of debt since it will present no problem three years from now, and by then you can even add an additional $Z-thousand. Its easy! And so much fun!”

 

The result is that a period of economic growth and lower interest rates in effect carry the seeds of destruction; during these good times debt rises faster than income; a practice that is clearly unsustainable, as a matter of principle. While such a fatal trend lasts, it is only a matter of time and the right trigger before ‘much’ suddenly becomes ‘too much’, before the ‘cheating on time’ catches up on the cheaters.

 

Time. That is another key to the answer of ‘too much’; for households, for corporations and for governments. One does not have to ask whether ‘this’ or ‘that’ is too much debt; simply look at the trends and if the increase in spending consistently exceeds growth in income, and would seem to continue to so, the writing is on the wall.

 

Finally, some people also believe, although they might not say it out loud, that it is good to carry as much debt as possible for as long as possible in a climate of rising inflation. It means that one can take out a loan to purchase something today and repay the loan at a later time with dollars that are worth much less. They might even point to the fact that when a Japanese investor purchased a 30 Treasury bond that has now come due, he paid ¥300 for every dollar value of the bond. Yet today the investor only gets ¥120 for each dollar. The dollar amount has remained unchanged; the bond’s ‘value’ shrank by 60% as a result of the decline in the purchasing power of the dollar. This is much more than just cheating on time; it constitutes nothing less than fraud.

 

Despite the fact that interest rates are adjusted upwards to counter the effect of inflation, in a period of consistently rising inflation rates lag to some degree, thereby making the taking on of more debt seem profitable. If one accepts this view, then one would take on more debt when real interest rates are very low or negative, as they are at time of writing. But then one should make sure to have a fixed rate on the debt, as any increase in rates will be devastating to a household that is already stretched near to the limit.

 

Yet this situation of debt increasing faster than income is of relatively recent vintage.

 

 

Natural limits to credit

In the time of hard money, when coins had value and notes were backed by the promise that these could be exchanged for money, there were really only two ways in which credit could be given.

 

A seller is in a position to provide credit to a buyer should that be required. A merchant, for example, could sell goods ‘on the tab’ and usually required payment at month end or when wages are paid. If the customer happened to be a farmer, the period of credit might have been longer; the merchant may had to wait until the harvest is in before the account could be settled.

 

For a long time, banks were the only financial institutions that could extend credit other than the kind of consumer credit quoted in the first example. Banks made a profit from taking in deposits and lending this money to borrowers at a higher rate than what it paid on deposits. The bank also earned part of its income on lending the bank’s own capital, or from investing this in business ventures.

 

Later, Savings and Loan institutions came into being to provide a specific form of credit, namely money to purchase a home. The S&L’s, too, took in deposits on which they paid interest and used these deposits to make loans to borrowers at a higher rate of interest to cover costs and earn a profit. With the exception that they were limited to one market and that the loans were generally long term, the S&L’s were much like the banks. They, too, could only lend whatever money they could attract as deposits

 

There are two essential features of these early forms of credit. Firstly, the provider of credit had to have assets of some kind in order to extend credit: the merchant had to have goods to sell before credit could be given, while the banks had to have their own capital and deposits on hand before they could make loans. In principle, credit was limited to a portion of the total material wealth in the economy; by the goods that were for sale and by the houses that had been or were being built. And, of course, by the availability of real money, hard cash.

 

Credit received was fully backed by some hard asset, irrespective whether it was goods bought on credit, or a home that was purchased with a mortgage, or money borrowed from a bank. This clearly limits how much credit could be advanced in the economy. Whatever fraction of the total existing wealth was subject to credit, its remained only a fraction of that wealth. Further, when the amount of credit that could be advanced was limited, it was doled out to people who presented low risk.

 

Risk was another factor that limited the total amount of credit. In an environment where the merchant or bank itself suffered a loss in case of default, lenders took good care not to advance credit when there was a risk that the borrower might fail to repay his loan, or if the buyer of goods on credit might fail to settle his account.

 

This does not mean that a credit crunch is impossible in an economy where hard money is in circulation and where lenders face the risk of loss through default; it is only that in such an economy the probability of a credit crunch is low and the magnitude of the crisis relatively small.

 

 

Fractional banking, credit and money

The introduction of fractional banking changed the rules for credit. No longer was credit linked to the availability of hard assets or real money. In fact, credit became money.

 

Fractional banking is based on the principle that because banks have historically run low risks when they lend money. Based on this fact, it is in principle possible for a bank to lend out more than the amount of its assets – its own capital plus deposits taken in. When this principle became practice, assets at hand no longer placed a ceiling on what could be lent out, but merely served as a cushion to ensure that should any default on loans occur these can be absorbed as a loss without any risk to the survival of the bank.

 

It remained the bank’s responsibility to do careful credit risk analysis when approached by a borrower, as the bank itself had to absorb any loss due to loans that went bad. On the other hand, banks became more profitable. Previously for every $100 that was deposited in the bank, only the same $100 could be lent out to earn an income. Now, with fractional banking, some higher multiple of $100 can be lent to borrowers. The process of money creation is simple – all that has to be done is to credit the account of each borrower with the borrowed amount. The money did not have to exist in material form elsewhere before the loan was granted, instantly providing the borrower with money to spend.

 

Assume that five people each wanted to borrow $100. The bank has received a deposit of $100 and is therefore in a position to accommodate their requirements. After completing the formalities satisfactorily, the accounts of each of the five borrowers are credited with an amount of $100. Suddenly, where there was only $100 on deposit with the bank, there is now the amount of $600. An it is real money that can be drawn against those accounts; cash to be spent or payments that can be made by cheque, and for whatever purpose the borrower desires.

 

This step was a major philosophical change with respect to the nature of credit. Loans no longer consisted of existing money that was being recirculated through the banks and the banking system and the economy; loans now actually created fresh new money that for all intents and purposes was as real as the hard coins that were in circulation.

 

But this is not the end of it. Assume that one of the borrowers uses his $100 loan to pay the merchant who had advanced him credit. The merchant takes the money to his bank and makes a deposit to his account. This bank now has increased its assets by $100 and is again able to lend some multiple of $100 to new borrowers. It does not even matter if this bank is the same one that had ‘created’ that same $100 just a short while before.

 

Fractional banking can be compared to a lot of dominoes, where one event gives rise to a whole cascade of subsequent events – in the case of banking, the making of a deposit of $100 can give rise to a whole cascade of loans and deposits and new loans again. There is in principle no end to credit and money under a fractional banking system To ensure this domino lending does not get out of hand, interest rates for inter-bank loans are adjusted by the authorities – the Federal Reserve – in order to set the ‘cost’ of money. This makes it easier or more difficult for borrowers to obtain and employ credit, thereby regulating the growth in the ‘money’ supply.

 

Also, there are banking rules that restrict the amount of ‘new money’, in the form of credit, a bank can create for each $100 that is deposited in the bank. Regulations for a bank’s capital asset requirement define how much cash the bank has to keep in reserve to allow for contingencies. At there are controls, even if some people believe these are not ideal nor always properly enforced.

 

 

Installment credit

One other from of credit became popular in time to play a role in the escalating use of credit in the run up to the 1929 panic. Installment credit is a formal version of the well known practice where merchants advanced customers credit. What can be termed ‘over the counter’ credit typically applied to the essentials and basics of daily living and was usually required to be settled in full at the next pay day. With installment credit things changed; people could purchase more expensive durable items on an extended payment plan over many months or even years – a practice that was sometimes referred to as the “never-never”.

 

It was a new fangled idea, but became very popular and made its contribution to the then very high credit total in the run up to the 1929 Crash. As is the nature of debt, it survived the collapse on Wall Street, when paper wealth was wiped out. It thus was a part cause of the Great Depression that brought much grief to the American population.

 

Today a modern economy without consumer credit is unthinkable. It has become so much part of our lives that nobody anymore speaks of the ‘never-never’ as a means to describe it. No longer has the debt to be settled and the slate wiped clean before one can obtain new credit It is accepted that everyone except perhaps the really wealthy is as deep into consumer credit as they can be.

 

It is the fun way to enjoy life today!

 

 

The state

Politicians really care about their constituents. They want the best for them that the state can provide. This includes provision and upkeep of the infrastructure, which is one of the obligations of the state. However, over and above the basic requirements of civilisation, there are many things voters would like to have, and politicians are keen to supply these. Their enthusiasm is unfortunately limited by the amount of taxes they can extract from voters. Since heavy taxes are counter-productive, at least from the politicians’ point of view, they are keen to borrow whatever funds are needed in excess of the state’s income.

 

Government lending has the main advantage that since everyone fully trusts government to repay its debt, even if they are issuing new debt to do so, government can borrow at relatively low interest rates. A second advantage is that governments do not have a finite life span, unlike the individual borrower or even a corporation. Governments go on and on and lenders to the government know that they are sure to get their money some day.

 

These ‘advantages’ also mean that governments at times tend to over-indulge at the table of debt. Then, typical of so many elements of the relationship between governments and citizens, when circumstances change adversely in ways that were not foreseen, it is not so much the politicians as the ordinary folk who suffer the distress of financial dyspepsia.

 

As a consequence, governments tend to set an example of ever-increasing debt. When the economy is good, the excuse is that whatever debt is taken on will be easily repaid when the economy has grown much further, and, when times are bad, the excuse is government has to kick-start the cycle of increased spending.

 

 

Corporate debt

And it is not only individuals and governments who succumb to the age-old temptation to keep on taking more and more debt on board when conditions are lenient, only to find later, when circumstances deteriorate, that the choice between sink and swim gets taken out of their hands into those of their creditors and the bankruptcy court.

 

Corporations, at least the larger ones, have the advantage over households that they can issue bonds – negotiable financial instruments that earn interest and have to be repaid at some specified point in time. Some bonds convert to shares in the corporation at a stated price, which mean that the lenders to the corporation who have purchased the bonds are in fact shareholders-to-be.

 

This means corporations can tap two different markets for funds; they can obtain credit from one or more banks, or they can by-pass financial institutions and go directly to the financial markets by issuing corporate bonds. The latter step generally carries more risk for the buyers of the bonds, the lenders, so that corporate bonds require the corporation to pay more interest than, say, the equivalent Treasury benchmark or a secured bank loan.

 

Later, when we examine the current situation, the focus is more on individuals and on the government than on the corporate sector. Which does not remove the fact that, in the US, corporations are more deeply in debt than ever before.

 

 

Increasing US Public debt and an out of control money supply

We now move out of a general discussion of credit into recent history and the sort of trends that contribute to the formation of the Credit Bubble.

 

The first stage of the inflation of the Bubble started might be said to have started with the explosion in US Public debt during the Reagan era of the 1980’s. Consider that in 1960, before the start of the Vietnam War, US Public debt stood at $291 billion. By 1970, ten years later, the debt had increased by 34% to $389 billion. Another ten years later, after a period of high inflation in the US, the total debt had risen to $930 billion, an increase of 139% in that decade. In 1981 the Reagan presidency began and two years after the end of his 8 year term of office, in 1990, US Public debt had jumped to $3233 billion for an increase over the ten years of 248%. By the year 2000 – after three years of supposedly budget surpluses -  US Public debt was $5.674 trillion, another 75% higher than in 1990.

 

Over recent years the Congress imposed ceiling on the US Public debt had to be raised time and again. Some new ceilings that were supposed to be good for a number of years have not lasted as long as one year before requiring attention again. At the time of writing the latest ceiling, at $6.5 trillion, is in effect and has been for some time, requiring the Treasury to use all manner of subterfuge to obtain the necessary cash to keep the wheels of government turning. Now there is even talk of removing the ceiling altogether!

 

The 2004 draft budget actually makes provision for an increase in the ceiling of almost a trillion dollars, but, even more revealing of the lawmakers’ intent, there is a proviso for regular increases in the debt ceiling that would double the limit to $12 trillion over the next decade. The implication is that the trend to ever more debt is intact. Of course, if the draft should be adapted, the politicians will make full use of the latitude for more debt it provides, even if – and probably especially if – the economy is in a shambles for the next few years. Spending in one’s voting district is the one sure way to get re-elected!

 

The example so far set by government has triggered an appetite for new debt on a wide front by all parties, individual and corporate, that exceeds anything that had gone before.

 

If there are no strictly enforced limits for credit  – in the form of limits to the growth in the money supply – then a fractional banking system can support nearly unlimited credit. As explained above, when $100 are deposited at a bank money it can grow exponentially through the banking system. As a first stage, the $100 give rise to say $500 of new credit; when this credit is spent and whoever receives the money then deposit it in their banks, it is possible for these banks to advance a fresh $500 out of thin air for every $100 that is added to their assets. The first $100 has now given rise to the initial $500  plus the fresh ($500 x 5), for a total of $3000 of new credit, and the process continues further.

 

An out of control money supply gives rise to inflation. That basic economic rule has only one exception; and that is when all the fresh money that is printed gets saved under the mattress, when the money is effectively taken out of circulation and not spent.

 

Within an economy, when the amount of money increases faster than the volume of all manner of things that are being purchased with that money, then the prices of these goods will rise, because demand will exceed supply. Simple economics.

 

The problem with the use of the term ‘inflation’ in this context is that it has developed a restricted meaning. Inflation in common economic parlance is when consumer prices rise; when groceries and gasoline and eating out and travel and accommodation and shoes and clothes and furniture and SUV’s and the many other nice goodies that households spend money on, become more expensive. When the cost of living increases.

 

Yet people spend money on the purchase of other things too: they buy bonds and equities and property and collector’s coins and antiques; if these things enjoy increased demand and the prices increase faster than they ought to, then that too is a form of inflation, even though most of these things never gets reflected in the inflation index.

 

These things become more expensive in their own right, not because they are inherently worth more. If the process continues, while easy money in the form of credit remains freely available, equities and property and collectibles continue to increase in price until their prices by far exceed their material worth, according to commonly used yardsticks. Then some commentators begin to speak of asset bubbles. Inflation!

 

However, many if not most economists do not see this as inflation, only as an increase in overall household wealth – and therefore ample reason to spend even more by taking on more debt! Which is exactly what has happened as a number of factors have converged to create one of the largest and lasting asset bubbles of financial history. And, in doing so, also lifted all manner of debt to levels that were never experienced before. In parallel to the growing bubble in assets developed a rampant growth in all forms of credit that is still continuing at the time of writing.

 

One of the more relevant of the factors that contributed to the asset bubble had its origin in a president who was willing to take wild chances with the future of the US economy in order to make sure that he would be re-elected. He ensured that the taps on the US money supply would be wide open, in order to boost the economy; secondly, that there would be a strong dollar to off-set the increase in the trade deficit that was bound to erupt when US consumers increased their spending, much of it on imported mass produced goods.

 

These official efforts coincided and combined with a technological revolution that had raised investor interest to fever pitch and beyond. At the same time, there was a world outside the US suffering the after-effects of its own excesses, which meant that foreign investors were keen to invest in the ‘only game in town’, the USA. By doing so they kept the dollar strong, while also helping to fund the growing asset bubbles.

 

NAFTA and the export of US manufacturing to foreign shores simply meant that the US was importing an ever increasing portion of its consumer goods; while this is a negative for the trade balance, thereby increasing the overall debt owed by the US to the rest of the world, it was a key component in the ‘fight on inflation’.

 

Competition among foreign economies whose currencies were weakening against the dollar meant that prices of imported goods remained low, thereby preventing American manufacturers of these goods from increasing prices. Inflation, in its economic use of the term, was absent, and this meant that interest rates could be lowered, to make it even easier for households and corporations to increase the amount of their debt.

 

Finally, a booming new market in all manner of derivatives could be made to serve just about any purpose, which included the ability to absolve oneself from all kinds of risk, including the risk that credit given, or debt purchased, will default. With derivatives, the matter of holding large amounts of debt no longer carried risk, and so there was no limit to the amount of debt that could be taken on board by pension and other investment funds – thereby, in a manner of speaking, taking money out of circulation and placing it under the mattress, reducing the effect on inflation of a rapidly increasing money supply.

 

In the Brave New World of the late 90’s, debt was safe; debt was good.

 

As we know, always when something is good, more has to be better.

 

Any one of these factors on its own would have had a minor and probably fleeting effect on credit market. Two or three of them in combination may have seen credit increase at a higher than normal pace, and then slow down again. All of them together established a climate in which control over the debt explosion became difficult and would have been counter-productive if it had been attempted. If the right things had been done in time, the asset bubbles would have burst sooner, causing much less fall-out damage than is due to occur when the bubbles finally collapse. It seems likely the term ‘collateral damage’, often heard in war, will come to apply to the financial world too.

 

 

Bubbles deflating

The Nasdaq Bubble was the first to go when it became clear that the massively inflated valuations, handmaiden of all bubbles, of the dot.coms and other high tech stocks could no longer be supported, not even by the wildly irrational forecasts of future performance. That collapse wiped perhaps as much as $5 trillion off investor balance sheets, yet it was treated by the media as just a hiccup that will sooner or later reverse itself into a new bull market. ‘Buy and hold’ remained the catchphrase of analyst gurus even while the Nasdaq sank 70% and more below its high.

 

However, when about $17 000 dollars of paper wealth disappears for every man, woman and child in the US, there does develop a bit of a dark hole in household balance sheets. No wonder consumers began to think twice about choosing between a new car or to drive the old model for another year, choices that risk putting the economy into a tailspin.

 

When it became evident from sales figures that consumers were beginning to spend less, three things happened: interest rates were lowered to the lowest in 40 plus years; retailers of durable goods came up with such attractive offers – no down payment, no interest on financing and sometimes a year or more before the first installment – that buyers queued up to get these bargains, setting many new sales records. As newfound optimism spread through the economy, consumers were confident that they could easily cope with a load of fresh debt, which they proceeded to take on with gusto. Surely the economy was ready to take off just as it did in the mid 90’s, which meant that it would be easy to service all the new debt and even repay the loans quite soon.

 

At the same time, as a third development, the property market accelerated; home-owners were using cheap mortgages to acquire more up-market properties, and this initiated an upward spiral in house prices across the whole spectrum. Other home owners who were happy to remain where they were, used the opportunity to refinance their mortgages at much higher prices and lower interest rates – a measure that meant taking on even more debt, while leaving them with a nice cash balance that could be spent as they wished.

 

The property boom and the refinance market have been the key drivers behind consumer spending since the equity markets peaked, but this market is approaching to its own peak. After all, house prices can increase at 20% plus for only so long before homes are priced out of reach of prospective buyers, even at super low mortgage rates. It is unlikely that the euphoria and patriotism ignited during the Iraq war can remain high for long enough to supplant any lasting decline in the property market. Which means the wheel has turned to its full extent and the credit cycle is due to start unwinding in the not too distant future.

 

This review discussed some of the main factors behind the developing Credit Bubble in capsule form. There are however two more factors to consider – the steep growth in the money supply and the role of structured finance.

 

 

Money supply

As mentioned earlier, when a county’s money supply grows at a substantially higher rate than its GDP, inflation sooner or later becomes a fact of life – unless the excess money is parked under the bed as hard cash, and not spent.

 

Here we will merely mention some statistics on the growth in the money supply relative to the growth in the GDP. Consider the following table.

 

	M3 Money	% change	GDP	% change
1960	312.2 billion		2352.9 billion
1970	677.0	117	3566.5	51.6
1980	1995.1	195	4936.6	38.4
1990	4149.2	108	6664.2	35.0
2000	7090.5	70.9	9243.8	38.7

 

It is clear that the money supply throughout the past 40 years has increased substantially faster than the growth in GDP, much faster than what could be prudently justified. There has been some slowdown in the official figures for the money supply during the 90’s, but this should be viewed as an illusion.

 

M3 money supply, used here, consists of hard cash and very liquid bank accounts. It does not take into regard the purchasing power of credit cards nor the kind of recycling of credit discussed in the next section, which keeps the money market highly liquid so that there is little need to tap the formal sources of cash and near cash reflected in this table. 

 

More on this later.

 

 

Structured finance

This term applies to many different kinds of financial transactions that are employed for a variety of purposes. Two common characteristics are that the new financial instruments rely on derivatives to make them work and that they contribute to liquidity in the system.

 

Here is a simple example of how structured finance can help to boost the credit bubble. Consider ABC as a large second hand car dealer. Under the previous dispensation, before derivatives took off, ABC would have a certain amount of their own capital with which to buy cars that will be offered for sale. Once the car is sold, mostly on an installment plan, the contract would be discounted at a financial institution, who advances ABC hard cash in return for the income stream derived from the sale. But, as a rule, ABC have to assume responsibility that the installments are actually paid and will suffer the loss if the buyer disappears or fails to pay. ABC therefore diligently checks the credit worthiness of each new client, even if this means that a potential sale may have to be called off if the risk of default is too high.

 

With structured finance the situation is much different. ABC combines a large number of sales into one financial entity. Actuaries calculate the degree of risk of default associated with full that entity, which, if the number of contracts is suitably large, will be relatively low, so that the ‘bundle’ of contracts will have a good credit rating. On the basis of this risk assessment, ABC can now find someone to insure the installment stream derived from all the contracts in the entity against non-payment. This insurance typically has a ceiling beyond which ABC will again assume responsibility, but in the bull market of the 90’s, and even later, the ceiling would have seemed high enough that ABC saw no risk at all in these transactions.

 

With this bundle of insured contracts ABC can now enter the money market, where all kinds of money market funds, including pension funds, are keen to purchase good quality investments. So someone buys ABC’s contract entity, secure in the knowledge that the actuaries have given it an adequately high rating. ABC scores a nice profit on the sale and is now flush with cash again to acquire the trade-ins of all the people who are buying new cars on the easy terms that prevail and business continues without a break.

 

The key fact is that ABC does not have to perform due diligence when a prospective customer comes to buy a car on terms; ‘the system’ is taking care of the risk. Supposedly the risk is distributed across many corporate entities, but effectively the risk from all sources is being concentrated in the few large players who offer credit insurance. All is fine while people are able and willing to keep up their payments, but it becomes a real catastrophe should a significant proportion of debtors stop paying or simply disappear.

 

If that should happen, credit insurers will be the first to fold, thereby placing similar and other credit instruments under a cloud; the worth of these instruments and other insured credit, perhaps to the tune of $2 trillion or more, will be downgraded overnight by wide margins and the whole credit market will seize up in gridlock.

 

Much the same process as with ABC is taking place in the property market. The GSE’s – Fanny Mae and Freddy Mac, etc – are also using structured finance to mediate between banks, and other institutions writing mortgages, and the money market. Mortgages are purchased from the primary mortgage market players, then packaged in bulk and sold as structured financial entities in the money market, using the funds so obtained to ensure enough liquidity so that the ‘front line’, where mortgage writing is taking place, is always flush with cash and always ready for the next customer.

 

Two aspects of this process need mentioning. The first has already been mentioned and relates to changes in perceptions that have taken place. Consider how things used to be.:

 

If someone asked you for a loan, you wanted to be certain that it can and will be repaid. If a stranger had stopped you on the sidewalk downtown and asked, “Buddy, can you lend me $5000. I’ll repay it with interest 30 days from today.”, no sane person would ever think of complying with the request. Similarly, if a customer had come into your business to buy a second hand vehicle on terms, you would have checked his credentials and his credit worthiness thoroughly. The same applied to a bank that was dealing with a request for a mortgage; and even more so if the request was for an amount near to or at the price that was to be paid for the house, which would have increased the risk to the bank.

 

With structured finance and debt insurance this has all changed.

 

The front line – the bank, the S&L, the second hand car dealer and others – no longer carries any risk. It is all being diffused into ‘the market’ and thus, they say, all is well. Instead that each corporate entity gets saddled with all the risk of the business it does, and thus makes it very selective in concluding deals, this risk is spread through the economy by the marvel of derivatives. And so business can flourish.

 

Except that at the other end of the economy, far away from where the main action is, sits a relatively small number of debt insurers to whom all the threads of risk that is being diffused eventually leads. Now we do not have 50 000 small entities each taking good care of their own risk; we have perhaps a dozen or so large entities sitting on all the risk and – if they are wise – hoping that the actuaries really know what they are talking about.

 

But the big problem are the changes this has wrought at the front, where all the action is. Now that there is no constraint because of risk, and with a high measure of liquidity, the name of the game is turnover – the more turnover, the greater the profit. Whether one is selling cars, or furniture or TV’s or writing mortgages, it is all the same; if a potential customer crosses your doorstep he can only leave with a signed and sealed contract in his pocket. It does not matter who or what he is, the risk of dealing with him will disappear into the network, but some profit will remain to improve the month-end bottom line.

 

That is all that counts.

 

Logically, this means there is a lot of really bad debt being written and absorbed into ‘the system’. It also means when actuaries use historical data to calculate the risk associated with a large number of installment contracts, or mortgages, they are not allowing for the future effects of the fresh bad debt that did not exist a few years ago. Potentially bad debts that were not revealed because the tough times only started recently.

 

By the time they adjust their tables to the new reality it will be too late – the time bomb they have helped build would have gone off and the people who were so happy with their insured investments in the money market will discover when they need them that the insurers have gone. Disappeared. And that the risk is all theirs.

 

On that day there will develop a large black hole in the portfolios of many a pension and money market fund; confidence in ‘the system’ will disappear like mist before the sun and the credit crisis will enter its final imploding stage. 

 

The second aspect of this process is that it explains at least in part why there is so little or no inflation. Remember, if the excess money supply gets parked under someone’s bed, it has no effect on inflation. Well, much of the excess money supply in the US sits parked in money market funds as a result of all manner of structured finance deals that turn debt into valued financial instruments. Apparently very safe, but, in reality, an ever mounting catastrophe just  waiting for the right time and the right trigger to begin collapse.

 

 

The current situation

Not much thought is needed to realise that the changing nature of credit over the ages has culminated in a system where hubris – in the form of belief that all is safely under control and that nothing can go wrong – reigns supreme. We know that ever since Ancient Greek times hubris has always come before a fall. And it is likely to so again.

 

The changing face of credit has now put in place the groundwork for a tremendous credit binge in the US. By using all these new avenues leading to easy credit, corporation and household alike are piling on risk with little care for the consequences, fully secure in the belief that ‘the system’ will take of it all. Nothing can go wrong.

 

With government showing the way through its own example.

 

This does not mean other developed countries are unscathed – the United Kingdom, for example, also has a roaring property bubble while early in 2003 it was reported that as much as 10% of UK retail sales were being funded by consumer credit. However, in the US the credit situation has developed the furthest towards a comprehensive credit bubble and it will serve as a proxy for the kind of risk brewing in other financial markets.

 

The topic of this essay is the Credit Bubble, predominantly the one in the US we believe is now in the process of developing to full blown maturity. We believe we have provided enough background to convince readers that in the kind of climate as described it is just about inevitable that a Credit Bubble will develop. It is impossible to offer hard facts that would prove to everyone’s satisfaction that a real Credit Bubble already exists. Therefore we only provide some essential charts to show that there exist trends in the US economy that are unsustainable.

 

The few charts and statistics showing how the credit situation has developed over recent decades should be examined for the trends they display, rather than to attempt to spot the seeds of actual disaster in the most recent data. 

 

Firstly, a brief mention of the cost of debt. US debt – Public, corporate and household – recently stood at $31 trillion. Interest has to be paid on this amount and whether it is done directly or indirectly, individual American households do the servicing. They of course do so on behalf of their own debt, but they also service corporate debt through the prices they pay for goods and services and they pay interest on US Public debt through the taxes that are collected.

 

If we assume a round 100 million households at an average of 2,8 people per household, then each household is responsible for the servicing of $310 000 dollars of debt, as well as for the eventual repayment thereof. At an average interest rate of say 6%, the annual service cost of this debt is over $18 000, while if the capital is to be repaid over 30 years – with no more debt being made anywhere – an additional $10 000 per household have to be budgeted each year.

 

In other words, the total cost per household of all the US debt – assuming that the debt is to be repaid as a priority – is $28 000 per household. That represents just about half of the estimated median household income and does not leave much room to take on new debt.

 

The picture looks bleak, but note the catch phrase in the above paragraph: “. .  with no more debt being made anywhere.” While the total amount of debt increases, the situation gets worse, not better. It would be bad enough if the increase in household income at least outpaced the increase in household debt, but that is not so.

 

Household debt has been increasing faster than disposable income does for some 18 years now, which means that there is little hope that improved financial conditions in American households over time may help to alleviate the magnitude of the problem.

 

If debt is allowed to continue to increase faster than income, as seems likely given the way that consumers are exhorted to spend more, the future situation is bound to become catastrophically worse.

 

It is the trend that is the problem, even if economists can reason that the current situation is not critical. And, with economic growth scaling lower as consumers have less and less discretionary income left over after they have paid for more expensive medical care and it costs more to fill up the tank and more for their accommodation, there is very little hope at the moment that the trend can reverse; that the mountain of debt will be reduced.

 

This is important; many economists who analyse the debt burden find that with the low interest rates of the moment households actually pay less to service their debt than what they used to pay some time ago. That may well be true, but one firstly should not confuse the below 2% official rates – and the zero rates on recent purchases of durable goods – with the much higher rates asked for consumer credit and especially for credit card debt, the fastest growing segment of household debt.

 

Secondly, the theme of this essay is not that the crisis of a Credit Bubble stands ready to implode right now; it is that the recent and current trend is not sustainable and will result in disaster at some point in time.

 

And if interest rates should be increased to any significant degree, for whatever reason, the catastrophe will be on us within a matter of months, not years.

 

 

Two charts

The following two charts highlight the kind of trends that are contributing to what can only become a Credit Bubble, if it has not already done so. After all, who are we to decide that a Credit Bubble exists right now if some of the finest minds in the field of economics are not very clear on the characteristics that would really mark a true Credit Bubble. Perhaps it all boils down to the question asked earlier, “When does ‘much’ become ‘too much’?”

 

Anyone who sets out to answer this question should take into regards that Total US Debt (Public, corporate and household) to GDP has reached a factor of 3. To make it perfectly clear, Total US Debt at a time when GDP is approaching $10 trillion, has grown to be three times more than GDP.

 

The last time the ratio came near this level was in 1934, when the ratio was about 2.8. At first glance, then, a factor of 3 does not seem outrageous, or even risky, given all the new features such as derivatives to take care of risk. But note the year of the previous peak – it was in the depths of the 1930’s Depression – and then consider that the debt to GDP ratio before the 1929 Crash was well below 2. When the Crash happened and in its afterglow, household assets and corporate earnings evaporated and the economy took a nose dive as people lost their jobs, but all of the debt remained.

 

As a consequence of the declining economy, the Debt to GDP ratio increased from well below 2 to 2.8. If history should repeat along the same lines, we might well be looking at a Total Debt to GDP ratio approaching a factor of 5 in the not too distant future, 3-4 years from now (2003).

 

There is however no agreed to rule in economics that defines the ratio where a Credit Bubble can be said to exist, leaving the issue very much open to personal interpretation.

 

 

Chart 1. US Public Debt against GDP.  Annual ratio since 1960

Source: Federal Reserve of St. Louis

 

It would not serve our contention that a major Credit Bubble has formed, or is in the process of forming, if we simply stated US Public debt was $290 billion in 1960 and it had increased to $5,67 trillion by 2000. The near 20 fold increase is stunning, but the US of 2000 has vastly greater potential to repay debt than the one of 1960. In looking at the increase in debt in the US, we have to compare it against the ability to pay.

 

This chart shows the ratio of US Public Debt against GDP, with the latter variable, which measures the size of the economy, equated to the ability to repay debt. During the post WWII period, debt decreased as a fraction of the then fast growing GDP. This lasted until the late 1960’s, when the cost of the Vietnam war began to escalate. From then onwards to the mid 1990’s US Public debt grew  at a substantially faster rate than the economy.

 

The poor example set for the people by its government was apparently interrupted during the late 1990’s; the boom years of very rapid growth in personal and corporate wealth – and therefore in taxes. The years of the Clinton budget surpluses, that were reported with much fanfare amid dreams of repaying all the Public debt within the next 10-12 years. Yet, despite using the cash flow from the Social Security system to generate bookkeeping surpluses, the Public Debt increased by $786 billion between the end of 1995 and the end of 1999. As we have since discovered, with great loss of confidence in the integrity of corporate America, corporations, too, were employing strange and innovative accounting practices during those years. At best, these years merely experienced slower growth in the Public Debt and a rapid increase in GDP, to result in a downward trend on the chart.

 

But those years of dubious budget surpluses and very steeply rising GDP are history. The upward trend in the ratio of debt to GDP has resumed and is likely to continue for the foreseeable future. With the Iraq war to be paid, with substantial spending on homeland security and perhaps new military ventures, and with a struggling economy now causing a severe decline in Federal and state revenues, it is certain that the next few years will see the ratio of debt to GDP consistently climbing to new highs.

 

What can reverse the trend in this ratio? Obviously, one measure is to substantially cut back government spending and thus reduce the demand for new debt; secondly one could hope for a resumption of the high economic growth of the late 90’s. This would swell the inflow into government coffers to such a degree that the politicians would be stretched to think of new ways of spending it all; or, of course, of a combination of the two.

 

At the moment, corporations are waiting for demand for their products and services to rise before they invest in new facilities. Consumer are expected to limit spending while improving their domestic balance sheets. These factors form a recipe for a long drawn out decline in economic growth, which means conditions in the US economy are unlikely to even approach those of the heady 90’s for quite a number of years. Which only leaves the possibility of government spending being reduced substantially, within the ambit of the much lower revenues that can be anticipated for the near to medium term.

 

However, the chances of that really happening are infinitesimal, as shown by history and from what is known of the political mindset. It is politically so rewarding to cheat, not only on time, but also on future generations – who later have to deal with the massive load of debt – that no proposal to reduce the debt has a snowball’s hope of success.

 

In other words, there is a high probability that the trend shown in the above chart is intact for the foreseeable future. Again, it is not necessary to quibble over the question whether the US already has too much Public Debt; it is the trend that is critically important – and the probability that the trend can be reversed in time.

 

Simple logic dictates that while the situation with respect to the Public Debt may not as yet have precipitated a crisis, it will do so at some point in time. Inevitably so.

 

And it is not only the Government that is facing a lot of problems in the not too distant future. There are other trends in credit that are promising even more severe problems than the Government shifting a debt load onto future generations.

 

Chart 2. Combined Consumer Debt against Disposable Income.

Source: Federal Reserve of St. Louis

 

The chart shows the ratio between combined consumer debt and disposable income. The consumer debt represents three categories from the available data: normal bank loans by individuals, consumer credit and real estate loans from banks.