The underlying problem is deeper: For the past 25 years we have been over-consuming and over-borrowing to do it. The problem is debt itself.
Consider the ratio of household debt (all mortgage debt, credit cards, bank loans of all kinds) to the U.S. gross domestic product. This ratio rose steadily in the period after World War II until it stabilized at around 40% to 50% in the 1960s and 1970s. In the mid-1980s, it turned a corner and broke through 50%, hitting 60% in 1988 and 70% in 2000. It then accelerated all the way to 100% in the seven-year stretch from 2001 to 2007.
All that borrowing by individuals had a powerful stimulatory effect on the economy. Business sales grew, and production increased to meet improved demand. The result was an astonishing period of almost unbroken economic growth during the past 25 years.
But debt was growing faster than income, so the aggregate “credit ratio” of household debt to median household income steadily deteriorated. The problem, of course, was worst at the lowest end of the income spectrum. But the pattern of growing debt pervaded society. People maxed out credit cards and pulled the equity out of their houses. And most people stopped worrying about ever paying the debt back, since the abundant liquidity in our system made it seem that debt could always be rolled over and refinanced.
In short, more of our prosperity than we have been willing to admit has been driven by debt. At the global level we were in a huge financial imbalance, borrowing hundreds of billions per year from China and other countries so we could go on over-consuming. But debt-driven prosperity is an illusion, since debt must someday be repaid. That ugly fact remains hidden until the debt ratio gets very high.
Why don’t both borrowers and lenders see this in time to stop? Perhaps borrowers are shortsighted, and lenders are corrupted by large cash bonuses. These are both very likely true. But even if they were not, no one can say when the end will come, and it is in everyone’s interest to keep the party rolling. Consumers want to go on consuming, and banks want to go on making profits.
What finally brings the party to an end is when the banks begin to have funding problems. If a Bear Stearns or a Lehman Brothers starts to look dangerously over-extended, first a few funders will pull back, and then more will follow. The bank’s stock price begins to fall, and the price of insuring its borrowing begins to rise. Then its funding begins to dry up, and a financial crisis is at hand.
We have seen similar events happen in developing countries, most recently in the East Asian crisis of 1997 to 1998, but we never thought it could happen to us. Well, it just has. The current events are not at all like an ordinary business cycle; they are not a mere recession brought on by tight monetary policy or too many inventories. Rather, we are witnessing a systemic crisis, a joint collapse of financial prices, financial institutions and the real economy.
Have we ever seen a systemic crisis in the U.S.? Yes we have — in the 1930s. The data for household debt do not extend back that far, but there is a related series kept by the U.S. Commerce Department called “individual and noncorporate debt.” The ratio of that number to GDP rose rapidly from 55% in 1920 to a peak of 97% in 1932. The 1920s were also a boom time, but in retrospect, that too was debt-driven growth, and it ended in the systemic crisis known to us as the Great Depression.
There are of course many differences between our era and the 1930s. Among other things, government has become much more activist and is far more willing than it was in the 1930s to intervene to stop the slide. But does the government literally have the power to stop the slide? It can no doubt help at the margin, and it is certainly obliged politically to try everything it can. But merely spending money may have no more than a temporary effect. The essential problem is that people have too much debt, and that problem can only be solved by debt reduction.
How do you reduce debt? There are really only two ways: repay it or default on it. A renegotiation of terms is also possible — this is a blend of repaying and defaulting. Repayment of even some debt means that Americans must regain the habit of saving.
Our ratio of household saving to disposable personal income, which had been in the 8% to 10% range as recently as the 1990s, fell to nearly 0% by 2007 but has returned to about 5% in the fourth quarter of 2008. Saving means consuming less, and of course this hurts the economy. Default is happening too, and this clobbers the banks. But there is no way to reduce debt without harm. De-leveraging is as painful as borrowing is pleasant.
Government policies that are directed toward debt reduction, such as the administration’s latest program to promote mortgage debt renegotiation, are well focused. But the government is deeply misguided when it beats on the banks to “lend more”: The banks have lent too much already, and consumers have borrowed too much. If the name of the problem is too much debt, “lend more” hurts rather than helps.
We have met the enemy, as Pogo said, and he is us.
This article originally appeared on Forbes.com.
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