Total Debt Rising Slowly - Analyst Blog

In the first quarter, total non-financial debt in the economy rose at a seasonally adjusted annual rate of 3.5%. That is less than half the rate that the economy was going into debt on average between 2000 and 2007.

The onset of the financial meltdown caused a sharp slowdown in the rate of debt growth in the second half of 2008, so the 6.0% growth in debt shown in the table below (from

) is a bit misleading, as it includes rapid debt growth in the first half of the year and a big decline late in the year.

The composition of the debt has changed significantly. Households reduced their debt at an annual rate of 2.4% in the first quarter, up from a 1.6% rate of decline in the fourth quarter and the seventh quarter in a row that households have managed to bring their debt level down.

Just to be clear, not all of that debt reduction has come from people virtuously paying down their credit cards and mortgages. Debt that is defaulted on also goes away, just like debt that is repaid. For the Flow of Funds report, there is no real difference. For

(

) or

(

) it makes all the difference in the world.

Non-financial business debt (financial debt, such as borrowings by banks, are excluded since the purpose of that debt is to be lent out again and would lead to significant double-counting issues) was unchanged in the first quarter after five consecutive quarters of businesses whittling down the debt on their balance sheets. Despite the severe budget constraints that most of them are working under, state and local governments slowed the rate at which they are going into debt to an annual rate of 4.3%. That is 47% slower than State and Local governments were adding to their debt from 2000 through 2007.

While the private sector has been struggling to get out of debt, and the lower levels of government are slowing the rate that they go into debt, the same is not true of the Federal Government. From 2000 to 2007, Federal Debt was actually growing much more slowly than debt in the rest of the economy, in large part due to actual declines in 2000 and 2001. If those years are excluded, the debt growth rate of the Federal Government averaged 7.22%, just slightly lower than the debt growth rate for the rest of the economy. The Federal Debt growth rate was 18.5% in the first quarter, which was a notable acceleration from the fourth quarter rate of 12.6%, but also significantly lower that the 22.7% rate for all of 2009.

It is somewhat encouraging to see the private sector getting their balance sheets in shape, but the table above only looks at the liability side of the balance sheet. The other side is assets.

The graph below (from

) shows household net worth (assets-minus liabilities) as a percentage of GDP. From 2002 through 2007, even though household debt was rising at a breakneck clip, asset prices were rising even faster. The result was a huge increase in household wealth as a percentage of GDP. For the most part, this was due to the increase in housing prices, with a significant assist from a bull market in stocks.

From its peak in late 2007 to its trough in the first quarter of 2009, household net worth declined by a staggering $17.7 Trillion dollars. Since then, efforts and paying down debt, the stabilization of housing prices (even though that might be temporary) and a rebound in the stock market have combined to lift total household net worth by $6.3 Trillion. However, that still leaves the American households poorer by $11.4 trillion than they were in the third quarter of 2007.

That sort of hit to wealth is going to leave a mark. That wealth represented many people's retirements, and with the Baby Boomers on the cusp of getting their golden watches (OK, that’s a metaphor -- I don’t think anyone gets those any more) people are going to try to rebuild their net worth by spending less and paying down debt.

If everyone starts saving at the same time, there is no one left to spend. That slows the economy, resulting in higher unemployment. Without a paycheck and relying on unemployment benefits that are just a fraction of what you used to earn makes it very difficult to save or pay down debt.

While thrift is virtuous on an individual level, and collectively we really do need a much higher overall savings rate, if everyone gets religion at the same time the results can be disastrous for the economy. This is what is known as the "paradox of thrift." 

The Savings rate has increased during the recession: in April it was 3.6%, up from less than 1% in 2007. From the 1950’s through 1980, the normal savings rate was between 9 and 10%, occasionally going a bit higher during recessions and a little bit lower than that during booms.

After 1980, the savings rate entered a secular decline. A declining savings rate can give a big boost to economic growth. A rising savings rate will tend to slow down an economy, but unfortunately you cannot go from a low savings rate to a high savings rate without the savings rate rising. For the long-term health of the economy, we need a much higher savings rate. That means that the economy will be facing significant headwinds for several years as the savings rate is rebuilt.

However, savings are needed for investment. In a closed economy, savings will equal investment. We do not, however, live in a closed economy, and we were able to continue to invest (although not particularly wisely, as so much of it ended up going into McMansions 40 miles from where people work) only by importing savings from abroad. Doing that means running a trade deficit and either selling off assets or going into debt with the rest of the world (for much more on this see:

.)

When the private sector all of a sudden starts to get religion all at the same time and tries to deleverage, the government has to step in and be the spender of last resort. If it does not, the economy will collapse and eventually get stuck in a sub-optimal equilibrium, aka a depression, and one that can last an extremely long time.

Thus the rapid growth rate in Federal debt should be seen as a necessary evil, or even as a good thing at this point. That is not a condition that can last forever, and over the long term we need to bring the debt level of the Federal government down. Right now, though, we need to plug the hole of declining household debt levels, which leads to much less spending power on the part of consumers.

Rather that seeing the rise in Federal debt as a dangerous explosion, it should be considered a shift of liabilities from the household sector, also known collectively as taxpayers, to the Federal government, also collectively known as taxpayers. It's not pretty, but it has to happen.