Excessive private debt was a principal cause of America’s Great Recession, which began in December 2007. During the current recovery, there has been some reduction in private debt, and concerns about it have been receding. That is a mistake. The private debt problem is not going away. It presents a continuing threat to economic growth and financial stability that could hurt all Minnesotans for years.
As of December 2014, America’s private debt equaled nearly $40 trillion, as recently reported by the Federal Reserve. Private debt includes credit extended to households, nonprofit enterprises, corporate businesses and financial institutions. Currently, private debt represents more than twice as much as GDP, the nation’s gross domestic product (which was $17.7 trillion). By comparison, U.S. government debt is less than half of our private debt.
Excessive private debt adversely affects economic growth and has real and serious consequences. Reduced investment returns will make it more difficult for Minnesotans to save enough for retirement and will tempt them to take on investment risks they do not understand. Reduced tax receipts will make it more difficult for governments to maintain public pensions, Social Security and health-care benefits. Reduced revenue will also force governments to try unique and untested financial policies. Reduced growth will similarly tempt companies to undertake various forms of risky “financial engineering” to boost profits. There are additional adverse consequences.
Problem has developed over decades
America’s private debt problem has been developing for some time. In 1949, private debt relative to GDP stood at only 55 percent. During the next 60 years, private debt grew steadily to a peak of 288 percent of GDP as of March 2009 (almost three times our annual income).
While debt was climbing at an increasing pace over those 60 years, America’s income was growing at decreasing rates. In the 1950s and 1960s, GDP grew at about 4 percent per year. Growth has steadily declined since then and is now projected by the nonpartisan Congressional Budget Office to be less than 2.5 percent per year for the next decade. This has been a big decline.
American consumers, nonprofits, businesses and financial institutions combined took on debt for almost 60 years at rates faster than the economy was growing. That process could not continue indefinitely. It did not. The Great Recession reduced our private debt relative to GDP. But as the recovery has continued, private debt is back to an unhealthy 225 percent of GDP.
The nearly $40 trillion of America’s private debt as of the end of 2014 was owed 34 percent by households, 11 percent by nonprofit enterprises, 19 percent by corporate businesses and 36 percent by financial institutions, according to the Federal Reserve. Of these four sectors, only households and financial institutions reduced their debt in relation to GDP in the past six years. Household debt is down from its peak due primarily to mortgage foreclosures and consumer credit write-offs — not so much due to consumers paying down debt.
High corporate debt
By contrast, corporate debt has remained high and is growing. One reason for continued high levels of corporate debt has been the expansionary monetary policy of the Federal Reserve. Extremely low interest rates and “quantitative easing” were intended to encourage corporate borrowing to stimulate the economy. This has occurred. For example, U.S. companies issued on average almost $1.4 trillion of rated debt per year for each of the past three years, according to The Securities Industry and Financial Markets Association. This was almost double the amount of such debt issued per year from 1999-2005.
Of course certain debt can be constructive and help grow the economy. Debt to finance new facilities, equipment and inventory, for example, can be useful. Some of the new corporate debt, however, is not economically constructive. A significant portion of funds borrowed by U.S. companies has gone to stock buybacks. Debt helped fund approximately $1.5 trillion of stock buybacks during the past three years; and data so far indicate buybacks in 2015 will be even more aggressive.
Low interest rates have also encouraged yield-hungry investors to take on more risk in their portfolios, enabling companies to issue more than $300 billion of high-yield (“junk”) rated debt in each of the past three years. There are undoubtedly other distortions (or “bubbles”) in credit markets caused by extremely low interest rates that have been in effect for the past six years.
Another serious problem with excessive debt is that it can depress economic growth. Several studies have confirmed that debt levels as they exist today predict rates of growth well below the post-World War II experience.
Limits to usefulness of the Fed’s approach
Unfortunately, both the U.S. government and the private sector have been ready, willing and able for more than 65 years to undertake policies and procedures that increase private debt. While the Federal Reserve has found it necessary to use debt as a tool to promote economic recovery after the Great Recession, there are limits to the continued usefulness of that approach. Equally, there are also limits to the benefits to our economy presented by hungry private debtors and willing private creditors.
Why do we think America’s private debt represents a lingering peril? There are several reasons. At 225 percent of GDP, our current level of private debt is already more than it was in 1999, and it is growing. Much of that debt has been incurred at unusually low rates of interest. We think there are probably distortions in financial markets that will become more evident as the Federal Reserve raises interest rates. Those distortions could cause disruptions in financial markets.
In addition, the very recent expansion of America’s private debt includes a large number of loans in sectors such as student loans, subprime auto loans, high yield debt and investment grade loans to finance stock buybacks. Many of these may not have been economically productive.
To the extent that debt grows faster than GDP, we also think that there will not be enough creditworthy borrowers and productive activities to absorb ever-increasing amounts of debt. Loans will inevitably chase borrowers who are not creditworthy, and when they cannot pay, financial market problems and anemic economic growth will result. In fact, once private debt is roughly 250 percent of GDP, we think that approaches a tipping point. Recent history provides ample proof of that conclusion.
Ways to lower private debt growth
There are, however, several ways to help reduce the rate of private debt growth. One would be to reduce the deductibility of interest under the Tax Code. A second would be to implement policies that increase the productivity of American workers. An increase in interest rates may also reduce the rate of debt growth and inhibit debt that is for less productive purposes — but at some level, increased rates would restrict economic growth. Overall, a multi-pronged approach by the U.S. government and the private sector would be appropriate.
Although a few commentators are calling for these changes, it appears unlikely much will be done in the near future. In that case, we all would be wise to anticipate slower economic growth for the next few years. Minnesota investors should not take on too much risk in search of what used to be “normal” returns. They should also be alert for market disruptions. Minnesota consumers need to get better advice and be careful before taking on debt. They cannot assume that because a lender has agreed to lend them money that it is necessarily in their financial interest to borrow. Finally, Minnesota voters should be skeptical about appeals to increase nonproductive debt and should be open to proposals to increase America’s productivity and economic competitiveness.
David Edstam of Edina is a retired senior finance executive. Steve Carlson is a former Edina resident (now in Connecticut) and retired finance lawyer and former Minnesota deputy commissioner of commerce (2011-12).
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