Over the past few weeks it has been clear that another exploration of deflationary risk is in order. Having already published Inflation vs. Deflation (3-15-10) and Avoiding Global Deflation (7-18-10), as well as The China Bubble (6-8-10) there seemed no point in compiling additional alarming, but anecdotal information. Nothing has changed. Debt is too high almost everywhere, certainly in the U.S. and the Eurozone, and even if Chinese debt ratios appear low, the information available could be misleading because China’s banking system is opaque, and much of their collateral may be grossly overvalued.
Because for the past thirty years the global economy has relied on rising debt to fuel rapid economic growth, as debt levels become unsustainable, economic growth slows. When that occurs, asset values drop, meaning that outstanding loans are no longer backed by sufficient collateral. Even in a mildly deflationary environment – which for now, thankfully, is all we are dealing with – real rates of return on large investment funds cannot realistically be projected at levels that cause total interest payments to consume an inordinate percentage of GDP. The more debt exists as a percentage of GDP, the more a burden interest payments become, and the more imperative it becomes to keep interest rates low to maintain solvency – whether that is solvency of government, business, or household entities.
As an aside, when considering levels of debt, what level is deemed sustainable will affect the ability of nations to issue currency without triggering currency devaluation – and paradoxically, the more weakened other currencies are relative to each other, the more difficult it becomes for any nation to resort to currency devaluation to whittle away the real value of their debt on global markets. In short, the accumulation of unsustainable debt both mandates and impels low rates of investment returns.
In this post I’ve attempted to compile information on total national debt in comparison to annual gross domestic product (GDP), and then attempted to correlate this ratio to national assets (based on 10x GDP) to calculate the amount of national credit available based on a borrowing ceiling of 50% of assets. I also attempted to determine total interest payments as a percent of GDP based on various rates. Finding good information is difficult, the topic is vast, and many assumptions are inevitable in the course of producing useful generalizations, but here goes:
This post presents four tables designed, hopefully, to convey information useful to evaluate the strength of currencies and the sustainability of total national debt; they evaluate the Eurozone along with the other six largest nations, the US, China, Japan, Brazil, Russia, and India, who collectively represent about 70% of the estimated global GDP. The first table estimates government debt as a percent of GDP. The second table, just for the U.S., displays reported total debt (government, commercial, consumer) as a % of GDP for the years 1890 through 2010. The third table estimates total debt as a percent of GDP, and then calculates available credit based on a collateral value of 10x GDP, with a borrowing limit of 50% of collateral value. The fourth table estimates total interest payments as a percent of GDP based on interest rates of 2%, 4%, and 8%.
These tables are compiled with data from a multitude of sources; CIA, GPO, UN, World Bank, IMF, US Census Bureau, and much more. Of extraordinary value in these compilations is Wikipedia, where tables referencing multiple authoritative sources can be found listing GDP, Population, and other basic data. The debt of nations can be split into three very distinct areas: government – local, state, and federal – businesses, and consumers. These national debts, along with the GDP of nations, are denominated in trillions. The GDP of all nations combined, for example, is valued at around 58 trillion in 2010 U.S. dollars.
All of these reported debts represent claims by creditors for things that have already happened; were already built or consumed. These various debts don’t include any unfunded future liabilities, there are no future services that can be withheld in order to reduce these debts. These total debt balances are for money that is already spent, home mortgages, commercial mortgages, corporate and financial debt, and the debt of governments. In researching information on the internet, while GDP estimates are readily available, and the federal government debt of nations is reasonably available, the rest of the data is fairly elusive.
In the above table, government debt is compared between the seven largest economic entities, including the Eurozone as one entity. The information on debt comes from the 2009 CIA table Gov’t Debt as a % of GDP. The GDP and population figures, including those compiled for the 16 member nations of the Eurozone, come from compilations on Wikipedia; List of Countries by GDP, and List of Countries by Population, which in-turn sources its data from the CIA, the IMF, and the World Bank.
This table, which doesn’t include state and local government debt, shows the U.S. with a reported government debt equivalent to 54% of GDP, which is better than the Eurozone, with a debt/GDP ratio of 79%. In reality the government debt as a percent of GDP when you compare the U.S. and the Eurozone are probably about the same. Among the major nations, India (57%) and Brazil (60%) also have high levels of government debt, and Japan has a staggering 193% debt/GDP ratio. Only Russia (8%) and China (17%) have apparently avoided crushing levels of government debt.
Government debt, however, is only one leg of the stool; the other legs are commercial debt and household debt. In the next table data is presented for the U.S., looking not just at government debt, but all debt. The data for this second table is gathered from three sources, which all corroborate an astonishing statistic – that the total debt in the U.S. is currently higher than it was during the great depression in the 1930s. Currently the reported total debt / GDP ratio in the United States is 370% and rising. At the height of the great depression, total debt / GDP was barely 300%.
Instead of presenting this data graphically – three corroborating versions of which can be seen in the reports from MarketOracle, Morgan Stanley (ala Paul Kedrosky), and Daily Markets – the above table breaks the last 120 years of American history into four 30 year financial eras. In all four 30 year periods, the total U.S. debt fluctuated between 140% and 160% of GDP. Two of the 30 year periods, the those beginning in 1890 and 1950, respectively, saw debt as a percent of GDP display very little variation. For example, between 1890 and 1920 the maximum debt/GDP ratio was 165%, and the minimum debt/GDP ratio was 125%. For the period beginning in 1950 the variation was even more unremarkable, with the 1950 beginning level of 140% comprising the lowest ratio, and the 1980 ending level of 160% comprising the highest ratio. This parallel between the two relatively stable periods makes any parallel one may infer between the two relatively unstable periods quite ominous. Because the 300% debt/GDP extreme achieved in 1930 took 20 years and a grueling economic depression to unwind. As of 2010, America’s total debt is around 370% of GDP and rising.
The next table, below, attempts to determine what resources the United States and other nations may have available to maintain their debt load or even increase it. In order to come up with some comparisons, two major assumptions are made – that national assets are equivalent to ten times GDP, and that total debt is equivalent to triple the reported government debt (with the exception of the U.S., where there is a more accurate estimate of $51 trillion in total debt). As can be seen, based on these assumptions, the debt/asset ratios for these nations (col. 3, below) display predictable parallels to the debt/GDP ratios, except in the case of the U.S.
Parallels break down, however, with the next step, which determines how much additional credit these nations can muster (col. 4, below). For the purposes of comparison, available credit is calculated by assuming a nation’s collective borrowing remains viable up to an amount equivalent to 50% of their collective assets. As can be seen, the absolute value of each nation’s GDP has a decisive effect on the calculation, since countries with much larger GDPs such as the U.S. have as much remaining borrowing capacity – 19.8 trillion – as the much smaller Chinese economy – 22.4 trillion – despite the fact that China has a debt/equity ratio of 5% vs. America’s 36%.
There are a lot of caveats to any sort of compilation of national borrowing capacity. Altering the assumptions yield vast repercussions. What if the debt held by households and businesses don’t mirror the levels of government debt? What if some nations have asset bubbles that are significantly more over-valued than the assets in other nations? But it’s important not to let these concerns completely overshadow the point, which is that global debt as a percentage of global GDP and global assets is getting dangerously elevated. This is obviously the case in the U.S., Japan, and the Eurozone, but what about China? Because China has a nearly impenetrable banking system, getting aggregated information is impossible, but the Chinese probably have significant debt that is not observable, and they may have asset bubbles – which collateralize their debt – that are about to pop. Consider these quotes from the article “China’s record debt has economists worried,” published last November by Bill Powell in CNN Money:
“The U.S. fueled its housing and consumption bubbles by providing easy credit. China seems headed in the same direction, although the victims would be different this time. In the first nine months of the year, Beijing has shoveled $1.27 trillion in new loans into the economy, up 136% from the same period last year. That money has gone to three main areas: infrastructure, manufacturing, and real estate. According to a recent analysis by Monaco-based hedge fund Pivot Capital Management, China’s total lending reached 140% of GDP at midyear. That kind of lending makes China an ‘outlier’ compared with other BRIC (Brazil, Russia, India, and China) countries — and is already well beyond the levels that ‘have led to sharp and brief credit crises in the past,’ the Pivot Capital report contends. Moreover, an increasing number of Chinese loans are being funneled into projects unlikely to generate an attractive economic return. From 2000 to 2008 it took just $1.50 in new credit to generate $1 of GDP growth. Now that ratio is 7 to 1. (In the U.S., just before the financial crisis hit, the ratio was only 4 to 1.)”
For more on China, consider the report “China’s rising bank debt could leave nation exposed” published earlier this month by Ambrose Evans-Pritchard in The Telegraph:
“Chinese banks are expanding their balance sheets rapidly through higher leverage – a policy that relies entirely on the continuance of torrid growth. Concerns are mounting about the opaque operations of China’s banks. The regulator ordered them to carry out a stress test this month based on a 60% fall in property prices.”
Before moving on, it’s important to connect the vulnerability of national economies who have relied on excessive debt to deflationary pressures. The U.S. housing market, for example, has now collateralized the accumulation of debt by U.S. households that easily exceeds $10 trillion. What happens when these homes are all suddenly worth 50% as much? This same scenario may also occur with the commercial real estate market in the U.S., putting another nearly $5 trillion in debt at risk. Government debt, while not explicitly collateralized to hard assets, is none-the-less backed by the vitality of the economy of the nation. Business debt is collateralized by the assets of the business, which lose their value in a downturn. The point is this: If the value of the collective assets in the U.S. go from 10x GDP to 5x GDP, i.e., if they lose $70 trillion in value, there is no fiscal or monetary policy imaginable that could prevent a collapse of liquidity and a deflationary spiral.
The next table examines the sustainability of debt levels in the major nations by estimating debt service as a percent of GDP based on various interest rates. While these debt levels are speculative in the case of nations other than the United States, because they are based on a total debt estimate of 3x government debt, in the case of the United States all of the variables are fairly well documented. As can be seen, debt service at an interest rate of 2% consumes 7.2% of U.S. output, at rate of 4% consumes 14.4% of U.S. output, and at a rate of 8% consumes 28.8% of U.S. total output.
What this all means is hard to distill, but salient points abound. Debt payments necessarily are paid from an active producer to a passive consumer. Incentives to produce are dashed in a debt-rich economy. Existing debt and current deficits are only part of the picture – cash-flows are also being decimated now by payments for future liabilities. While pay-as-you go plans such as Social Security are unfairly identified as a source of massive unfunded liability (ref. Funding Social Security), the Wall Street pension plans are in dire straits because they been projecting investment returns that are elevated because they depended on accumulating debt. Here the relationship between national debt and rates of return is a painfully relevant indicator of impending deflation – we have reached the point there is too much debt out there to pay high rates of interest without going bankrupt, and consequently our retirement pension funds will require far greater infusions of cash from the workers, further lowering productivity.
Turning to salient questions, why would economists deny an economic cycle is in recession, if growth is only through growing assets atop a speculative bubble? Didn’t any experts think total national debt mattered? Why for that matter, isn’t information readily available on aggregate debt by nation and currency zone? Is consumer debt or commercial debt that hard to estimate? Can no informed assumptions be made? Are discussions of aggregate debt still irrelevant? If not, where are the figures?
The GDP numbers used here, along with the debt numbers in all sectors for the USA, come from what appear to be reliable and redundant sources. Therefore the estimate that just a 3% real rate of return on total debt in the USA will require interest payments of 10.8% of GDP is well founded. Of equal importance is the impact the reduction to a 3% earnings projection has on the long-term balances for investment funds that are obligated to disburse defined benefit obligations to current and future retirees. If return projections are lowered to 3%, they will necessarily require gigantic leaps in their annual collections in order to fulfill these future promises.
National debt of all kinds, government, business, household, is facilitated by low interest rates. Once these low rates induce a sufficient percentage of national assets to be encumbered, either contractually or intrinsically as part of the economic ecosystem that determines and defends the vitality of a nation’s currency, it becomes crucial to maintain low rates to avoid bankruptcies. In the early stages, and then with increasing desperation, as these low borrowing rates stimulate economic growth catalyzed by excessive speculation, assets acquire value that would not accrue in an environment of sustainable, higher rates of interest. These overvalued assets are the collateral, they secure additional borrowing, they are engines of liquidity. The higher debt levels get, the more new debt it takes to generate the same unit of economic growth. Eventually buying must slow down, and asset values come down to earth, which means loans are secured by property that is worth less than the loan. When this becomes pandemic, you have a deflationary decline.
National debt and rates of return is an endlessly compounding topic that defies concise explanation, hence a conclusion to this post that may as well be throwaway haiku. One final aside: Related to passive investor claims on ongoing productivity, which in the U.S. at 3% interest is 10.8% of all output, is the demographic reality that defines nations as much as their levels of debt. Japan, the Eurozone, and China all confront rapidly aging populations, although the Chinese are a generation behind Europe and Japan. The U.S. has a perfectly even age continuum, with about 20 million people in each five year age group through about age 60. Brazil still has a pyramidal age structure, although the slope has steepened in the last 10-20 years. In general, the 30% of global output not summarized here are emerging nations, with young populations and relatively low levels of debt. Will they be the locomotives that pull the developed world out of their debt funk, by playing an integral part in a new wave of sustainable growth? Or will the canny and heedless West simply mortgage the emerging world like it mortgaged itself, making them just another bubble? Or are we advancing so fast, our efflorescence of technology and freedom so rapid, that real economic growth will erase our debt?
Debt elimination without a deflationary crash requires GDP growth while simultaneously reducing debt. But without bubbles the world would no longer dream, or reap the lasting benefits from the valid advances every bubble leaves behind. In the future, what’s wrong with a space tourism bubble, where we vacation at a constellation of resorts orbiting in the vicinity of L5? Or a geriatric bubble, with products such as exoskeletons that would enable safe downhill skiing at age 110? Or highly advanced virtual reality devices, bubble enclosures in reality, where young and old enter cyberspace and become indistinguishable? Aren’t bubbles innovative engines? But debt is debt, and walls are walls, and interest rises, and interest falls.