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Limits to debt

This article is an excerpt from Chapter 2 of Richard's new book (working title 'The End of Growth'), which is set for publication by New Society Publishers in July 2011. Given the urgency and fragility of the global economic crisis, we will be serializing the rough content as Richard writes it.

Follow Richard's writing process through Facebook and Twitter accounts created expressly for this publication.

Limits to Debt
Let’s step back a moment and look at our situation from a slightly different angle. Take a careful look at Figure 1, the total amount of debt in the U.S. since 1979. The graph breaks the debt down into four categories—household, corporate, financial, and government. All have grown very substantially during these past 30+ years, with the largest percentage growth having taken place in the financial sector. Note the shape of the curve: it is not a straight line (which would indicate additive growth); instead, up until 2008, it more closely resembles the J-curve of compounded or exponential growth (as discussed in the Introduction).
US debt outstanding chart
Figure 1
Growth that proceeds this way, whether it’s growth in U.S. oil production from 1900 to 1970 or growth in the population of Entamoeba histolytica in the bloodstream of a patient with amoebic dysentery, always hits hard limits eventually,
With regard to debt, what are those limits likely to be and how close are we to hitting them?
A good place to start the search for an answer would be with an exploration of how we have managed to grow our debt so far. It turns out that, in an economy that’s based on money creation through fractional reserve banking, with ever more loans being taken out to finance ever more consumer purchases and capital projects, it is usually possible to repay earlier debts along with the interest attached to those debts. There is never enough money in the system at any one time to repay all outstanding debt with interest; but, as long as total debt (and therefore the money supply as well) is constantly growing, that doesn’t pose a practical problem. The system as a whole does have some of the characteristics of a bubble or a Ponzi scheme, but it also has a certain internal logic and even the potential for (temporary) dynamic stability.
However, there are practical limits to debt within such a system, and those limits are likely to show up in somewhat different ways for each of the four categories of debt indicated in the graph.
With government debt, problems arise when required interest payments become a substantial fraction of tax revenues. Currently for the U.S., the total Federal budget amounts to about $3.5 trillion, of which 12 percent (or $414 billion) goes toward interest payments. But in 2009, tax revenues amounted to only $2.1 trillion; thus interest payments currently consume almost 20 percent, or nearly one-fifth, of tax revenues. For various reasons (including the economic recession, the wars in Iraq and Afghanistan, the Bush tax cuts, and various stimulus programs) the Federal government is running a deficit of over a trillion dollars a year currently. That adds to the debt, and therefore to future interest payments. Government debt stands at $13.6trillion now (it has increased by more than 50 percent since 2006), and it’s growing at over $1 trillion a year due to the deficits, which are officially projected to continue for several years.[1] By the time the debt reaches $20 trillion, roughly ten years from now, interest payments may constitute the largest Federal budget outlay category, eclipsing even military expenditures.[2] If Federal tax revenues haven’t increased by that time, Federal government debt interest payments will be consuming 20 percent of them. Interest already eats up nearly half the government’s income tax receipts, which are estimated at $901 billion for fiscal year 2010.[3]
Clearly, once 100 percent of tax revenues have to go toward interest payments and all government operations have to be funded with more borrowing—on which still more interest will have to be paid—the system will have arrived at a kind of financial singularity: a black hole of debt, if you will. But in all likelihood we would not have to get to that ultimate impasse before serious problems appear. Many economic wags suggest that when government has to spend 30 percent of tax receipts on interest payments, the country is in a debt trap from which there is no easy escape. Given current trajectories of government borrowing and interest rates, that 30 percent mark could be hit in just a few years. Even before then, U.S. credit worthiness and interest costs will take a beating.
DollarsHowever, some argue that limits to government debt (due to snowballing interest payments) need not be a hard constraint—especially for a large nation, like the U.S., that controls its own currency. The United States government is constitutionally empowered to create money, including creating money to pay the interest on its debts. Or, the government could in effect loan the money to itself via its central bank, which would then rebate interest payments back to the Treasury (this is in fact what the Treasury and Fed are doing with Quantitative Easing 2, which we shall discuss more below). For a perspective on why U.S. government debt may not face limits anytime soon, as long as the economy returns to growth, see James K Galbraith.
The most obvious complication that might arise is this: If at some point general confidence that external U.S. government debt (i.e., money owed to private borrowers or other nations) could be repaid with debt of equal “value” were deeply and widely shaken, potential buyers of that debt might decide to keep their money under the metaphorical mattress (using it to buy factories or oilfields instead), even if doing so posed its own set of problems. Then the Fed would become virtually the only available buyer of government debt, which might eventually undermine confidence in the currency, possibly igniting a rapid spiral of refusal that would end only when the currency failed. There are plenty of historic examples of currency failures, so this would not be a unique occurrence.[4]
Some who come to understand that government deficit spending is unsustainable immediately conclude that the sky is falling and doom is imminent. It is disquieting, after all, to realize for the first time that the world economic system is a kind of Ponzi scheme that is only kept going by the confidence of its participants. But as long as deficit spending doesn’t exceed certain bounds, and as long as the economy resumes growth in the not-too-distant future, then it can be sustained for quite some time. Ponzi schemes theoretically can continue forever—if the number of potential participants is infinite. The absolute size of government debt is not necessarily a critical factor, as long as future growth will be sufficient so that the proportion of debt relative to revenues remains the same. Even an increase in that proportion is not necessarily cause for alarm, as long as it is only temporary. This, at any rate, is the Keynesian argument. Keynesians would also point out that government debt is only one category of total debt, and that U.S. government debt hasn’t grown proportionally relative to other categories of debt to any alarming degree (until the current recession). Again, as long as growth returns, further borrowing can be justified (up to a point)—especially if the goal is to restart growth.
The limits to household debt are different, but somewhat analogous: consumers can’t create money the way banks (and some governments) do, and can’t take on more debt if no one will lend to them. Lenders usually require collateral, so higher net worth (often in the form of house equity) translates to greater ability to take on debt; likewise, lenders wish to see evidence of ability to make payments, so a higher salary also translates to a greater ability to take on increased levels of debt.
As we have seen, the actual inflation-adjusted income of American workers has not risen substantially since the 1970s, but home values did rise during the 2000-2006 period, giving many households a higher theoretical net worth. Many homeowners used soaring house value as collateral for more debt—in many cases, substantially more. At the same time, lenders found ways of easing consumer credit standards and making credit generally more accessible—whether through “no-doc” mortgages or blizzards of credit card offers. The result: household debt increased from less than $2 trillion to $13.5 trillion between 1980 and 2008. This borrowing and spending on the part of U.S. households was the major engine not only of domestic economic expansion during most of the last decade, but of worldwide economic expansion as well.
But with the crash in the U.S. real estate market starting in 2007, household net worth also crashed (falling by a total of $17.5 trillion or 25.5 percent from 2007 to 2009—the equivalent loss of one year of GDP); and as unemployment rose from 4.6 percent in 2007 to almost ten percent (as officially measured) in 2010, average household income declined. At the same time, banks tightened their lending standards, with credit card companies slashing the number of offers and mortgage lenders requiring much higher qualifications from borrowers. Thus the ability of households to take on more debt has contracted substantially. Less debt means less spending (households usually borrow money so they can spend it—whether for a new car or a kitchen makeover). This is potentially a short-term problem; however, the only way the situation will change is if somehow the economy as a whole begins to grow again (leading to higher house prices, lower unemployment, and easier credit). Here’s the catch: increased consumer demand is a big part of what would be needed to drive that shift back to growth.
So we just need to get households borrowing and spending again. Perhaps government could somehow put a bit of seed money in citizens’ pockets (cash for clunkers, anyone?) to start the process. But any such strategy must fly against a demographic headwind: As mentioned earlier, Baby Boomers (the most numerous demographic cohort in the nation’s history, encompassing 70 million Americans) are reaching retirement age, which means that their lifetime spending cycle has peaked. It’s not that Boomers won’t continue to buy things (everybody has to eat), but their aggregate spending is unlikely to increase, given that cohort members’ savings are, on average, inadequate for retirement (one-third of them have no savings whatever). Out of necessity, Boomers will be saving more from now on, and spending less. And that won’t help the economy grow.
When demand for products declines, corporations aren’t inclined to borrow to increase their productive capacity. Even corporate borrowing aimed at increasing financial leverage has limits. Too much corporate debt reduces resiliency during slow periods—and the future is looking slow for as far as the eye can see. Durable goods orders are down, housing starts and new home sales are down, savings are up. As a result, banks don’t want to lend to companies, because the risk of default on such loans is now perceived as being higher than it was a few years ago; in addition, the banks are reluctant to take on more risk of any sort given the fact that many of the assets on their balance sheets consist of now-worthless derivatives and CDOs.
Meanwhile, ironically and perhaps surprisingly, U.S. corporations are sitting on over a trillion dollars because they cannot identify profitable investment opportunities and because they want to hang onto whatever cash they have in anticipation of continued hard times.
If only we could get to the next upside business cycle, then more corporate debt would be justified for both lenders and borrowers. But so far confidence in the future is still weak.
The category of financial debt—which, of the four categories, has grown the most—consists of debt and leverage within the financial system itself. This category can mostly be disregarded, as financial institutions are primarily acting as intermediaries for ultimate borrowers. But this category does not directly include the notional value of derivatives contracts, which is roughly five times the amount of U.S. government, household, corporate, and financial debt combined (roughly $260 trillion in outstanding derivates, versus $55 trillion in debt), and derivatives have arguably helped create a situation that limits further growth in the financial system’s ability to perform its only truly useful function within society—to provide investment capital for productive enterprise.
One of the main reforms enacted during the Great Depression, contained in the Glass Steagall Act of 1933, was a requirement that commercial banks refrain from acting as investment banks. In other words, they were prohibited from dealing in stocks, bonds, and derivatives. This prohibition was based on an implicit understanding that there should be some sort of firewall within the financial system separating productive investment from pure speculation, or gambling. This firewall was eliminated by the passage of the Gramm–Leach–Bliley Act of 1999 (for which the financial services industry lobbied tirelessly). As a result, all large U.S. banks have for the past decade become deeply engaged in speculative investment, using both their own and their clients’ money.
With derivatives, since there is no requirement to own the underlying asset, and since there is often no requirement of evidence of ability to cover the bet, there is no effective limit to the amount that can be wagered. It’s true that many derivatives largely cancel each other out, and that their ostensible purpose is to reduce financial risk. Nevertheless, if a contract is settled, somebody has to pay—unless they can’t.
Credit default swaps (CDSs, discussed in the last chapter) are usually traded “over the counter”—meaning without the knowledge of anyone other than the two counterparties; they are a sort of default insurance: a contract holder acts as “insurer” against default, bankruptcy, or other “credit event,” and collects regular “insurance” payments as premiums; this comes as “free money” to the “insurer.” But if default occurs, then a huge payment becomes due. Here’s one example: In 2005, auto parts maker Delphi defaulted on $5.2 billion in outstanding bonds and loans—but over $20 billion in credit default derivative contracts had been written on those bonds and loans (the result: massive losses on the part of derivative holders, much more than for those who held the bonds or loans). This degree of leverage was not uncommon throughout corporate America and the U.S. financial system as a whole. Was this really reducing risk, or merely spreading it throughout the economy?
An even more telling example relates to the insurance giant AIG, which insured the obligations of various financial institutions through CDSs. The transaction went like this: AIG received a periodic premium in exchange for a promise to pay party A if party B defaulted. As it turned out, AIG did not have the capital to back its CDS commitments when defaults began to spread throughout the U.S. financial system in 2008, and a failure of AIG would have brought down many other companies in a kind of financial death-spiral. Therefore the Federal government stepped in to bail out AIG with tens of billions of dollars.
Broken bank signIn the heady years of the 2000s, even the largest and most prestigious banks engaged in what can only be termed criminally fraudulent behavior on a massive scale. As revealed in sworn Congressional testimony, firms including Goldman Sachs deliberately created flawed securities and sold tens of billions of dollars’ worth of them to investors, then took out many more billions of dollars’ worth of derivatives contracts essentially betting against the securities they themselves had designed and sold. They were quite simply defrauding their customers, which included foreign and domestic pension funds. To date, no senior executive with any bank or financial services firm has been prosecuted for running these scams. Instead, most of the key figures are continuing to amass immense personal fortunes, confident no doubt that what they were doing—and in many cases continue to do—is merely a natural extension of the inherent logic of their industry.
The degree and concentration of exposure on the part of the biggest banks with regard to derivatives was and is remarkable: as of 2005, JP Morgan Chase, Bank of America, Citibank, Wachovia, and HSBC together accounted for 96 percent of the $100 trillion of derivatives contracts held by 836 U.S. banks.[5]
Even though many derivatives were insurance against default, or wagers that a particular company would fail, to a large degree they constituted a giant bet that the economy as a whole would continue to grow (and, more specifically, that the value of real estate would continue to climb). So when the economy stopped growing, and the real estate bubble began to deflate, this triggered a systemic unraveling that could be halted (and only temporarily) by massive government intervention.
Suddenly “assets” in the form of derivative contracts that had a stated value on banks’ ledgers were clearly worth much less. If these assets had to be sold, or if they were “marked to market” (valued on the books at the amount they could actually sell for), the banks would be shown to be insolvent. Government bailouts essentially enabled the banks to keep those assets hidden, so that banks could appear solvent and continue carrying on business.
Despite the proliferation of derivatives, the financial system still largely revolves around the timeworn practice of receiving deposits and making loans. Bank loans are the source of money in our modern economy. If the banks go away, so does the rest of the economy.
But as we have just seen, many banks are probably actually insolvent because of the many near-worthless derivative contracts and bad mortgage loans they count as assets on their balance sheets.
One might well ask: If commercial banks have the power to create money, why can’t they just write off these bad assets and carry on? Ellen Brown explains the point succinctly in her useful book Web of Debt:
[U]nder the accountancy rules of commercial banks, all banks are obliged to balance their books, making their assets equal their liabilities. They can create all the money they can find borrowers for, but if the money isn’t paid back, the banks have to record a loss; and when they cancel or write off debt, their assets fall. To balance their books . . . they have to take the money either from profits or from funds invested by the bank’s owners [i.e., shareholders]; and if the loss is more than its owners can profitably sustain, the bank will have to close its doors. [6]

So, given their exposure via derivatives, bad real estate loans, and MBSs, the banks aren’t making new loans because they can’t take on more risk. The only way to reduce that risk is for government to guarantee the loans. Again, as long as the down-side of this business cycle is short, such a plan could work in principle.
But whether it actually will in the current situation is problematic. As noted above, Ponzi schemes can theoretically go on forever, as long as the number of new investors is infinite. Yet in the real world the number of potential investors is always finite. There are limits. And when those limits are hit, Ponzi schemes can unravel very quickly.
These are the four categories of debt. Over the short term, there is no room for growth of debt in the household or corporate sectors. Within the financial sector, there is little room for growth in productive lending. The shadow banks can still write more derivative contracts, but that doesn’t do anything to help the real economy and just spreads risk throughout the system. That leaves government, which (if it controls its own currency and can fend off attacks from speculators) can continue to run large deficits, and the central banks, which can enable those deficits by purchasing government debt outright—but unless such efforts succeed in jump-starting growth in the other sectors, that is just a temporary end-game strategy.
A single statistic is revealing: in the U.S., the ratio of total debt to GDP rose to more than 300 percent by 2005, exceeding the previous record of 290 percent achieved immediately prior to the stock market crash of 1929. External debt, what the U.S. owes the rest of the world, increased to $3 trillion, this capital balance having been in surplus just a few years previously.
Remember: in a system in which money is created through bank loans, there is never enough money in existence to pay back all debts with interest. The system only continues to function as long as it is growing.
So, what happens to this mountain of debt in the absence of economic growth? Answer: Some kind of debt crisis. And that is what we are seeing.
Debt crises have occurred frequently throughout the history of civilizations, beginning long before the invention of fractional reserve banking and credit cards. Many societies learned to solve the problem with a “debt jubilee”: According to the Book of Leviticus in the Bible, every fiftieth year is a Jubilee Year, in which slaves and prisoners are to be freed and debts are to be forgiven. Evidence of similar traditions can be found in an ancient Hittite-Hurrian text entitled “The Song of Debt Release”; in the history of Ancient Athens, where Solon (638 BC–558 BC) instituted a set of laws called seisachtheia, canceling all current debts and retroactively canceling previous ones that had caused slavery and serfdom (thus freeing debt slaves and debt serfs); and in the Qur’an, which advises debt forgiveness for those who are genuinely unable to pay.
For householders facing unaffordable mortgage payments or a punishing level of credit card debt, a jubilee may sound like a capitol idea. But what would that actually mean today, if carried out on a massive scale—when debt has become the very fabric of the economy? Remember: we have created an economic machine that needs debt like a car needs gas.
Realistically, we are unlikely to see a general debt jubilee in coming years; what we will see instead are defaults and bankruptcies that accomplish essentially the same thing—the destruction of debt. Which, in an economy like ours, effectively means a destruction of wealth and claims upon wealth. Debt will have to be written off in enormous amounts—by the trillions of dollars. Over the short term, government will attempt to stanch this flood of debt-shedding in the household, corporate, and financial sectors by taking on more debt of its own—but eventually it simply won’t be able to keep up, given the inherent limits on government borrowing discussed above.
We began with the question, “How close are we to hitting the limits to debt?” The evident answer is: we have already probably hit realistic limits to household debt and corporate debt; the ratio of U.S. total debt-to-GDP is probably near or past the danger mark; and limits to government debt may be within sight, though that conclusion is more controversial and doubtful.
1. U.S. Department of the Treasury, TreasuryDirect, “Historical Debt Outstanding, 2000-2010,” http://www.treasurydirect.gov/govt/reports/pd/pd.htm.
2. Congressional Budget Office, Report to the Joint Committee on Taxation, March 5, 2010.
3. Congressional Budget Office, “Monthly Budget Review,” October 7, 2010.
4. Carmen M. Reinhart and Kenneth Rogoff, This Time Is Different: Eight Centuries of Financial Folly (New Jersey: Princeton University Press, 2009).
5. Michael J. Panzner, Financial Armageddon (New York: Kaplan Publishing, 2008), p. 45.
6. Ellen Hodgson Brown, The Web of Debt (Third Millenium Press, 2010), p.197.

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