That recovery has in part been driven by a force that could be its undoing: debt. Nearly $46 trillion of it, or more than 2-1/2 times our annual economic output.
That figure comes from a report issued last month by the Federal Reserve, supplemented with data from the Treasury and Commerce departments and the President’s Council of Economic Advisers. It represents the total debt outstanding held by households, businesses, and all levels of government.
The federal government holds the largest slice of that debt: $17.8 trillion as of September 30. Gross federal debt reached a milestone in 2013, exceeding GDP for the first time since the end of the Second World War. It continues to grow, as the chart below shows.
But that is not the only source of public debt. State and local governments doubled their outstanding obligations to $3 trillion between 2003 and 2010, although they have since retrenched. The Federal Reserve estimates that those levels of government now are servicing around $2.9 trillion in debt. That brings gross government debt outstanding to nearly $21 trillion, or 118 percent of GDP. We place eighth in the world in that category, behind Japan, Greece, Lebanon, Jamaica, Italy, Portugal and Ireland.
It’s not just government that has gorged on debt. Businesses and households together owe more than $25 trillion, more than half the $46 trillion debt load. Non-financial businesses have outstanding credit of $11.8 trillion, according to the Federal Reserve, a figure that declined during the recession but that has grown by 18 percent since 2010.
Private household borrowing is significantly higher at $13.4 trillion, but still lags its 2007 peak. Consumer credit more than doubled to $12.9 trillion between 1999 and 2006, with annual increases averaging over 10.6 percent over that period. It slowed once the financial crisis struck in 2008. The balance actually fell through 2011 and has risen modestly since.
The federal government has accounted for the lion’s share of borrowing over the past few years. Total debt rose to $46 trillion in 2014 from just over $37 trillion in 2008. Federal borrowing accounted for 92 percent of that increase. It now greatly exceeds private household debt, as the chart below shows.
It was not always so. Between 1999 and 2009, household outstanding debt surpassed gross federal debt, often by significant margins. The gap in 2007 was $4.8 trillion. But the lines crossed in 2010, when outstanding federal debt climbed by a staggering $1.8 trillion in a single year to $13.7 trillion. It has since risen by more than $4.1 trillion.
This is not the outcome the Federal Reserve was seeking when it took the unprecedented step of reducing interest rates to zero more than six years ago. The theory was that cheap credit would induce banks to lend more to households and businesses, which in turn would borrow and spend more. The additional borrowing hasn’t happened, for reasons that mystify theorists. It may be that stricter regulations and the exaction of penalties for their past loose lending practices have deterred banks from lending to families and businesses with less than stellar credit. It may be that banks have little incentive to lend money at low rates of interest when they can realize bigger gains by engaging in more exotic and speculative transactions. And it may be that consumers, having so recently suffered the unpleasant consequences of incurring too much debt, are concerned about overextending themselves again.
The federal government, by contrast, has taken full advantage of monetary liberality. Because the Fed has set interest rates so low, the Treasury Department actually made lower annual payments on its debt in 2014 than in 2007, though its indebtedness swelled by nearly $8.8 trillion over that period.
The borrow more/pay less absurdity grew more bizarre with quantitative easing. Under that series of initiatives, the most recent of which concluded in October, the Federal Reserve’s holding of Treasury bonds rose from $480 billion in September 2008 to $2.46 trillion at the end of last month, making it the Treasury’s second largest creditor, behind the Social Security trust funds (from which Treasury has borrowed $2.8 trillion) and well ahead of China ($1.3 trillion).
Under this arrangement: 1) the Federal Reserve creates credit ex nihilo, which it: 2) extends to the Treasury Department, which: 3) pays the Federal Reserve interest on the borrowing, which: 4) the Federal Reserve returns to the Treasury. Last year, the Fed gave back nearly $99 billion to the Treasury Department, making quantitative easing the Administration’s largest and most effective deficit reduction program.
Such monetary alchemy is not available to households and businesses. Some, in fact, are harmed by the easy money policy. The Fed’s unorthodox policies benefit borrowers, investors and banks, but damage savers. Abnormally low interest rates have reduced the after-tax share of income devoted to minimum mortgage payments to their lowest level since 1981. Interest payments on non-mortgage debt also has fallen as a share of after-tax income.
Savers, meanwhile, have suffered. Former Federal Reserve Chairman Ben Bernanke acknowledged in an October 2012 speech that his policies had “involved significant hardship for some,” since the return on savings is unfairly low.
That is by design. The Fed sees spending as the engine of economic growth and debt as spending’s jet fuel. Cheap credit is a frontal assault on the virtue monetarists most despise: thrift.
The Fed’s distortion of the price of risk also has arguably increased inequality, something the European Central Bank’s Yves Mersch discussed in a speech last October. It is interesting that CBO’s version of the Gini index — a widely-used measure of inequality — shows that sharp increases in inequality accompanied previous aggressive monetary interventions by the Federal Reserve. The Fed’s unprecedented iterations of quantitative easing and its zero interest rate policy have spurred on equity markets, enriching the investor class, as wage growth has languished. If the Fed retrenches, stocks could take a beating.
Which is why Wall Street shudders when Fed officials say they might hike interest rates later this year. The arguments against a rate rise have grown more feeble as economic news has brightened. There is scant rationale for extending extraordinary policies that aim to stimulate an economy that at last seems to require no stimulation.
The Fed may nevertheless shrink back from its plans. Increasing the cost of debt service would worsen federal deficits by raising the interest payments government makes on its enormous and mounting debt; make mortgages, car and student loans and credit card debt more expensive for consumers; and potentially cause shocks on Wall Street that could ripple through the broader economy. When the Fed raised interest rates during the middle part of the last decade, it inflicted seismic damage on the financial sector, crashed the stock market and triggered a severe recession. If the stock market were to go all wobbly later this year, the Federal Reserve might shelve its plans to raise interest rates.
That would be consistent with the approach the Fed has taken since early in the last decade. Between 1954 and 2000, the effective rate set by the Federal Reserve averaged 6.09 percent. Since then, it has averaged just 1.74 percent, including the round of cuts early in the last decade that helped inflate the real estate bubble and the extraordinarily low rates that the Fed has set since 2008 to help repair the damage caused by the bursting of that bubble.
Since then, the debt load has grown substantially and, with it, consumer and government addiction to cheap credit. Some are alarmed by this development. “It is essential to move away from debt as the main engine of growth,” the Bank for International Settlements argued last year in its annual report.
Paul Krugman, on the other hand, has declared the government’s medium term fiscal outlook to be “distinctly not alarming.” He and others maintain that government should take advantage of low interest rates to incur more debt. It would be “irresponsible and destructive,” Krugman has written, to attack the debt problem now. That issue is best left to future generations, he and others argue.
Call it the new American exceptionalism: the unshakable belief that the U.S. government’s creditworthiness will remain bullet-proof, the dollar will forever reign, and the central bank can conjure cheap credit without limit and without adverse consequences.
Perhaps we really are different, immune to debt’s toxic effects. If so, there is no danger in the Federal Reserve administering dose upon dose of the cheap credit narcotic.
If not, the withdrawal will be harsh and debilitating.