The Looming Consumer Fiscal Cliff

A paper titled "How to Predict the Next Financial Crisis" by Steve Clemons and Richard Vague provides us with insight relating the level of private debt to the overall health of the economy and how the fiscal cliff that should be of greatest concern is one that is related to private debt levels.

The Great Recession resulted from a huge increase in consumer indebtedness, particularly mortgage debt.  In six short years, mortgage debt grew by 98 percent as shown on this chart: 

Although there has been modest improvement, total private debt has declined by only 3 percent since the Great Recession and is once again beginning to grow.  In case you were wondering, during the period from 1997 to 2007, population in the U.S. grew by 10 percent and was accompanied by a 41 percent increase in total private loans.  Borrowing growth really did outstrip population growth.

If we look back in time for comparison's sake, mortgage debt as a percentage of GDP grew by 16 percent from 1960 to 2000.  This rose to 68 percent between 2000 and 2010, an excess of $2.5 trillion in mortgages over the previous 40 year trend line, yet another expression of just how overly indebted consumers have become in this new reality of ours.  

By one measure, the Great Depression and Great Recession had one thing in common; private debt-to-GDP ratios grew very rapidly in the decade preceding the crisis (45 percent and 40 percent respectively) to the point where the ratio exceeded 150 percent.  The authors note that it is this buildup of private debt levels can be used to predict the onset of a significant economic contraction.

This is what private debt-to-GDP trends looked like prior to and during the Great Depression (in blue) and Great Recession (in red):

It is the rapid growth in debt levels that would appear to be the key factor in signalling an economic crisis.

The buildup of private debt prior to the Great Depression and its subsequent 22 percent reduction resulted in a massive 45 percent contraction in GDP; as indebted consumers began to pay down their debt using dollars that would otherwise be used for spending or investment, they stopped stimulating the economy through consumption of goods and services.  During the Great Recession, private debt decreased by only 3 percent and GDP contracted by 3 percent, a far cry from what happened during the Great Depression in both cases.  This resulted in the Great Recession being a walk in the park compared to what happened to Americans during the Great Depression.

We are being exposed to news about government debt and deficit levels and the fiscal cliff on a daily basis.  Here is a bar graph that compares the private and public debt-to-GDP levels showing the imprudence of consumers:

Lastly, here is a bar graph showing the private debt-to-GDP levels from 1916 to 2011:

You can see the rapid rise in the debt-to-GDP ratio during the 1920s as it roared past the 150 percent mark and how sharply it fell during the early 1930s (i.e. a consumer fiscal cliff).  A similar debt buildup took place during the late 1990s and early part of the new millennium as, once again, the ratio passed the 150 percent mark, however, this time, it was not followed by a sharp consumer fiscal cliff.  Is that yet to come?  Since consumers did not pay down their debt levels during the Great Recession as they did during and after the Great Depression, is the other shoe about to drop since potentially crippling high private debt levels are still in place.   You will also notice that after World War II, the private debt-to-GDP levels were at a very low level after the system "cleansed itself".  This low private debt level enabled the parents of the baby boomer generation to massively stimulate the economy through the purchases of homes, cars and other consumer goods as they established their families.  This is quite clearly not the case today.

The authors conclude that because of its sheer size, the growth and contraction of private debt may be more important in determining the future trend of the economy and future economic crises than money supply, government debt, trade, tax, reserve requirements and other factors.  American consumers who are most likely to borrow to consume are those that generally drive the majority of consumption in the economy and when their ability to borrow more to consume more is affected, the negative impact on economic growth is amplified.  That could well be a fiscal cliff that is even more threatening to America's economic well-being that the one being manufactured by Washington.  Perhaps Mr. Bernanke and his Federal Reserve Bank buddies should also take note.  There really is a price to pay for "easy credit" and it's a painful one, particularly when that credit has been a bit too easy to obtain.