- Total Debt/GDP
- Near-Record Private Debt
- Gigantic Total Debt
- An Enormous Federal Reserve Balance Sheet
- Can We Grow Our Way Out?
- Should You Make Any Changes to Your Financial Plan?
- Government Spending
- The Deficit
- The National Debt
- The Federal Reserve
- The Road to Japan
- The Money
- Post Financial Crisis
- The Road Ahead
Yes. The amount of debt today is higher than it was before the financial crisis. Before the Great Recession, the total debt in the U.S.—that is, government, business, and personal debt combined—was $53 trillion. At the end of 2020, it had increased by 51% to $80 trillion.
There was a period at the bottom of the Great Recession in 2009 in which total debt relative to the size of the economy (gross domestic product, or GDP) was higher than it is today. But that was when the GDP was at its low point. (The high water mark for this ratio was around 416%, and it is somewhere near 400% now.)
The critical debt rate is what was before the financial crisis. That was the level of debt that helped break the economy. And it is the same now as it was then.
Plus, if you add the $7 trillion of debt the Federal Reserve owns—which must be replaced with new public and private debt if the Fed ever wants to reduce its balance sheet—the ratio of debt to the size of the economy today is higher than it was before the financial crisis. Do these high levels foreshadow another financial crisis? Not necessarily.
Today we have more government and corporate debt and less mortgage debt. And governments and corporations might be better able to withstand higher interest rates than homeowners with subprime mortgages could do. That test is coming. The Federal Reserve has been hiking short-term rates, and last week long-term interest rates finally spiked. Rising rates put pressure on highly indebted individuals, corporations, and, in some cases, governments.
Exploding Public Debt and Deficits
You would think that with the stock market at an all-time high and interest rates at exceptionally low levels, the United States must have its financial house in order. Nothing, however, could be further from the truth. When President Reagan took office, the federal public debt ratio to Gross Domestic Product (GDP) was around 31%. When he left office, it was about 50%.[i] Today, after the 2008 Great Recession and the COVID-19 pandemic, with total government debt around $27 trillion and a $21.5 trillion GDP, the debt ratio stands at 129%. The previous high of 118% occurred at the end of the Second World War.[ii]
Today, the deficit hovers around 14% of the GDP. The only time it was higher was also at the end of WWII when it reached 27%. Amazingly, it took only four years in 1948 until the U.S. government turned this deficit into a surplus.[iii]
Near-Record Private Debt
With a GDP of $21.5 trillion, private debt today—which includes mortgages, car loans, and business debts—is about $34 trillion, making the ratio of private debt to GDP 160%. Before the Great Depression, it was 140%, and right before the 2008 Great Recession, it got as high as 170%.[iv]
Gigantic Total Debt
In 1980, total debt—private, corporate, state, and federal—was 1.75 times the GDP. Today, it is around 3.8 times. Think of it this way: in 1980, we had $175,000 of debt for every $100,000 of GDP. Today $100,000 of GDP equates to $380,000 of debt.
In raw numbers, total debt in 2008 was $50 trillion. Today, twelve years later, it is at $80 trillion.[v]
An Enormous Federal Reserve Balance Sheet
The Federal Reserve’s balance sheet is currently $7.4 trillion, equating to 35% of the GDP, eclipsing the previous high of 23% of the GDP during the Great Depression and 20% at the end of WWII.[vi]
And after ten years of quantitative easing, the Federal Reserve now owns 22% of outstanding Treasuries, 5% higher than the previous high of 17% in 1974.[vii]
Can We Grow Our Way Out?
With President Biden’s $1.9 trillion COVID-19 relief package and, my guess, another aimed at infrastructure, the administration hopes that the economy can outgrow its current debt levels similar to post-WWII.
However, the level of private debt is more significant now. The government limited personal debt during the war, requiring large down payments on installment loans and restricting terms to one year.[viii] Plus, the depression forced untold bankruptcies and the write-off of enormous personal and business debt.
So, after the war, consumer and business spending quickly made up for any reduction in government outlays. But unlike then, there is more competition for economic success because the rest of the world does not lie in ruin from the war.
Should You Make Any Changes to Your Financial Plan?
As bad as these debt levels are, they are not predictive. Keep your allocation between stocks and bonds that meet your goals and risk tolerance. Don’t chase rising stock prices. Resist the drumbeat of inflation predictions. Diversify some outside of the United States. Maybe lock in any variable rate loans. If possible, pay down some debt.
Contributions to Gross Domestic Production (GDP)
For twenty-odd years, companies’ lagging investment spending has made economic growth (GDP) increasingly dependent on consumer spending.
Companies can buy manufacturing plants, equipment, and products; buy another company; pay down debt; or buy back stock. Only spending on plants, equipment, and products directly affects economic growth.
However, over the past decade, stock buybacks have been the preferred spending method. Stock buybacks cut the outstanding stock amount, boosting earnings per share and making companies seem more profitable.
Today, many executive salaries are paid in stock, and stock compensation depends on earnings per share. Buybacks spiked in 2018 to $770 billion. In 2019, however, volume was down 8% to $709 billion. These companies’ capital plowing into buybacks has grown at a compound annual growth rate (CAGR) of 10.4% since 2015.
As a percentage of the American GDP, the national deficit was 15.2% in 2020, the most significant economic share deficit since 1945. Much of this additional spending was to offset COVID-19’s effects on businesses and individuals.
That spending level might have raised the government’s contribution to the GDP, which has averaged around 17% for almost forty years.
However, with a deficit that significant and total government debt now at $28 trillion, it is unlikely that government spending will increase as a percentage of the GDP.
President Trump came into office in 2016 promising to get tough on China and other countries he felt were using unfair trade tactics. Around this time, the trade deficit took around 2.7% off of the GDP.
A country that buys more goods from foreign countries than it sells runs a trade deficit. Calculating GDP during such a deficit requires a subtraction. If not, you would count the goods and services twice.
In 2019, the trade deficit subtracted 5.8% from the GDP as President Trump’s tariffs and other policies had yet to show much promise. It is not easy to make any conclusions based on 2020 data because of the impact of COVID-19.
The U.S. has become dependent on consumer spending for economic growth. Debt has fueled much of that spending. In 1980, the total government, corporate, and personal debt was around $5 trillion. Today, it is around $80 trillion or roughly an increase of 7% a year.
If we want to rely less on consumption to fuel economic growth from now on, our best bet is for companies to stop using money on stock buybacks and start investing. And let us hope this new investment causes us to produce more goods and services that we can then sell overseas, reducing our trade deficit.
The U.S. Deficit and National Debt
President Joe Biden enters the presidency inheriting an enormous deficit, a central bank with an unprecedented balance sheet size, and an economy reeling from the pandemic.
His first proposal was a $1.9 trillion COVID-19 relief package. If implemented, much of it will be funded with additional government debt and eventually bought by and added to the Federal Reserve’s balance sheet.
The deficit is the annual difference between what the U.S. government spends and what it collects through taxation. The debt is the sum of yearly deficits.
The federal government ran a $3.1 trillion deficit in the fiscal year 2020, more than triple the fiscal year 2019. This year’s debt was 15.2% of the GDP, the most significant deficit as a share of the economy since 1945.
In 2015, the deficit was $438 billion, roughly 2.5% of the GDP. In 2009, at the height of the Great Recession, the deficit rose to 9% of the GDP. During the Reagan presidency, when the deficit entered public discussion, it averaged 5% of the GDP.
A deficit of $3.1 trillion is the amount the government spent in excess of the taxes it collected. To make up for the shortfall, it sold $3.1 trillion in government bonds, many of which end up being owned by the Federal Reserve.
The National Debt
By December 31, 2020, the national debt had jumped to $28 trillion, up 39% from $20 trillion when President Trump was sworn in. The government owns $5.73 trillion of this debt (most of it by the Social Security Trust Fund). This means that, in some years, the government took in more money than it paid out and used the surplus to buy US Treasury bonds.
The Federal Reserve, the government’s bank, owns almost $5 trillion. Most of it was bought after 2010 through the unconventional monetary policy of quantitative easing or QE, so the government owes itself about 36% of the debt.
The Federal Reserve
Before the 2008 financial crisis, the Fed’s balance sheet was about $1 trillion. After implementing QE, it ballooned to almost $5 trillion. As the economy recovered, it shrunk to around $4 trillion. However, responding to the COVID-19 pandemic with additional QE caused it to balloon to approximately $7 trillion, a jump of almost $3 trillion in three months.
Government securities comprise $4.8 trillion of that $7 trillion. The rest consists mostly of mortgage-backed securities (MBSs). MBSs are mortgages bundled and sold as a security.
You might be surprised how much the government is involved in the housing market. Total mortgages in the United States amount to around $10 trillion, so the Fed, at $2 trillion, owns about 20% of all outstanding mortgages. Fannie Mae and Freddie Mac (President Trump’s plan to move them entirely into the private sector never happened), two companies that package and guarantee mortgage-backed securities and were casualties of the 2008 financial crisis, remain 80% government-owned.
The Road to Japan
Japan’s central bank, the Bank of Japan, owns about 45% of Japan’s total government debt, and its balance sheet is about the size of the nation’s economy. It has even resorted to buying equities to spur economic growth.
Japan still has a market-based economy but is less capitalistic, meaning more and more of its money is generated by government spending and less by bank lending.
For context, the Federal Reserve owns about 18% of our government’s debt, and its total balance sheet equates to roughly 33% of GDP. Assuming President Biden’s full economic proposal is passed and all new government debt ends up being owned by the Federal Reserve, it will bump up the Fed’s percentage of government-held debt to around 25% and a total balance sheet of approximately 35% of GDP.
Get ready for more talk of socialism or the evils of government debt. However, that ship has sailed. The government’s outsized role in the economy was here to stay once the powers decided it was a better option than a global depression.
Here in the U.S., before the 2008 financial crisis, commercial banks created most of the economy’s money. For example, when a customer went to a bank to request a loan, the bank would do its due diligence. If they decided to give the customer a loan, that loan created new money, as the bank credited the borrower with a new bank deposit.
The government’s role was relatively small. For example, currency dollar bills were only obtained by exchanging a bank deposit. Government spending was paid for by taxes or bond sales. Neither activity resulted in any new bank deposits; instead, existing money moved around within the economy.
Lending by commercial banks, buying financial assets from commercial banks, and paying commercial banks’ employees created most of the new money.
Post Financial Crisis
A central bank implements QE by buying financial assets. It can buy them from commercial banks or nonbank entities such as pension plans, mutual funds, or any other entity that owns financial assets.
When the Federal Reserve buys a bond from a bank, it pays for the bond by crediting the bank’s reserve account at the Fed. Reserves are how banks pay other banks. However, they don’t increase the public’s money supply.
Say your bank is Wells Fargo, and you write a check for $2,500 to your car mechanic, who happens to bank with Citi. Wells Fargo deducts $2,500 from your checking account. Then it transfers $2,500 from its reserve account at the Fed to Citi’s reserve account. Citi then increases the mechanic’s checking account amount by $2,500. There are no actual cash moves. It is a series of interlocking IOUs handled electronically.
When the Federal Reserve buys a bond from a nonbank, the seller’s bank credits them with a deposit. The Federal Reserve provides the bank with an equal number of reserves to offset that deposit. That deposit is new money since no one’s bank account gets reduced by the amount.
For example, on March 9, 2020, the money supply was around $4 trillion. By the end of the year, it ballooned to $6.7 trillion. Some of that was probably from new loans as companies activated lines of credit to offset the pandemic. Some was also from the Federal Reserve’s massive new QE program, which included buying financial assets from nonbanks.
The Road Ahead
It is over. Capitalism has changed. The Fed’s balance sheet is now a tool in the economic toolkit. That was the risk once they decided to use it to prop up financial assets and encourage the wealth effect.
It is too big to reduce. The Federal Reserve tried reducing it in 2018 when the number of treasuries and mortgage-backed securities (MBS) not being reinvested ($50 billion per month) by the Federal Reserve was close to the level of maturing treasury bonds and mortgage payments from homeowners.
After switching to QT, the Dow Jones Industrial Average went down 16%, the S&P 500 dropped 18%, and the NASDAQ fell 22%.
Reducing their holdings of treasuries would require the public to purchase trillions of new government bonds, which could cause interest rates to rise and jeopardize any economic recovery.
Remember, the old system of banks producing the money supply was not some grand plan but the result of competing interests struggling for power.
These are the opinions of financial advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice.
[ii] Amadeo, Kimberly, “ US National Debt by Year Compared to GDP and Major Event,” the balance, February 5, 2021, https://www.thebalance.com/national-debt-by-year-compared-to-gdp-and-major-events-3306287
[iii] Amadeo, Kimberly, “ US Budget Deficit by Year Compared to GDP Debt Increase, and Events,” the balance, October 8, 2020, https://www.thebalance.com/us-deficit-by-year-3306306
[iv] Perkis, David F, “ Making Sense of Private Debt,” Economic Research Federal Reserve Bank of St. Louis, March 2020, https://research.stlouisfed.org/publications/page1-econ/2020/03/02/making-sense-of-private-debt
[vi] Christopher J. Waller, Lowell R. Ricketts, “ The Rise and (Eventual) Fall in the Fed’s Balance Sheet,” Federal Reserve Bank of St. Louis, January 1, 2014, https://www.stlouisfed.org/publications/regional-economist/january-2014/the-rise-and-eventual-fall-in-the-feds-balance-sheet
[viii] Richardson, Gary, “Federal Reserve’s Role During WWII,” Federal Reserve History, https://www.federalreservehistory.org/essays/feds-role-during-wwii#:~:text=The%20Reserve%20Banks%20processed%20applications,postwar%20return%20to%20peacetime%20activities.