2010 Will Be Worse

January 01, 2010
By Monty Pelerin

The year 2010 is likely to be the pivotal year where pundits stop referring to the recession and begin openly talking about a depression.

Our economic problem is rather simple to describe: There is too much debt relative to income and/or wealth. Below is a single graph that depicts the condition of our economy. It shows total debt of the U.S. as a percentage of GDP from 1870 forward. The debt figure includes all private and public debt. It does not include liabilities associated with unfunded government mandates like Social Security and Medicare. (Note: according to the U.S. trustees of these funds, the present value of the liabilities is about $106 trillion. Including them would boost the ratio below to nearly 1,000%.)

The amount of debt relative to GDP is staggering from a historical perspective. Several points are worth making about the graph:

• The long-term "norm" for the ratio appears to be around 150%. The red lines band the "norm" at 130% and 170%, respectively.
• Other than the two boom periods that commenced in the 1920s and the 1980s, the ratio never exceeded the upper band.
• Each cross resulted in enormous credit-driven booms. The first ended in the Great Depression. The second will produce a similar if not bigger bust (we are merely at the beginning of this event).
• The credit expansion that led to the Great Depression was not nearly as overextended as the current expansion.
• Peak credit occurred after the Depression began. Government spending and the shrinkage in GDP continued to drive the ratio up early in the Depression.
• Since this graph was published, today's ratio has grown to near 380%, about double the level when the U.S. entered the Depression.
• While it appears as though current private borrowing may have peaked, funding enormous government deficits continues to drive the ratio up, as does GDP shrinkage.

No economic theory rationalizes a proper "norm," yet intuitively, we know that such a number exists. Debt must not exceed some percentage of income, or else it cannot be serviced. Equivalent conceptual ratios for individuals and businesses have been used by the banking industry as lending criteria for more than a century. For various reasons, banks neglected these guidelines over the past couple of decades, contributing greatly to the credit bubble.

The government has decided that the cure for too much debt is more debt. This solution cannot work, especially when credit is already so overextended. Income and wealth cannot support present debt levels. Credit will adjust back to the mean, regardless of what the government attempts. Whether this is via orderly payment or via default, the reduction in debt is inevitable.

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