The pathology of debt bubble(s)

The global financial crisis, although triggered by the US subprime mortgage debacle, has its root cause elsewhere: global debt overdose. Most explanations focused on irresponsible debtors and careless lenders, whether pointing to excessive borrowings by consumers or even by entire countries, tell only part of the story.

There is another facet to this crisis which has remained shrouded in mystery: the steady and imbalanced growth in the indebtedness of financial institutions among G8 nations. That is where the most worrisome overdose occurred: one with lasting implications for global financial stability.
Simply put, some of these banks or financial institutions have been allowed to borrow and lend a lot more money than reasonable, disrupting, in the end, the delicate balance in world’s credit markets. The level of global wealth destruction in the 18 months following September 2007, the beginning of the crisis, is historically unprecedented: $40 trillion.

In September 2009, one year after the cataclysmic demise of Lehman Brothers — which triggered the largest convulsions in this crisis — the majority of that staggering destruction still remains unexplained. Who is it precisely that allowed this overdose to happen: Management? Central banks? Governments? Something else?

If regulators worldwide are expected to devise and implement lasting solutions, the answers cannot stay ambiguous. After all, there is a limit to invigorating wobbling economies with national or regional stimulus financings, no matter how long and for how much: sooner or later, taxpayers of countries most affected by this disruption deserve solid answers.

A nation’s total debt

That consumers in America and Europe were both living beyond their means, and that perhaps the average household debt should have been capped not to exceed 120% of the average disposable income, is reasonably well understood and documented.

But it weren’t just consumers and households enjoying the foolish comforts of living on borrowed money; most governments among G8 nations were on it too.

That brings us to the notion of total indebtedness of countries, which comprises not just the loans held by its consumers and households but also, the ones held by its businesses, farms, governments and all its financial institutions. Economists measure the reasonableness of a nation’s total debt outstanding by comparing it to the size and growth of its GDP. Much like a consumer’s capacity to finance his loans with his future earnings, the comparison to GDP provides some insight into a nation’s ability to pay down its debt over time, helped by total economic expansion and productivity gains.

The national debt outstanding of the USA is an interesting place to start. The most prominent creditor nation some 50 years ago, now the largest borrower in the world,has a total debt outstanding nearing 350% of its GDP.

Although this ratio is not as bad as for certain European countries, the irony still remains that over the last decade the world has witnessed a record acceleration rate in the debt burden of its wealthiest economy.

Left unrestrained, such acceleration has a number of disquieting consequences ranging from abrupt credit contractions to alarming currency fluctuations. As already witnessed over the last 2 years, these are all destabilizing and can have dire consequences.

So what is it about the USA that got its total national debt into a “hockey stick”?

Dissecting the US debt “bubbles”

While from 1997 to 2007 the US GDP grew from $8 to over $14 trillions a few things happened to the make-up of American total debt. Some of these are well known and understood, some others are less so. Yes, there were debt-bubbles in the US over that decade, but not everywhere. The chart below, derived from data form the US Federal Reserve, graphically and unambiguously tells the story of these bubbles.

Household and consumer debt clearly formed a bubble, as it outpaced growth in GDP by more than $4 trillion for a number of reasons. Chief among them was the availability of low interest rates which allowed increased borrowings for purchasing homes but, also, for consuming more as well. Reckless lending led to subprime mortgages that allowed home buyers, who would otherwise never qualify, feed the speculative housing boom which also inflated other forms of consumption. But all that is well known and understood.

Surprisingly, in the same decade, corporate indebtedness has kept pace reasonably well with GDP growth. Although it outpaced it a little bit, it was not by an alarming amount. Perhaps this is because of the 2001 stock market crash. Following the crash, businesses of all sorts and sizes had started to exercise more prudence. With the exception of construction and real-estate companies, credit was reasonable, especially among technology companies who learned the importance of having manageable debt loads.

What is less known, and even less publicized, is that in spite of negative press coverage, government debt (including Federal, State and local) has lagged behind GDP growth. Despite the war on terror and unexpected tax cuts, the fact remains that talk about government deficits at all levels has been more successful in the political blame-game than in stimulating economic vitality during that decade. But, that is another and rather complicated topic which we are not going to address here.

Without a doubt, the financial sector debt has delivered the largest and the most disturbing of bubbles to the US economy. Had it kept pace with GDP growth — instead of galloping ahead uncontrolled — it would have risen closer to $9 trillion than the $16 trillion it ended up surpassing in 2007. The result? A $7 trillion bubble in 10 years, from a sector which includes all the banks and savings companies, but, also, other financial institutions ranging from insurance companies to retirement funds. On closer look to Federal Reserve’s statistical data however, it is the country’s “shadow banking” system — investment banks, securities dealers, hedge funds, mutual funds, and all other non-bank financial institutions that defined deregulated American finance — that contributed to inflate this bubble to unprecedented heights, and not regulated banking. Whether we call it excessive financial leverage or easy and reckless credit, the results are the same: economic instability and dislocations.

To-date, we have heard rumblings about grossly inadequate or blatantly inconsistent regulations, along with mistaken policies of abundant money supply. We have also heard about the lack of parsimony in the American consumer culture and the need to moderate the temptations of a credit society.

But what we haven’t heard in sufficient clarity yet is: who was ultimately responsible for overleveraging in the financial sector? Allowing overexposure to real-estate, jumbo loans for gigantic corporate takeovers, non-transparent bookkeeping, and, perhaps most importantly, a compensation system that begets uncontrollable risk taking, all have more to do with poor corporate governance than with the shortcomings of regulations.

It is increasingly obvious that both are intricately linked and perhaps even inseparable, but how are we going to address the issues if we don’t start by recognizing that the notion of self-governance in banking has failed shareholders, employees and, ultimately, taxpayers ?

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