An interesting article by James Kostohryz over at Minyanville.com about a McKinsey report that shows America’s debt problem is very manageable. This view coincides with the author’s personal view. Kistohryz points to a few factors to base his belief. My comments follow his:
1. US public debt levels are quite moderate compared to other developed nations. Japan and various European counties were able to grow, albeit relatively modestly, for several decades while sustaining much higher debt levels. There’s no reason why the US can’t do the same in the years to come. It’s important to understand that because US public debt is at levels that have proven in the past to be easily manageable by other nations, there’s little reason to think that deleveraging by the US government is an absolute necessity nor much less to think that such a process must necessarily become a drag on US economic growth. To the contrary, based on precedents from Japan and Europe, the US government still has substantial room on the public balance sheet to enable it stimulate economic growth if it chooses to do so. (This is true when you compare to Japan who is nearing a government debt equal to two times its Gross Domestic Product (GDP). We are still at 85% government debt to GDP. But, we are catching up fast. Last year, we borrowed close to 40% of our government spending. That is set to happen again this year. What is being ignored by James and others is the unfunded liabilities that the U.S. has coming down the pike. We have $17 trillion in unfunded liabilities for Social Security, which begins negative cash flowing in 2016. Medicare is worse with about $40 Trillion in unfunded liabilities. I think it has negative cash flow in 2017. So we may be in a better position now, but it won’t last. We need to act now.)
2. US non-financial business sector debt is extraordinarily low by global standards. Thus, there’s no real debt constraint for US businesses to invest and grow. And this means that there’s no major endogenous constraint to productivity growth — the main component of overall economic growth. This is absolutely true, especially in the tech sector. This is probably why tech has done better than other industries recently.
3. US Household debt as a % of GDP is relatively high in the US relative to other developed countries, although not dramatically so. More importantly, on the aggregate and in absolute terms, the debt and debt service obligations of US consumers are quite modest and manageable relative to their incomes. The problem of unsustainably high debt-to-disposable income ratios are concentrated in a relatively narrow subset of the US population amounting for somewhere in the neighborhood of 25% of all consumers. This means that roughly 75% of US consumers have plenty of room on their balance sheets to employ leverage to supplement income for purposes of investment and/or consumption. At the very least, with respect to these 75% of consumers, deleveraging need not be a force that drags down economic growth. Putting these facts together leads to the conclusion that if the financial situation of the 25% of consumers that are overleveraged is merely stabilized, aggregate investment and consumption growth can proceed in a normal, albeit moderated, fashion driven by the 75% of consumers that are fine. (This is a stretch. The U.S. consumer is strapped with more debt than any other nation. It is 120% of GDP. This cannot last. We are in uncharted waters for personal debt. As far as 75% of the population being able to take more debt, I highly doubt it. This group may be able to, but if rates rise, the cost to service the debt would destroy them. Our savings rate is back to 3% after a spike to almost 5%. This means that Americans don’t have much wiggle room in the budget. We could increase spending by 3% and wipe out our savings. This shows that Americans future consumption is essentially confined to pay increases, which aren’t expected anytime soon. So I disagree here).
4. US financial sector leverage is moderate by global standards. After recent equity raises, US banks and financial institutions are substantially better capitalized, on the whole, than the global average. And US financial institutions are currently well capitalized relative to US historical standards. This means that there is plenty of room on the balance sheets of US financial institutions to provide the credit to businesses and consumers that the US economy requires to in order to grow at a healthy rate. Please note that the circle is complete: The US government, businesses, and most US consumers are in a sufficiently solid position to stimulate a healthy demand for credit, and US financial institutions are sufficiently capitalized to provide that credit. (This argument is similar to a 300lb man saying he is healthier than a 400lb man. It is true, but both need to alter their lifestyle. Also, the banks are not as well capitalized as they advertise. They are allowed to mark their assets to a model, rather than the market. This improves their balance sheet because they can price an asset at 90 cents on the dollar as opposed to the current selling price of 50 cents on the dollar. Also, banks are still levered at 17 to 1 – much too high. Of course, European banks are at 30 to 1 in some cases so we do look good in comparison).
5. US financial sector assets as a % of GDP are extraordinarily low by developed world standards. Thus, in relative terms, the US economy isn’t especially vulnerable to a financial sector crisis. (Really! How about the assets that are off the balance sheet like Credit Default Swaps. Estimates have those assets anywhere from $20 to $40 Trillion. That is as large as the entire worlds market capitalization. Really!)
6. US external debt as a % of GDP is quite modest by global standards. Americans mainly owe money to fellow Americans. Thus, the US economy is less vulnerable than many think to the vagaries of international politics and/or capital markets. (This is the old argument from the 90s that our debt is actually good cause it is providing savings to American citizens. We still require about 30% of our debt from foreigners. Another 50% is being bought by the Fed through money creation so that really doesn’t count, does it. If we just print dollars to give to ourselves, that isn’t really a good thing is it? The better case is to have little debt so the cost of debt for corporations drop and productivity improves along with corporate profitability.)
While we may not face an imminent threat from our debt levels, the day of reckoning is coming. Japan has avoided this day of reckoning because its debt was entirely funded by an aging population. However, the population is no longer saving and have started spending in retirement. So Japan’s date with the debt devil is probably closer than ours. However, we will dance with the debt devil someday if we don’t rectify our situation soon. This talk of deficits not mattering is bladerdash.