Excessive Debt – Still The Biggest Risk

Share this article

At the end of the 1990s and in the early years of this new century, we were among very few investment managers voicing any alarm about excessive debt. Today, even the disinterested can’t escape the plethora of nightly news reports about how excessive debt is endangering our financial well-being.

As individuals, Americans over the past three decades have evolved from diligent savers to aggressive spenders. With only brief exceptions through the 1980s and 1990s, the U.S. economy expanded, consumers grew increasingly affluent and the need to save became a distant memory. Most in our society lost sight of the fact that our economy is cyclical and that savings were the cushion that sustained families in times of occasional unemployment. The two recessions in this century’s first decade revealed how unprepared most people were for a recessionary environment. Debt forced many into bankruptcy.

In a similar vein, many years of spectacular growth in real estate prices overpowered any concerns about cyclicality and led to the most remarkable surge in real estate speculation in U.S. history. Because real estate prices seemed to go in just one direction, debt was a trivial concern and was viewed simply as a method to magnify profits. All was good until reality intruded and cyclicality reasserted itself. When real estate prices declined, minimal equity levels were quickly eliminated, and many financially strapped owners were unable to retain their properties. Insufficient recognition of the destructive potential of debt submerged vast numbers of the financially unsophisticated as well as the allegedly knowledgeable.

Now debt crises have escalated to the national level. Less than two years ago Dubai initiated the march of debt-endangered sovereigns. Iceland, Ireland, Greece and Portugal have joined the parade, and growing numbers of analysts fear that Spain or Italy may also enter their ranks. Governments and central bankers have been working overtime to craft rescue plans to ward off defaults and to prevent contagion. Notwithstanding bailout pledges, the markets seem unconvinced of their potential for success. Telltale interest rates have risen to ominously high levels for Spanish and Italian bonds.

As I write, legislators in this country are wrestling with several options for raising the U.S. debt ceiling. Despite strong opposition from the most conservative members of Congress, passage seems highly likely, even if it should be somewhat delayed. Despite large projected deficit cuts, however, this bill will not solve our domestic debt problem.

In their classic summary of financial crises of the past 800 years, This Time Is Different, Carmen Reinhart and Kenneth Rogoff assert that countries are in danger of debt crises once government debt reaches 90% of Gross Domestic Product. Most commentators acknowledge that the U.S has become too debt-dependent, but believe that a prudent plan of deficit reduction is all that is needed to pull us back from the brink of danger. That may, however, be overly complacent.

It is widely recognized that publicly-held federal debt is about 64% of U.S. GDP, not an overly-worrisome level. The U.S., however, stands behind far more debt than that. The infamous Social Security lockbox holds promises from the government to pay that bring the debt total to 95% of GDP, already over the Reinhart/Rogoff 90% danger line. But most probably government debt doesn’t stop there. For decades the government has implied that it would stand behind government-sponsored enterprises like Fannie Mae and Freddie Mac, the financially crippled mortgage giants. Adding those liabilities brings the government’s debt-to-GDP ratio to 138%. Going one step farther, is it likely that the federal government would let any of the 50 states fail? That prospect adds even more to the massive debt burden. Clearly our government has responsibilities that put its debt-to-GDP burden far into the danger zone. Even the most aggressive of the currently-proposed deficit reduction plans will not cut into the debt over the next decade, and the debt-to-GDP ratio will remain at extreme levels as far as the eye can see.

Individuals learned the cruel truth during the past decade that excessive debt leaves one vulnerable to such unforeseen conditions as unemployment and real estate price declines. Nations around the world, the United States included, need to recognize the extreme danger that their current debt levels pose. Recessionary conditions would certainly heighten the risks, and the potential for recession is rising as economic conditions are obviously slowing across most of the world.