In Debt We Trust: Here Comes the Bust

By: Billy Alpert

On September 15, Fed Chairman Bernanke said that the recession is “very likely over”.  At this juncture there is really no point in believing anything that comes out of this man’s mouth, in fact, over the not too distant past it was actually wise to use his statements to forecast that the exact opposite would happen.  Here I refer to Bernanke’s calls that the subprime mortgage market was “contained” in March of 2007 months before the subprime mortgage market imploded which led to the downfall of many financial markets. Then there’s Bernanke’s call from July 2005 citing that “there was no housing bubble” and that the economic fundamentals supported the high price levels for homes; now that didn’t turn out so well. There’s plenty more, but you get the point.

Although history tells us Bernanke will be wrong again, let’s look at other evidence that says so. In order for the recession to be over, the conditions that caused it would have to have disappeared or been removed, right?

Well the primary cause of the recession is the credit based monetary system we have: debt.  But the enormous amount of debt has not been cleared from the system yet since the start of the recession in late 2007, in fact total credit market debt has increased.

Recall, “very likely over…”

To put it in perspective, at the start of the great depression in 1929, the ratio between debt (both public & private) and the economy’s output (GDP) was 200%, rather high, but much more manageable.  And in 1933, during the heart of the great depression, the ratio between the amount of total debt in the economy and the total GDP exploded to about 300%. It is no wonder why the depression resumed and intensified in the late 1930s: because the government’s efforts to stimulate borrowing and spending after the 1929 correction just added more debt which couldn’t give us a sustainable recovery, because it eventually needed to be cleared out. Now why does debt “eventually need to be cleared”?  Well because it is borrowed money, there is interest, and when debt and borrowing grow at a faster rate than the economy grows, it’s unsustainable just as me or you borrowing money at a faster pace than we make money is unsustainable and we will eventually have to default.  The interest keeps building exponentially and must be paid, and adding on more debt just buys a little more time, but intensifies the problem of the debt needing to be paid.  Luckily by 1934 the debt began to contract with waves of defaults, which caused the second dip into depression which was inevitable and necessary to finally rid the economy of excess debt.  By the late 1930s we saw a huge decrease in debt levels which is no wonder why it led to a prolonged robust recovery beginning in the 1940s.

Now flashing back to the nearer term, in 2001, at the beginning of the recession following the dotcom bust, the debt to GDP ratio was at an alarming level of about 280%. This was a result of a prolonged binge of borrowing and debt that began in the 1980s and took off after 1993 thanks to the Federal Reserve’s policy of extremely low interest rates which facilitates borrowing. The sensible solution would have been to allow the debt to contract during the 2001 recession to put the economy back into balance for sustainable recovery. Unfortunately, the Federal Reserve (chaired by Greenspan) started a campaign to prevent the removal of debt and rebalancing of our economy, and instead lowered interest rates to historic lows for 2002-2004. This policy encouraged even more borrowing and debt which fueled the housing bubble. As a result of this rampant borrowing, the economic activity picked up and we escaped the 2001 recession via unsustainable debt accumulation, so the recovery was really a façade and was very weak as shown by lackluster job growth after 2001-2003.  Thanks to the Fed’s policies, the ratio of total Debt to GDP grew to a dangerous level of 340% (higher than any level reached in the 1930s) by December 2007, the start of the current recession.

Obviously we’ve dug a huge hole by not taking the pain and letting the markets clear out the debt around 2001-2003, and instead made the problem much worse by 2007. We delayed the inevitable correction by adding on more debt, which just buys a little more time, but makes the eventual correction much more severe. In the last two years, the Federal Reserve along with the government made the same mistake as they did in 2001: they refused to let the correction occur and instead encouraged more debt via fiscal stimulus and the lowering of interest rates to ZERO. We are now in a dangerous situation, and as of July 2009, the debt to GDP ratio has exploded even higher to over 370%.

That’s right, it is likely that the underlying fundamentals of our economy have worsened since the start of the recession and that the worst is in front of us, not behind us because the burden of debt has only increased.

So overall, it seems Bernanke will be wrong again about his prediction of the recession ending soon, because the underlying cause of the bust, excessive debt, did not go away, in fact it was worsened.

Also, note that all of the “recoveries” since the 1990s were not as robust as advertised, because all we did was borrow and spend more money to escape each recession while building up a huge bubble of debt that never went away, and had to bust eventually. We have yet to have a truly sustainable recovery that is not based on borrowing and spending, but production and savings which gives us prosperity.

There actually was progress made in terms of clearing out the debt since July 2008 as total consumer debt outstanding has contracted over 4% or $100 billion from the peak, but this progress is entirely negated by the federal government taking on around $2 trillion in debt.

Although our economic freedom is being blamed now, we must remember that these unprecedented levels of total debt in the economy were not the works of free market capitalism; they were primarily a result of  the Federal Reserve’s practice of central economic planning and price fixing. The Fed had the ability to create capital out of thin air and fix the interest rate to artificially low levels, which allows near infinite levels of debt accumulation. In a free market, capital to be lent can only come from savings, so there is a limit of how much debt can be accumulated, and as there is increased demand for borrowing, then the price of borrowing, the interest rate, rises which discourages further borrowing. Capitalism cannot even exist with 0% interest rates because then there’s no incentive for savings and capital formation for investment. All of these over-leveraged banks that failed were only able to take the enormous risks they did due to the Fed providing them with cheap money to borrow.  Contrary to what the media repeats, the free market can actually regulate itself and prevent bubbles if allowed to operate.

The only logical way to fix this problem is to undo what caused it. Therefore, a good start would be to remove the powers of the Federal Reserve which allow them to create capital out of thin air which only fuels the bubbles we’ve come to experience and boom/bust cycles. There is no way any entity can know what the interest rate should be, so it makes sense to let the market decide.  Also, rather than trying to force feed borrowing and spending, the government policies should stop encouraging more debt accumulation as a way to get us out of this crisis originally caused by too much debt.  It would be beneficial if they finally sit back and let the inevitable correction and rebalancing occur, instead of making it worse.  Through these measures, we may be able to finally clear out the debt and see the light at the end of the tunnel which is lasting recovery and prosperity.