The Next Debt Crisis
The US economy is under a crushing debt burden. Total debt in the US economy is more than 350% of GDP. Everyone knows that this level of debt is completely unsustainable and that a debt crisis is inevitable. But what most people don’t know is what the next debt crisis will look like or how to see it coming.
As humans, we often assume that the future will look like the past, and the most recent memory of a US debt crisis came during the 2008 recession.
The 2008 crisis was centered around the household sector and the banking sector.
Total debt in the household and banking sectors reached 207% of GDP in the aftermath of the crisis. Today, household and banking sector debt is around 150%.
The Debt to GDP Threshold
Total debt in the United States is near a record high, more than 350% of GDP, when counting the government and private sectors. If the household sector and banking sector have a lower debt burden than in 2008, that means there has been a very sharp debt build-up in other sectors.
The total debt in the federal government and business sectors has been surging in recent years, charging towards 180% of GDP.
Not all debt is bad, but with thousands of years of history with debt, we have learned a few things. We have learned that a bit of debt tends to be helpful and boosts the economy, but a lot of debt is dangerous, brings instability, and is ultimately harmful.
What is this magic line where debt transitions from helpful to harmful?
When we review the research on debt, a range of 80% to 90% of GDP appears over and over.
Reinhart and Rogoff, in their paper Growth in a Time of Debt, wrote in the concluding remarks that debt to GDP over 90% in the government sector leads to worse growth.
The European Central Bank published a paper that drew a negative debt threshold of around 90%-100% but also noted that adverse effects could start as low as 70%-80%.
The Bank of International Settlements published a paper titled the Real Effects of Debt, and the paper drew a threshold for the government sector of around 85% of GDP. The corporate sector had a threshold of around 90%, and the household sector was about 85%.
The key point here is that across many peer-reviewed papers, we find the same general threshold for debt. When any sector has a debt load that’s more than 80% to 90% of GDP, major problems start to emerge. It doesn’t mean a debt crisis is imminent, but the adverse effects begin.
Let’s now review the major sectors of the economy and how much debt there is relative to our 80% to 90% debt to GDP threshold.
Banking & Household Debt
Starting with the banking sector or financial sector, we can see how debt surged way beyond our dangerous or negative range and reached 110% of GDP. A banking crisis followed and the financial sector deleveraged. Today, the banking sector has about 77% debt to GDP which is better than it was and it’s still declining, which is good, but it’s still too close to the negative range.
Usually, debt accelerations happen in more than one sector at a time. Usually, two sectors are working together. The household sector had debt that increased beyond the 80%-90% range, and a household crisis was the result. Today, household debt is 75% of GDP which is better than it was and it’s declining, which is also good, but it’s still high relative to history and too close for comfort relative to the threshold for negative effects.
If the banking sector and household sector have lower debt, how is it that total debt continues to rise?
The total US economy has not deleveraged at all since the 2008 crisis. All that happened is that we added debt in other sectors so that we could deleverage the problems areas of the banking sector and the household sector.
When the 2008 crisis happened, government debt was relatively low and way below the problematic range.
The banking sector and household sector were able to deleverage not because the system was deleveraged, but only because we rather shifted the debt to the government sector.
Government & Business Debt
Federal Government debt has now surged through the problem range and towards 100% of GDP. This doesn’t mean a crisis is imminent, but this is an area that will cause problems, and it already has.
The business sector, which includes corporations and all smaller private businesses, has been another source of massively increased debt and is flirting with the danger zone.
Debt levels in the business sector are rising.
So our two sectors that are rising are business and government.
Our two sectors that are falling are household and banking.
If we combine household and banking, this was the 2008 crisis. Since we are looking at two sectors instead of one, the dangerous range is 160%-180%.
We can see these two sectors were massively overleveraged and a big recession and banking crisis was the result.
The US economy did not solve the problems of 2008 and deleverage the entire system. Rather what happened was that the banking sector and household sector deleveraged at the cost of leveraging the government sector and the business sector.
The government and business sectors have debt levels that reach almost 175% of GDP, squarely in the danger zone.
Profit Margins
The government sector has worked with the business sector over the past 15 years to protect profits and balance sheets, particularly during the COVID crisis that saw a huge increase in government debt to prevent private sector bankruptcies.
Because the government sector has been willing to take on debt to prevent recessions that hurt business profits, the overall US business sector has been able to hold profit margins in the 11%-12% range, which is historically towards the upper end of the extreme.
This is a chart of pre-tax corporate profit margins. There is no room for margins to expand further from here. Margins have hit the ceiling historically.
However, the government has been willing to take on debt to help the business sector. This chart shows the effective corporate tax rate.
There is always talk of corporate taxes, but the data shows corporations have been able to pay an ever-lower effective tax rate, pushing the debt burden back to the government sector.
Conclusion
So when we think about the next debt crisis, we shouldn’t fight the old war. The household and banking sectors are far from healthy, but they are slowly decreasing and out of the researched danger zone.
Don’t mistake a deleveraging in the household and banking sector for a system-wide deleveraging. The government sector and business sector have picked up the tab and are now massively overleveraged. The government sector can do things to prevent a default, but what this means is that unless the government sector goes even deeper into debt, the next recession will fall very hard on the business sector.
A downturn in profits and profit margins will squeeze overleveraged businesses that have become accustomed to the government sector increasing debt to conduct bailouts.
The two sectors that are showing increasing levels of debt are the government and business sectors.
If we are looking to spot the next debt crisis, the data points toward the business sector or corporate sector, as many businesses will be heading into the next recession with highly leveraged balance sheets.
