US debt trends threaten economy
In an election year, the deficit that most people are focusing on is that of the federal budget. Dean Baker, co-director of the Center for Economic and Policy Research, reminds us that household debt and foreign debt have also been rising, with potentially serious implications for the long-term health of the US economy.
In a paper titled "Dangerous Trends: The Growth of Debt in the U.S. Economy" dated 7 September, he says that "the current paths of household and foreign debt are unsustainable trends... If current borrowing patterns even persist through the next presidential administration, both forms of debt would reach implausibly high levels. The inevitable adjustment process to a sustainable growth path will involve higher inflation and a drop in living standards, and almost certainly another recession."
Such views are not new. Many economists have been warning of the threat posed to the economy by these debt burdens since the 1990s, and continued to warn about them as the debt levels kept growing over the last few years.
For example, on 10 September, Stephen Roach, chief economist at Morgan Stanley, wrote in the Global Economic Forum:
In his paper, Baker provides a wealth of data showing how much the household debt and foreign debt have risen over the past few years, and how he thinks they will continue to grow and adversely impact the US economy.
Some of Baker's projections, though, may be a little alarmist. For example, he projects the growth path of household debt and shows that the ratio of household debt to disposable income will rise to 152.0% by the end of 2009 based on current trend. That would be far above historical norms. Realistically, though, current growth rates are not likely to be maintained for that many years.
Baker makes a similar projection for foreign debt, showing that at the current growth rate, the net indebtedness of the United States will exceed $7 trillion and the net foreign debt will be almost half the size of the economy by the end of the next presidential administration in 2009.
In my opinion, the problem is that even at current or slightly higher levels, these debts can pose a threat to the US and world economies.
With regards to the household debt, higher interest rates, which Baker also mentions, will by itself aggravate debt service burdens of households. With interest rates currently at historically low levels, the probability of significantly higher interest rates going forward is high.
With the foreign debt, the most likely manifestation of reversion to the mean is through a fall in the US dollar. Baker thinks that this can happen if foreigners stop buying US assets. He thinks that a fall in the US dollar would cause higher import prices and higher inflation, leading in turn to higher interest rates, "especially if the Federal Reserve Board deliberately raises rates in order to contain inflation".
In my opinion, inflation resulting from higher import prices may not cause the Federal Reserve to raise interest rates. It would be suicidal for the US economy for it to do so, and the Federal Reserve knows it.
Nevertheless, interest rates -- particularly the long rates which the Federal Reserve does not directly control -- may rise anyway simply because of the withdrawal of foreign buying of US debt. In other words, long-term rates may rise not because of the Federal Reserve but in spite of it.
And the probability of foreigners sharply curtailing their purchase of US financial assets is far from remote. Clearly, foreign investors can see that the US current account deficit continues to grow, threatening the long-term value of the US dollar. The current account deficit rose to a record US$166.2 billion in the second quarter, which is equivalent to 5.7 percent of GDP, up from 5.1 percent in the first quarter.
And there is little indication that this deficit is likely to reverse soon on its own. In July, the trade deficit was US$50.1 billion, the second largest in history, the highest being the deficit of US$55 billion just a month earlier.
So the debt trends are dangerous indeed, even minus the most alarming projections. Having said that, remember that the trends had been considered unsustainable even back in the 1990s. Yet, they have persisted till today.
Having outlasted the stock market bubble of the 1990s, who can say exactly how long these trends will ultimately last.
In a paper titled "Dangerous Trends: The Growth of Debt in the U.S. Economy" dated 7 September, he says that "the current paths of household and foreign debt are unsustainable trends... If current borrowing patterns even persist through the next presidential administration, both forms of debt would reach implausibly high levels. The inevitable adjustment process to a sustainable growth path will involve higher inflation and a drop in living standards, and almost certainly another recession."
Such views are not new. Many economists have been warning of the threat posed to the economy by these debt burdens since the 1990s, and continued to warn about them as the debt levels kept growing over the last few years.
For example, on 10 September, Stephen Roach, chief economist at Morgan Stanley, wrote in the Global Economic Forum:
[T]he jury is still out on...the months ahead when the US economy is finally taken off the special life support measures that have been so critical to this recovery. For America, that will be the ultimate moment of truth -- when the economy then comes face-to-face with the lingering imbalances of subpar income generation, sharply reduced saving, an ever-widening current-account imbalances, and a record overhang of household indebtedness.
In his paper, Baker provides a wealth of data showing how much the household debt and foreign debt have risen over the past few years, and how he thinks they will continue to grow and adversely impact the US economy.
Some of Baker's projections, though, may be a little alarmist. For example, he projects the growth path of household debt and shows that the ratio of household debt to disposable income will rise to 152.0% by the end of 2009 based on current trend. That would be far above historical norms. Realistically, though, current growth rates are not likely to be maintained for that many years.
Baker makes a similar projection for foreign debt, showing that at the current growth rate, the net indebtedness of the United States will exceed $7 trillion and the net foreign debt will be almost half the size of the economy by the end of the next presidential administration in 2009.
In my opinion, the problem is that even at current or slightly higher levels, these debts can pose a threat to the US and world economies.
With regards to the household debt, higher interest rates, which Baker also mentions, will by itself aggravate debt service burdens of households. With interest rates currently at historically low levels, the probability of significantly higher interest rates going forward is high.
With the foreign debt, the most likely manifestation of reversion to the mean is through a fall in the US dollar. Baker thinks that this can happen if foreigners stop buying US assets. He thinks that a fall in the US dollar would cause higher import prices and higher inflation, leading in turn to higher interest rates, "especially if the Federal Reserve Board deliberately raises rates in order to contain inflation".
In my opinion, inflation resulting from higher import prices may not cause the Federal Reserve to raise interest rates. It would be suicidal for the US economy for it to do so, and the Federal Reserve knows it.
Nevertheless, interest rates -- particularly the long rates which the Federal Reserve does not directly control -- may rise anyway simply because of the withdrawal of foreign buying of US debt. In other words, long-term rates may rise not because of the Federal Reserve but in spite of it.
And the probability of foreigners sharply curtailing their purchase of US financial assets is far from remote. Clearly, foreign investors can see that the US current account deficit continues to grow, threatening the long-term value of the US dollar. The current account deficit rose to a record US$166.2 billion in the second quarter, which is equivalent to 5.7 percent of GDP, up from 5.1 percent in the first quarter.
And there is little indication that this deficit is likely to reverse soon on its own. In July, the trade deficit was US$50.1 billion, the second largest in history, the highest being the deficit of US$55 billion just a month earlier.
So the debt trends are dangerous indeed, even minus the most alarming projections. Having said that, remember that the trends had been considered unsustainable even back in the 1990s. Yet, they have persisted till today.
Having outlasted the stock market bubble of the 1990s, who can say exactly how long these trends will ultimately last.
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