By the Asset Allocation Committee | PDF
American policymakers used deregulation and globalization to contain inflation from 1966 to 1982. Unfortunately, this policy was at odds with America’s superpower role, which required the United States to act as a global importer of last resort. If the United States did not consume all the goods the world wanted to sell to Americans, the world economy would face a liquidity crisis. Policymakers addressed the issues of controlling inflation and providing global liquidity by deregulating financial services, which made it easier for households to borrow money. Although deregulation and globalization have slowed real income growth, borrowing capacity has allowed households to absorb global imports, thus keeping the international system together. After 1995, these loans were increasingly attached to residential real estate, which was considered safe. Unfortunately, one of the major economic imbalances revealed during the Great Financial Crisis was excessive household debt. Since the crisis, the economy has been trying to remedy this over-indebtedness. There has been some progress, with household debt peaking at 129.4% of after-tax income in the first quarter of 2008, but falling to 84.4% in the first quarter of 2021. Since then, it has risen to 96.5 %.
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Although policymakers have not targeted this problem, we believe that resolving this debt situation is not only essential to improve the health of the economy, but that the austerity needed to reduce debt can be a political polarization factor. The last time the United States had a similar debt problem was in the late 1920s when the Great Depression was the solution, although the situation was not fully resolved until World War II. world. From a financial perspective, World War II finally solved the problem of private sector debt by placing that debt on the public balance sheet. Debt relative to the size of the economy has been reduced on the public balance sheet by financial repression.
One of the difficulties in discussing debt is the appropriate scaling; in other words, how do we know when the debt is “too high”? Economists often use nominal GDP or some kind of income measure to measure debt. The problem is that GDP and income are “flow” data, meaning they measure a quantity calculated over a period of time, while debt is “stock” data, which is a level to a specific time. In terms of debt, income or GDP may or may not tell us a lot about the ability to service debt.
Accounting often creates ratios that measure stocks or flows. For example, assets divided by liabilities are two stock numbers that give us an idea of a company’s or household’s balance sheet. Obviously, if the assets exceed the liabilities, it suggests solvency.
From 1970 to 1990, American households had more cash than debt. After 1990, household indebtedness increased, culminating in debt exceeding cash by nearly $6 trillion. The difference narrowed after the Great Financial Crisis by more than 50%. The huge injection of tax relief to households during the COVID-19 pandemic ultimately led to a debt overrun for the first time in three decades.
So, have we solved the problem of household debt? Perhaps, but the Federal Reserve’s distributive financial accounts, which examine household balance sheets by income, suggest that the debt situation has not necessarily been resolved.
We divide households into three groups: top 10%, middle 40%, and bottom 50%. The wealthiest 10% have seen their levels of cash rise relative to debt for most of this century, but that difference has widened dramatically during the pandemic. Since the upper income brackets were mostly excluded from direct cash payments, it is likely that this group liquidated appreciated assets. We note that all three classes took on more debt, but in the case of the top 10%, the accumulation of cash far exceeded these new liabilities. The middle 40% saw cash increase relative to debt in the first quarter of 2021, but over the past year liabilities have increased slightly relative to debt. However, for the bottom 50%, net debt continued to rise even with the influx of pandemic transfer payments.
We don’t have a data series by income before 1989, so we can’t compare what happened during and after the Second World War, but, given the high marginal tax rates of that period, we suspect that the lower income classes have seen their balance sheets improve. What can we learn from the table above? First, as interest rates rise, consumption may fall as the bottom 50% have increased their debt load during the pandemic. Consumption will then have to come from the top 50%. Second, given the massive cash balances of the top 10%, asset prices may find support in the coming months. While higher cash yields from higher interest rates may keep this cash on the sidelines, we believe this level of cash will eventually find its way into equity, commodity and debt markets. This flow may depend on signs that the FOMC is near the end of its tightening cycle, but once such a catalyst emerges, the conditions for a strong rally in financial markets are in place. The big unknown, of course, is which market the potential flows will favor.
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