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David Paul

David Paul

Posted: September 30, 2008 03:17 PM

Deleveraging Society


It remains unclear at this moment if there will be a resolution of the impasse surrounding the proposed $700 billion bank bailout bill. Since negotiations fell apart on Thursday, House Minority Leader John Boehner -- with a brief cameo of John McCain -- has been leading a phalanx of disgruntled House Republicans in opposition to the Main Street bailout of Wall Street.

Were that the situation was so simple.

The House Republican rerun of Pat Buchanan's Peasants with Pitchforks routine would be charming, if it were not so off base. This financial crisis, while being billed as a Wall Street bailout, is all about Main Street. And if the House Republicans want to see the roots of this crisis, they need only look in a mirror. This crisis is all about debt. It is all about us.

Over the past quarter century--dating to the dawn of the Reagan Revolution in fact--America has become awash in debt, and sub-prime home mortgages are just the tip of the iceberg. Home mortgages. Credit cards. Auto loans. Business loans. Federal debt. As shown below, since 1980, our public debt has grown ten-fold, from $4.4 trillion to over $45 trillion.

2008-09-30-Debtbysector.jpg

Somehow, in the early days of the Reagan years, one fundamental premise did not take root. While Reagan era luminaries such as David Stockman and Grover Norquist trumpeted about the notion that cutting revenue would lead inexorably to cutting expenditures, they underestimated the character and adaptability of the American political system. The abiding lesson of the Reagan years was not that Americans--people of thrift and hard work we were told--would embrace a government that did less for them so they could do more for themselves, but rather that there is nothing that we used to pay for with cash and hard work that we cannot instead pay for with debt--and leave for some future generation to deal with in the distant future.

Turns out, we are not as virtuous as we like to believe.

As illustrated below, our indebtedness--not just as a government but as a society--took off. As a percent of our national income, our cumulative debt burgeoned from a stable level of around 150% of GDP to 350% and counting.

2008-09-30-DebtGDP.jpg

As a nation, we have ceased to save, and--political rhetoric notwithstanding--we have never seriously considered that we should stop spending.

As we are getting in deeper and deeper debt, and as our national savings rate has declined to near-zero, we rely almost exclusively on foreigners to provide us with capital to fund our excessive public, private and corporate spending habits.

In addition, as the chart below illustrates, our growing debt is also increasingly owned by countries--China and Russia most notably--who are often our adversaries in international affairs. This fact was evident in the Fannie and Freddie bailout a few weeks ago, when Treasury Secretary Henry Paulson took pains to avoid any action that would diminish the value of the Fannie Mae bonds held by the Chinese, even as he wiped out the value of the preferred stock held by domestic banks.

Therefore, our growing indebtedness is quickly obliterating the dividing line between domestic fiscal policy and foreign policy. Like any debtor, we will increasingly have to temper our behavior in order to not get cross-wise with our creditors. If any of these holders of our bonds should decide to dump our paper or even move to diversify their central bank reserves out of US government securities, the dollar will fall further and our long-term interest rates will rise.

2008-09-30-Largestholdersoftreasuries.jpg

Our growing borrowing from abroad is a function of our continuing federal fiscal deficits, as well as our trade deficit--the difference between what we export and what we import. These two amounts together comprise our "current account" deficit, and generally reflect the amount of capital that we import every year to fund our public and private expenditures that we cannot pay for from governmental revenues, export earnings or out of our own annual savings.

The problem that we face is our growing addiction to debt as the driver of national income growth. The graph below presents the growth in national Gross Domestic Product over the past several decades, and illustrates the portion of that growth that can be accounted for through imported capital or financing as reflected in the current account deficit.

This data suggests that imported capital has funded an increasing share of our year-over-year GDP growth, and that since the beginning of this decade, the nation has experienced little growth in national income beyond that which has been purchased by borrowing against our future. While in all fairness, the current account deficit is not an exact proxy for imported capital--a portion of the trade deficit, for example, reflects accounting and other transactions--but the gist of the argument remains. The share of our annual GDP growth that is derived from infusions of foreign capital has been growing steadily over the course of this decade--the red line taking over the green--to the point where nearly all of our annual growth has been derived from foreign borrowing.

We are no longer a nation that is paying our own way and in control of our financial destiny, but rather have become addicted to increasing uses of debt to financing our way of life. These are not the characteristics of a great nation or a great people.

2008-09-30-GDPgrowthshareimported.jpg

The obvious question for the next president will be how to change course. The crisis we face is not how to fix a banking crisis, but rather how to deleverage a society that has become increasingly dependent on debt and imported capital.

Historically, the traditional fix to excessive debt is inflation. As inflation grows, the borrowed dollars are paid back in a devalued currency.

And that strategy appears to be in play already. As this final graph illustrates, the decline in the dollar over the course of the decade against the Euro, and increasingly against the Chinese Renminbi will allow us to pay these countries back with a currency that will be worth far less to them then the currency they originally lent to us. If this seems a bit confusing, just consider that in 2001, oil was priced at $20 per barrel, compared to around $100 per barrel today. That illustrates the extent to which the dollars that we are using to pay back our borrowing are worth less in value--80% less in the case of oil value--than the dollars they lent to us a few years ago.

2008-09-30-ValueofEuroandRenminbi.jpg

The risk, of course, is how long our international creditors will play this game with us, and when they will look to protect their own financial interests and be a bit less lenient in funding ours.

So as John Boehner and the House Republicans claim that they are looking out for Main Street, while decrying the abuses and profligacy of Wall Street, a long look in the mirror might serve them--and the rest of us--well. There are no innocents in this crisis, and the longer we refuse to look honestly at our complicity in the creation of this crisis, the steeper the cost will be of setting things right.