Reaching Debt Limits

If an economy is growing, it is easy to add debt. The additional growth in future years provides money both to pay back the debt and to cover the additional interest. Promotions are common and layoffs are few, so a debt such as a mortgage can easily be repaid.

Figure 1. Author's image of an expanding economy.

Figure 1. Author’s image of an expanding economy.

The situation is fairly different if the economy is contracting. It is hard to find sufficient money for repaying the debt itself, not to mention the additional interest. Layoffs and business closings make repaying loans much more difficult.

Figure 2. Author's image of declining economy.

Figure 2. Author’s image of declining economy.

If an economy is in a steady state, with no growth, debt still causes a problem. While there is theoretically enough money to repay the debt, interest costs are a drag on the economy. Interest payments tend to move money from debtors (who tend to be less wealthy) to creditors (who tend to be more wealthy). If the economy is growing, growth provides at least some additional funds offset to this loss of funds to debtors. Without growth, interest payments (or fees instead of interest) are a drain on debtors. Changing from interest payments to fees does not materially affect the outcome.

Recently, the growth of most types of US debt has stalled (Figure 3, below). The major exception is governmental debt, which is still growing rapidly. The purpose of sequestration is to slightly slow this growth in US debt.

Figure 3. US debt, based on Federal Reserve Z1 data,

Figure 3. US debt, based on Federal Reserve Z1 data,

The growth in government debt occurs because of a mismatch between income and expenditures. There is a cutback in government revenue because high oil prices make some goods using oil unaffordable, causing a cutback in production, and hence employment. The government is affected because unemployed workers don’t pay much in taxes.  Government expenditures are still high because many unemployed workers are still collecting benefits.

What can we expect going forward? Will the debt situation get even worse?

I think we can expect that from here, the debt situation will deteriorate. One issue is rising oil prices. While there seems to be a large supply of oil available, it is at ever-higher cost of extraction, because of diminishing returns. (This is even true of tight oil, such as from the Bakken.) Furthermore, I recently showed that not only do high oil prices adversely affect government finances, they also adversely affect wages.1

Figure 4. US per capita non-governmental wages, in 2012 dollars. Non-governmental wages and population from Bureau of Economic Analysis; Adjusted to 2012 cost level using CPI-Urban from Bureau of Labor Statistics

Figure 4. US per capita non-governmental wages, in 2012 dollars. Non-governmental wages and population from Bureau of Economic Analysis; Adjusted to 2012 cost level using CPI-Urban from Bureau of Labor Statistics

If wages are low, the temptation is for governments to try to create more “spendable income” by increasing debt. This can’t really fix the situation, however. The real issue is increasingly high oil prices, which adversely affect both government finances and wages. Adding debt adds yet more interest payments, adding a further burden to wage earners, and creating a need for payback in the future, when wages are even lower.

Ultimately (which may not be very long from now), the debt system appears likely to collapse. The Quantitative Easing (QE) which a number of governments are now using to hold down interest rates and make more funds available to lend cannot continue forever. While there are claims that QE is a bridge to “when growth returns,” it is seriously doubtful that economic growth will ever return. Inexpensive oil is simply too essential to today’s economy. As oil prices rise, wages fall, and demand for oil is further constrained. Falling wages also reduce demand for debt, as payback becomes more difficult.

How Household Debt Adds to Spendable Income

One thing readers may have not thought about is that it is the increase in debt that adds to a person’s (or company’s) spendable income. For example, taking out a car loan allows a person to buy a car. Paying back the loan over a period of years tends to reduce spendable income. If, in the aggregate, the amount of debt outstanding starts decreasing each year, spendable income is actually reduced below the level of wages, because in total, the balance is being reduced.

If we add the increase in household debt (mortgages, credit cards, student loans, car loans, etc.) to wages, this is the pattern we see historically. (The increase has been adjusted for inflation using CPI-Urban):

Figure 5. Per capita wages (excluding government wages) similar to Figure 5. Also, the sum of per capita wages and the increase in household debt, also on a per-capita basis, and also increased to 2012$ level using the CPI-Urban. Amounts from US BEA Table 2.1 and Federal Reserve Z1 Report.

Figure 5. Per capita wages (excluding government wages) similar to Figure 5. Also, the sum of per capita wages and the increase in household debt, also on a per-capita basis, and also increased to 2012$ level using the CPI-Urban. Amounts from US BEA Table 2.1 and Federal Reserve Z1 Report. *2012 estimated based on partial year data.

The pattern is very much what we would expect, given what we know about recent debt patterns. The amount of debt rose rapidly in the early 2000s,  when interest rates were lowered and lending standards relaxed. Some people bought new homes. Home prices escalated, with the higher demand. Many homeowners were able to refinance at lower interest rates. In the process, homeowners were able to “pull out” funds that they could use for any purpose they liked–fixing up the house, buying a new car, or going on a vacation.

By 2008, the party was over. In fact, the amount that was added through debt started decreasing in 2006 and 2007, after the Fed Reserve raised interest rates, in an attempt to choke back inflation caused by high oil prices. I talk about this in Oil Supply Limits and the Continuing Financial Crisis, available here or here.

Increased Government Debt Can Also Add to Spendable Income

In Figure 5, we added the increase in household debt to wages, to get an estimate of spendable income, adjusted for debt. Theoretically, at least part of the increase in government debt might also be added to spendable income, since it is often used (in leu of increased taxes) for programs that benefit citizens. (Some of the increased debt is used for things like bailing out banks, which is of questionable value in raising the spendable income of individuals, so perhaps not all of the increase in government debt should be added in estimating spendable income. Also, increased interest costs related to higher debt amounts would tend to have a dampening effect on spending, if interest rates are not continually dropping, as they have been under QE.)

If we add the increase in government debt (all kinds, including state and local) to the amounts shown in Figure 5, this is what we get:

Figure 6. Amounts shown in Figure 5, plus change in government debt added to the sum of (wages plus increase in household debt). Non-Government debt from Federal Reserve Z1 report, adjusted to 2012 cost levels using CPI Urban. *2012 amounts estimated based on partial year values.

Figure 6. Amounts shown in Figure 5, plus change in government debt added to the sum of (wages plus increase in household debt). Non-Government debt from Federal Reserve Z1 report, with changes adjusted to 2012 cost levels using CPI Urban. *2012 amounts estimated based on partial year values.

How much did citizens really spend? The Bureau of Economic Analysis tells us that as well, as an item called Personal Consumption Expenditures. We sometimes hear that in the United States, personal consumption of goods and services makes up more than 70% of GDP. In fact, this percentage has been growing since about 1950.

Wages (excluding government wages) as a percentage of GDP and personal consumption as a percentage of GDP, both based on data of the US Bureau of Economic Analysis.

Figure 7. Wages (excluding government wages) as a percentage of GDP and personal consumption as a percentage of GDP, both based on data of the US Bureau of Economic Analysis. *2012 estimated based on partial year data.

Strangely enough, wages excluding governmental wages have been falling as a percentage of GDP during the same period. How can wages be falling at the same time personal consumption is rising? I think that a large part of the  answer may very well be “increasing debt.”

If we compare wages to personal consumption expenditures, we find that wages were about 2/3 of personal consumption expenditures at the beginning of the period graphed, but gradually fell to a lower and lower share of Personal Consumption Expenditures.3 If we add a line to Figure 6 showing 2/3 of personal consumption expenditures, the line comes out very close to where we might guess it would, if all of household debt increases, and part of government debt increases were acting to increase personal spending (Figure 8).

Figure 8. Same data shown on Figure 6, plus a line equal to to 2/3 of Personal Consumption as shown on BEA Report 2.4.5. also adjusted to a per capita and 2012 cost basis using CPI-Urban.

Figure 8. Same data shown on Figure 6, plus a line equal to 2/3 of Personal Consumption as shown on BEA Report 2.4.5. also adjusted to a per capita and 2012 cost basis using CPI-Urban.

While there are too many variables to make this comparison exact, it does indicate that the increases in debt levels are of the right order of magnitude to explain what would otherwise be a very strange anomaly.

I might mention, too, that part of the reason that Personal Consumption Expenditures can be rising as a percentage of GDP is the fact that investment has been falling, as businesses move their manufacturing offshore, and as other changes take place. According to the American Society of Civil Engineers, we are allowing bridges, roads, and dams to deteriorate, and not adequately maintaining electrical transmission infrastructure. We are reaching limits on how far we can allow investment to drop, however. In fact, the time is coming when we will need to increase investment, or face loss of some of the infrastructure we take for granted.

Figure 9. United States domestic investment compared to consumption of assets, as percentage of National Income. Based on US Bureau of Economic Analysis data.

Figure 9. United States domestic investment compared to consumption of assets, as percentage of National Income. Based on US Bureau of Economic Analysis Table 5.1.

Where Do Debt Limits Put Us

Even if all debt limits were to do is erase the beneficial impact of debt increases, based on Figure 8, it appears that spendable income (or Personal Consumption Expenditures) would decrease by about 23%, to bring it back to might be expected based on wages.

In fact, reaching debt limits is likely be a messy affair, with some type of change (such as increasing rising interest rates as QE fails, or the US dollar losing its reserve currency status, or huge changes in the Eurozone) leading to changes that affect governments and currencies around the world. It seems likely that trade might be disrupted. Some governments might be replaced, and the debt of prior governments repudiated by the new governments. It is not clear what would happen to personal and corporate debt. In many countries, reform governments have redistributed land and other property. In such a circumstance, neither prior land ownership nor prior debt would have much meaning.

In our current circumstances, we are reaching debt limits because of a specific resource limit — lack of inexpensive oil. Oil is used almost exclusively as a transportation fuel and  in many other applications as well (such as construction, farming, pharmaceutical manufacturing, and synthetic fabrics). Expensive oil is not really a substitute, and neither is intermittent electricity. We are reaching other limits as well. Perhaps the most pressing of these is availability of fresh water. Fresh water can be obtained by desalination, but expensive water is not really a substitute for cheap water, for the same reason that expensive oil is not really a substitute for cheap oil. See my post, Our Investment Sinkhole Problem.

The situation of reaching debt limits because of resource limits is a worrisome one, because it is hard to see a way to fix the situation. People often say that our debt problem arises because we have a financial system in which money is loaned into existence, and as a result, requires growth to pay back debt with interest.  I am not sure that this is really the problem.

We have been used to a financial system that “works” in a growing economy. In such a system, it makes sense to take out loans on new business ventures. In such a system,  money is also a store of value. In a shrinking economy, relationships change. Some loans will still “make sense,” but such loans will be a shrinking proportion of current loans, with long-term loans being especially vulnerable. Money will either need to “expire,” or a high rate of inflation will need to be expected, making interest rates on loans very high. In a shrinking economy, businesses will fail much more often, and workers will more often lose their (fossil fuel supported) jobs.

Some have suggested that new local currencies will fix our problems. I am doubtful this will be the case. The problem may well be that all currencies start being more local in nature. What we may lose is interchangeability based on trust.

Notes:

[1] As background for those who have not read my post The Connection of Depressed Wages to High Oil Prices and Limits to Growth, wages recently have been depressed, in part because fewer people are working. Figure 4 above, showing “Per Capita Non-Government Wages,” provides a measure of how wages have changed. This is calculated by taking wages for all US residents, subtracting wages of government workers, and dividing by the total US population (not just the number working). The average wage calculated in this manner is than adjusted to the 2012 price level based on the CPI-Urban price index. Government workers have been omitted because I am trying to get at the base from which other funding comes. Government wages are ultimately paid by taxes on workers in private companies.

The thing that is striking about Figure 4 is that a similar pattern occurs in the 1973 to 1983 period as the 2002 to 2012 period. Oil prices were high in both periods. (Figure 10, below). In fact, the vast majority of wage growth has occurred when oil prices were $30 or less in 2012$.

Figure 3. Per capita non-government wages, calculated by dividing non-government wages from the Bureau of Economic Analysis by the US population, and then bringing to 2012$ using CPI-Urban price index, together with historical oil prices in 2012$, based on BP 2012 Statistical Review of World Energy data, updated with 2012 IEA Brent oil price data.

Figure 10. Per capita non-government wages, calculated by dividing non-government wages from the Bureau of Economic Analysis by the US population, and then bringing to 2012$ using CPI-Urban price index, together with historical oil prices in 2012$, based on BP 2012 Statistical Review of World Energy data, updated with 2012 EIA Brent oil price data.

There are several reasons why rising oil prices can be expected to reduce the number of people working, or the hours they work:

(a) Discretionary sector layoffs. Consumers find that the price of food (which uses oil in its production and transport) and of commuting is rising. Prices of other goods are also rising. This forces consumers to cut back on discretionary spending. Employees in discretionary sectors get laid off, because of these impacts.

(b) General layoffs. Even outside discretionary sectors, employees may be laid off, if the cost of goods rises indirectly because of a rise in oil price. Often this will be because of higher transport cost, but it could because of another use of oil, such as by construction equipment, or as a raw material. With higher costs of delivered products, companies find that demand falls, if they raise prices sufficiently to maintain profit margins. (This falling demand occurs because some consumers can no longer afford their products.) Businesses  find it necessary to scale back the size of their operations–lay off workers and close stores or other facilities. Alternatively, businesses can move operations to China or another low cost site of operation, to reduce costs, but this also leads to layoffs of US employees.

(c) Government layoffs. Eventually the government tax base is reduced, because of a smaller proportion of the population paying taxes. Governments also find a need to pay our more in direct costs–such as more for unemployment insurance, and more for asphalt (an oil product) for paving roads. Governments also find themselves laying off workers.

The effects outlined above can be mitigated to some extent by changes such as moving closer to work and more fuel efficient cars. But experience seems to suggest that even more what happens is that the effects shift from sector to sector over time, as businesses “fix” their problems, leaving them to with wage-earners and governments.

The high price oil situation was mostly resolved in the early 1980s, because other relatively inexpensive oil was available to drill, bringing the price down again. (The new price, at $30 barrel, was still 50% higher than the $20 barrel price prior to the crisis, though.) The availability of new low-priced supplies seems much less likely now, because we extracted the inexpensive-to-extract oil first. We are now reaching diminishing returns. While there seems to be plenty of oil available, it is high-priced oil.  This is even true of the new “tight oil” supplies in the Bakken and several other areas.

[2] Government debt in this post refers to all types of government debt combined, including state and local debt. Within this debt, only debt classified as “Marketable” is included. As such, it does not include debt owed to the Social Security system (because contributions that were collected by the Social Security system were spent on something else, and are not available to pay Social Security recipients) or to other pre-funded government agencies. Such debt is a future liability, not affecting today’s spending, so I didn’t add it in. (The Federal Reserve Z1 report also does not include it.) There are, in fact, a huge number of government obligations that are not reflected, such as promises to bail out pension programs and FDIC coverage of bank accounts, because they are contingent in nature.  Such programs can be expected to add to the problems we would have, if our debt system should fail.

[3] We would not expect non-government wages to equal Personal Consumption Expenditures, since for one thing, wages of non-government employees leave out expenditures by government employees. They also leave out various derivative amounts, such as expenditures by entrepreneurs, and expenditures of amounts that would be classified as rents and dividends. Changes in savings rates would also play a role.

About Gail Tverberg

My name is Gail Tverberg. I am an actuary interested in finite world issues - oil depletion, natural gas depletion, water shortages, and climate change. Oil limits look very different from what most expect, with high prices leading to recession, and low prices leading to inadequate supply.
This entry was posted in Financial Implications and tagged , , , , , , , , . Bookmark the permalink.

69 Responses to Reaching Debt Limits

  1. SlowRider says:

    Another example of the limits of debt: The best documentary I ever saw about the chinese housing bubble (12 Minutes).

      • Thanks for the link! I remarked a little about the debt situation on my post Observations Based on my Trip to China. A few observations based on what I know about the situation:
        1. Pumping up an economy with debt to buy an unneeded product has worked for eons as a way to increase GDP. War is the most popular way of doing this. US military intervention overseas, and all of its bases, sort of fit this role as well. A country gets a whole chain of businesses supporting the endeavor, and lots of employment.
        2. China does not allow migrants to move to cities as full citizens. They very carefully control who gets a license to move to the city, and thus are allowed to do basic things such as send their child to a school in the city. People who are being displaced might get licensed (to go to a specific city, not a high-demand city like Beijing), but people in general are not allowed to come to the city, unless they accept extremely secondary status. This has kept China from having all of the shanty-towns that are typical in third-world countries. China’s cities look beautiful because of this.
        3. Historically, Chinese workers have not had to pay for housing. Instead, housing has been provided by employers, as part of the wage package. This housing is quite minimal–shared outhouse, perhaps no electricity. (My perception though, that this shared housing was still better than in India. The shared outhouses there seemed to serve much higher numbers of people.)
        4. The government has been doing a lot of relocating of people, when they undertake public works of various sorts. They build new walk-up high rise buildings with indoor pluming for them, in the areas where they live, and sell them as condos. The results is that local people have to a make a mortgage payment for the first time in their life. This cost is at least somewhat subsidized by the buyout the government gives workers for their prior company-provided apartment. The condo is sold in very un-upgraded state (concrete floors, missing basic things like doors, and no air conditioning). Buyers can buy finishing items for their condo, but this adds to their condo payments. This means these folks are very stretched financially as well, and part of the economic boom comes from creating the accessories to the condos.
        5. China doesn’t have much of a pension program. It also has a one-child policy. The combination means that folks need to try to fund their own retirement, because neither the state or their one child can be depended on to provide much support. This means that there is higher savings than normal. With all of this savings floating around, and all of the other investment outlets paying very poorly, buying condos seems like the investment solution.

        Anyhow, it looked to me as though a debt bubble was forming when I visited in 2011. The professor I visited there had told me earlier that he had helped his son (in his early 20s) buy a condo, because they were such a good investment. This was back about 2009. It all seemed strange to me. The professor did not own a car–rode a bicycle to work.

    • you frightened me to death slowrider—but thanks anyway
      a really informative link

      • SlowRider says:

        What impressed me most was
        a) the waste of resources this means, if it is really going on all over the continent
        b) how they are betting completely on growth by taking on debt and building economies of scale, but are left without much to fall back on, if it turns out bad
        c) the implications for the global economy: if this is what the asian growth story looks like, it’s not sustainable

  2. Stan says:

    Is the cumulative debt chart inflation adjusted? (Are we looking at debt in real or nominal terms) I think this is the most powerful chart in economics I have seen in a while.

    • What I did was calculate yearly increments in debt. I then adjusted those increments, as if the CPI-Urban adjustment were the right rate to bring the increment to the current cost level. The older years would have looked a little lower, relative to the recent years, if I had used the GDP deflator as the inflation adjustment.

  3. SlowRider says:

    One more thought on debt in a broader context. Today, the wealth of the world is held mostly inside the financial system in the form of paper/digital assets (claims on real things). Each of those “assets” is also someone else’s liability, i.e. debt. Typical counterparties are governments, corporations and banks.
    My point is, global debt became unsustainable already when the assets inside the financial system became bigger than their corresponding claims in the real world. I don’t have the numbers, but that could have happened maybe in the 70’s already. In other words, the finite character of our world became a problem for our debt money system long ago.
    Now they try to maintain that unsustainable system, but at great risk and it has started to crack. There will come a time when the holders of these financial assets will transfer their money over to the real world before it is gone. Actually it is already happening.

  4. Leo Smith says:

    In the end there was God, and God looked down at the Waters, and the failure of his prototype Reality and at the balance sheet in His Hand.

    “Apparently I owe about 237 trillion credits to myself” he sighed, and drew a red line through the balance sheet with his finger. “There, that covers that. Next time I wont write in conservation of energy. That was my Big Mistake”.

  5. Ultimately, the problem will boils down to the following question: will the government be able to extract more from its citizens? It must reduce the burden of its debt, either via taxes or spending cuts, or via inflation. What means will be actually used, that is will be political profitable, depends on the results of the cultural propaganda. If people begin to think that austerity is necessary, then cuts will be enacted. If they can live with price freezing, like in Venezuela, then inflation can go on.

  6. Hj Gail, very glad I came across your blog [although more global -Euro related articles would be very welcome] – Here in the UK politicians are in a state of denial- the economy is just about to bounce back, and growth is just around the corner. Is there any US politicians that want to listen?

    • I am not sure there are many US politicians who want to listen. They seem to be enamored of today’s economists, who don’t think energy is a problem and think growth can go on forever.

      • Such short-sightedness amongst our short term politicians is depressing. We can at least look to Germany that is investing in a post peak/ post carbon future but I have yet to observe a political debate whether left or right prepared to even acknowledge the issues at hand. 5 years into a unique recession and the left wants more spending and rights wants less but all expect that growth is just around the corner. But you know this.

        But if it comes to advisers [and please accept my lack of subtlety] -as an actuary [Actuaries!?!] you are not a millions miles away from being an economist [apologies if you are]- so what logic are the economists working on? Is there an up and coming school of thinking which will succeed the current optimists? or is it simply that if you want work with politicians or business you need to be an optimist?

        I look forward to reading your next post.
        Jules

        • I am not sure I have an answer for how so many can be so deluded. Actuaries do work in the financial world, so they are not that far removed from economists. In some ways, they are more like the engineers of the financial world. They haven’t been steeped in the economic theory (and nonsense) that the economists spout, so seem to be more open to the issues at hand. Politicians couldn’t possibly admit that there is a problem they can’t solve, so they have an incentive not to believe anything that does not forecast business as usual.

  7. Greg Chadwick says:

    Gail, you mentioned that…”I am not sure I have an answer for how so many can be so deluded.” I suspect that most everyone who has some understanding of peak oil and the other predicaments we face are thinking much the same thing.

    However, I think you may have already touched on the answer in one of your replies. I believe it was you; or perhaps another blogger, who mentioned the possibility that the problem may be genetic in origin.

    Evolution equipped our species for one specific purpose, that is to live long enough to reproduce and raise offspring. As one clever writer succinctly described it, we’re very good at the three “F’s.” For better or worse, anything else was a side effect.

    To make a long and complicated story short, the cave man who was too busy thinking about the environmental impact of his tribe’s wood burning activities to notice the tiger in the nearby brush probably wasn’t one of our ancestors.

    Ironically, our species was smart enough modify and create a whole new man-made environment. But unfortunately, not being predisposed to consider anything past the end of our noses, we inadvertently created an environment where we were no longer so well adapted for long-term survival. That’s because now almost all of our existential problems are long-term.

    If you have a chance, check out Craig Dillworth’s book “Too Smart For Our Own Good.” He did a great job of tracing our use of technology over the ages, which goes a long way toward explaining our current predicament.

    The other issue is that the human brain doesn’t work anything like most people think it does. Another long story. The short and bitter version uncovered by research psychologists says that we are NOT primarily logical and rational creatures, we are frequently illogical and irrational and driven by hidden emotions.

    Worse, all human history is revisionist history as our memories are recreated every time we access them in ways that suit our immediate needs.

    And last, but not least; most of our decision-making is done subconsciously, and not just the walking and chewing gum variety. Like it or not, we’re all short-timers.

    We can argue all we want, there is a mountain of peer reviewed research hiding in plain sight for those who are masochistic enough to go looking for it. If anyone is interested in this depressing and demoralizing stuff, I can provide a list of interesting, but disconcerting books.

    BTW: Great blog Gail. The readers who add their comments are clearly well read and intelligent. Far more than I can say for what I see in the mainstream media.

Comments are closed.