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US debt, will it cause economic crisis 2?

by on 26/01/2018

Following the previous analysis of US public debt

i continue with the private debt analysis and its impact .

The economic crisis can have several different causes. My definition if an economic crisis is negative growth rate of economy. Viz the chart below. If we don’t take in account the negative economic growth at the volatile post war years of the late forties and fifties, the first post war economic crisis occurred at 1974-5 following the war in Middle East at October 1973 and the oil price shock that caused high inflation. Since there were only two more negative economic growth rates in the US economy, at 1981-83 and 2008-9.

In all three cases before the economic crisis oil prices jump up at 1973-74 from less than 20 US Dollars to 60 US Dollars per barrel, then between 1978-79 other hundred percent rise to 120 US Dollars per barrel (at 2015 prices). The next rise of commodity prices started at 2005 and peaked up at 2008, when oil and other commodity prices reached a peak, and then collapsed with the financial crisis of 2008.

Sudden jump in commodity prices, that may occur, as seen in the above charts, causes increase in energy and food prices, that are leading items in the consumers baskets, (food directly and energy through transportation and housing). To such development the central banks reacts with interest rate increase, that have an immediate effect on investments in real estate, shares and other wealth protecting items, that may cause collapse of net worth, with all its consequences.

Does it mean that all the economic crises in post WWII economy were caused by one factor, the commodity price increase? Definitely not, even if it can be one of the supportive factors that caused the economic crisis. In any case an extreme price jump of commodity prices, is usually short term, because either alternative commodities, or new technologies are introduced to the economy. A very good example is the exploitation of gas instead of oil, and the introduction of solar energy in massive scale in the last years.

The economic crisis is more often related to the aggregate demand. But the aggregate demand wouldn’t change overnight without a reason. The aggregate demand in the economy is directly derived from the net national income, meaning gross national income, minus savings. The other important factor is the the net worth of the economy, meaning gross asset value minus liabilities.

The GDP before every economic crisis according to our definition above must grow and with increase of the GDP also the national income growths, sudden drop on the aggregate demand cannot be explained by the sudden drop of national income. So the reason has to be rather in the net wealth. Since net wealth of the private sector is defined as gross asset values minus liabilities, while the liabilities are mostly in form of financial debts, the level of indebtedness of the economy is crucial to the level of wealth of the society.

It is generally accepted, that the 2008 crisis was caused by too high level of debt. Let us assume that the level of indebtedness of the private sector as percentage of GDP at 2008 is an unsustainable level. So let’s try to see how we are doing at end of 2017 with the indebtedness after 10 years compared to 2008. (all data are estimated to the end of 2017 and updated prices. Source Federal Reserve Statistical Release third quarter 2017)

1. The US GDP was about 15 trillion at 2008 and it grew to 20 trillion to end of 2017, increase of 33%.

2. The private debt is divided to Private Household Debts (PHD), that is about 15 trillion USD, almost without nominal change from the peak at 2008. Out of it 10 trillion is mortgages. More than one trillion USD are student loans, and the rest other consumer credit. It means private household debts dropped from 100% to 75% of the GDP.

3. According to data at end of 2017 the Non-Financial Business; the Credit Market Instruments liabilities was about 14 trillion USD compared to 11 trillion at the peak of 2008, what is 33% increase, that is in correlation with the GDP growth. Out of it the corporate non financial institution debts to the third quarter of 2017 was about 9 trillion USD, up from 6.5 trillion USD at 2008, 38% increase.

4. Financial Business’s debt shrunk to 16 trillion out of 18 trillion in 2008. This reduction of debt in financial sector represents the process of reduced financial activity in the US economy following the financial crisis of 2008.

Conclusion the indebtedness of private sector as a whole is below the 2008 level that was about 250%of the GDP, while at the end of 2017 it was just above 200% of the GDP. The rate out of the GDP of the non financial businesses and the households debts level from the GDP is very similar to the rate at 2008, while the financial businesses indebtedness is lower than the 2008 level.

Understandable the aggregate wealth value is also derived from the gross asset value and not only from aggregate debt. And the aggregate asset value has also direct influence on the debt, since the assets are the main collateral for the financial institutions to lend new loans, are the updated assets value. So increase in asset value, causes increase in indebtedness of the private sector, that brings increase in asset value, etc. This is a well known bubble phenomenon. Are we at the doorstep of such a phenomenon? As to the asset prices increase, if it is real estate, stock exchange prices, all those are in upward trend since 2012-13. To add to it the skyrocketing cryptocurrency and you have new “wealth creating bubble.

Still we have to see if it will bring an unprecedented increase in credit and indebtedness of the private sector.

Dow Jones industrial index

The net worth of US households is about 100 trillion US Dollars, 5 times the annual GDP, up from previous peak 80 trillion US Dollars at 2008, 5.3 times the annual GDP. Obviously the net worth of private households include the value of corporate and non-corporate equities and financial deposits and savings partly represented as liabilities in financial businesses, and the real estate assets, that are valued about 35 trillion US Dollars..

Net worth of nonfinancial corporate businesses is 17 trillion US dollars

Net worth of nonfinancial noncorporate businesses is 12 trillion US dollars

Net worth of financial corporate businesses is about 7 trillion US dollars, while the total balance sheet of financial institution is close to 100 trillion US Dollars. This ratio may be surprisingly low, but it is just right according to Basel III regulations of overall regulatory capital of 8% to Risk Weighted Assets Ratio.

It seems the private indebtedness is below the level of 2008, so it shouldn’t worry in the meantime. There are also some other important differences, that have positive impact on the economic stability. The first is the interest rates, that are much lower than at the 2008 level.

As to the commodity prices, mainly the oil price is at 2017 significantly lower than before the 2008 crisis.

Conclusion: The US economy as to its indebtedness and production costs, as to the commodities and financial costs is far better than it was before the crisis of 2008. Yet as mentioned above the excess reserves of the commercial banks deposited in federal reserve vault, can very easy and fast to change to a credit bauble. The most probable response to a credit bauble will be interest rate increase. That can have negative effect on the property prices, as well as on the profitability of the non financial businesses.

The other factor that seems be a foreplay to an economic crisis are the commodity prices. They necessarily increase the marginal production costs, that will cause price increases of consumption basket. That will be followed by interest rate increase, and the downward spiral will start to turn around.

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