Debt growing faster than GDP is a feature of our economic system. But why has debt grown so large over the past few decades?
To fully understand the role of debt in an economy, we need to put it in context. The debt profile illustrated in this graph shows the key categories of US debt, in ratio to GDP, over time.
As shown, total debt to GDP in the US has increased since 1950 by over 150 percentage points — from 142 percent to 294 percent of GDP. That’s an extraordinary, mind-boggling increase.
The debt profile also includes a dotted line showing the current account balance in ratio to GDP, which has a bearing on debt trends in any economy. If the current account is in deficit, the higher that deficit, the more borrowing the private sector has to do to finance (what is usually) a trade deficit. If the current account is in surplus, there’s less need for private debt. For the US, this current account balance went from roughly zero in the 1950s to negative 2 percent to negative 4 percent in recent years.
Looking at the US debt profile over time, we can see that total debt has always grown as fast or faster than GDP, except in periods of calamity. Debt outgrows income, and this growth is not a cycle but instead a jagged yet nevertheless unending upwards march. The same relationship between debt growth and GDP holds for the other Big 7 economies in the world. This uniformity suggests that debt outgrowing income is not an accident but an inherent feature of the modern economic system.
The graph shows a line of demarcation or, better yet, a point of inflection between the period from 1950 to 1981 — a period referred to as the Great Deleveraging — and the period from 1981 to the present — the Great Debt Explosion. Clear differences can be seen between these two periods.
At the end of the Second World War, the US experienced Depression-era deleveraging and enforced wartime frugality. Furthermore, during the war, the US government had taken over much of the financing of manufacturing from the private sector. As a result, in 1945, private sector debt — the sum of household and non-financial business debt — fell all the way down to a low of 37 percent of GDP while federal government debt hit a peak of 118 percent of GDP, reflecting the enormous expenses of the war.
After the war, the private sector resumed its ordinary role as a financier of manufacturing, and households rushed to buy new homes, cars, and other goods. As a result, by 1980, private sector debt had nearly tripled, from 37 percent to 101 percent of GDP. Over the same period, supported by this skyrocketing private debt, American business boomed, and US GDP grew by $2.6 trillion.
The government’s debt rarely declined in total amount during this period. However, the large rise in GDP, and the “denominator growth” it afforded, reduced the ratio of government debt to GDP from 117 percent to 40 percent. If there had been no private sector debt growth, US GDP growth would have been largely nonexistent. The term “Great Deleveraging” refers to the decline in the government debt ratio, specifically, the decline from its high as a result of the Second World War. But there was no overall or total debt deleveraging because private sector debt grew rapidly and offset government deleveraging. In fact, total debt grew and was more or less stable as a percentage of GDP from 1950 until 1981.
Then, beginning in the 1980s, a markedly different pattern emerged. Under President Ronald Reagan, government debt re-accelerated, and it has continued to grow under presidents of both parties, from 40 percent of GDP in 1980 to 128 percent in 2020. Private debt has not stopped growing either, rising from 101 percent of GDP in 1980 to 171 percent in 2020. In fact, private debt levels far exceeded government debt levels from the 1970s until the Global Financial Crisis of 2008. The government spending enacted to support the economy in the wake of the 2008 financial crisis and during the pandemic allowed the government debt ratio to catch up.
In the early 1980s, many economists made dire predictions about the likely consequences of high levels of government debt. They warned that it would constrain spending, crowd out lending and investment, lead to higher interest rates and inflation, and seriously encumber the country. At the time, inflation had reached 14 percent, and interest rates were close to 20 percent.
Since then, government debt has exploded and so we have had ample opportunity to put these predictions to the test. As it turns out, over this time span, interest rates have generally plummeted, not risen; investment has remained high, not been constrained; and household net worth has risen, not sunk. In fact, during this very period, household net worth has skyrocketed from roughly 351 percent of GDP to 654 percent, the greatest period of wealth accumulation in US history. A large part of this gain comes from government spending that has put money into household bank accounts, and the very large increase in total debt has fueled a rise in the value of stocks and real estate.
Recently, inflation in the US and the other Big 7 economies has been at levels not seen in a generation, rising to 9.1 percent in the US in June 2022. However, this was largely due to supply chain issues created by lockdowns in China and other countries to prevent the spread of the novel coronavirus and by supply disruptions in such commodities as oil, natural gas, and wheat caused by the war in Ukraine. If inflation were due to high levels of government debt, then the US would have had frequent bouts of inflation over the last 40 years. Instead, inflation has been consistently very low.
Similar patterns hold in other major economies. And if history is any guide, inflation will decline once these special circumstances abate. Though debt growth brings issues of inequality and high private sector debt ratios that we need to consider, if it’s true that government spending boosts net worth in the household macro sector, then maybe, instead of lamenting debt, we should be applauding it.
Boomers are cutting their credit card debt(Opens in a new browser tab)
* * *
Richard Vague’s career has spanned fields as varied as banking, energy, government, and the arts. He recently served as Secretary of Banking and Securities for the Commonwealth of Pennsylvania. Vague previously was managing partner of Gabriel Investments, an early-stage venture capital company; was also co-founder, Chairman, and CEO of Energy Plus, an electricity and natural gas supply company; and also co-founder and CEO of two banks – First USA, which was sold to Bank One, and Juniper, which was sold to Barclays PLC. He is the author of numerous books. His new book is Paradox of Debt: A New Path to Prosperity Without Crisis (Univ of Pennsylvania Press, July 11, 2023). Learn more at richardvague.com.
By Richard Vague
Discussion about this post