The financial crisis 10 years ago exposed excessive borrowing by U.S. homeowners and the financial sector, which led to a massive deleveraging effort. Now, debt is back on the rise, this time led by government. The total debt of all U.S. sectors is 3.5 times gross domestic product, closing in on the peak of 3.8 times in April 2009 and more than twice the 1.5 times ratio of the 1960s and 1970s.
But don’t get too concerned. With inflation likely to remain low and Treasuries continuing to be a haven for domestic and foreign investors, financing the expanding federal debt should continue without major problems. Indeed, with worries about faltering stocks, an aged business expansion and growing global protectionism, recent signs of the strength in Treasuries will probably persist.
Those aren’t the only reasons to be sanguine. Rising U.S. debt is predominantly a federal affair. Households and the financial sector continue to delever and other private sectors are holding steady. Consumer debt is down from its late 2007 peak of 133% in relation to disposable (after-tax) personal income, but remains elevated at 104%. Although that’s far above the 65% norm of the 1960s and 1970s, before the start of the decades-long borrowing binge in the early 1980s, further substantial declines are in the offing. A key reason is the aging postwar babies. As people get older, they pay down home mortgages and otherwise spend and borrow less. Also, the profligate postwar babies have insufficient assets for retirement and need to save vigorously and retire debt or work until they die. Consumer borrowing will also be discouraged by rising debt service costs that come as the Federal Reserve lifts interest rates.
Financial sector debt in relation to GDP has also declined considerably, according to Fed data, due to government regulations, especially the 2010 Dodd-Frank law. Combining that with the chastisement of big bank CEOs, the odds of another 2008-like financial crisis are low. Instead, if history is any guide, the next trauma will appear elsewhere just as the savings-and-loan crisis of the late 1980s was not repeated but was followed by the dot-com stock bubble collapse of the early 2000s. Then came the rise and fall of subprime mortgages.
Elsewhere, state and local government borrowing has been relatively flat in relation to GDP. Debt and equity financing by nonfinancial corporations also continues to be stable. Growth in plant and equipment spending is restrained by low capacity utilization rates. Corporate cash is ample, especially after the recent tax cuts.
Then there’s the federal government, where debt has leaped due to the huge deficits incurred in the wake of the financial crisis. Massive tax cuts and government spending combined with a shortfall in tax collections because of the economic slump deepened the red ink. From the first quarter of 2009 through the fourth quarter of 2017, the combined drop of $583 billion in household and financial sector outside financing was swamped by the $8.7 trillion surge in federal borrowing. That pushed federal debt from 35% of GDP to 83%.
Now, the prospect is for bigger budget deficits thanks to the recently enacted tax cuts, which add at least $1 trillion over 10 years, and the two-year budget deal that implies $300 billion more federal borrowing. Anticipate major infrastructure spending. The Trump administration proposes a $1.5 trillion program over 10 years, with $200 billion from the federal government and the rest from private sources and state governments. Financially strapped states, though, are reluctant to spend on infrastructure and private equity firms don’t like the red tape that tangles up new projects. So, more spending will likely fall on the federal government.
Federal entitlements, including Social Security, Medicare, Medicaid, disability insurance and food stamps, have jumped to 15% of GDP from 11% in 2000 and are headed for 20% in 2046, according to the Congressional Budget Office. With the Social Security Trust Fund rapidly moving from surpluses to deficits, Congress will be forced to introduce major reforms or else pay beneficiaries directly from the Treasury.
Nevertheless, “the bond rally of a lifetime” that I declared in 1981 when 30-year Treasuries yielded 14.7%, remains intact. If their yields drop from the current area of about 3% to my long-held 2% target in 12 months, the total return will be 25% for an interest bearing coupon bond and 33% for a 30-year zero-coupon Treasury. Where can you find comparable investment prospects?
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A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Some portfolios he manages invest in currencies and commodities.