New McKinsey Global Institute research shows that the unwinding of debt—or deleveraging— is a drag on a nation's economic growth. Historical experience, particularly with nations attempting to reduce debts in the post–World War II era, reveal that the deleveraging process is both long and painful.
That's bad news for the U.S., where the national debt now exceeds the entire economy.
The combination of too much debt and too little growth has repeatedly proven to be toxic, as is now seen in eurozone countries.
Growth has been, and will likely remain, a challenge for the U.S. The economy grew just 1.7 percent last year, roughly half of the growth in 2010 and the worst since the recession.
Economic growth needs to be at least 2.5% to improve the nation's dismal unemployment situation. Anything lower doesn't even keep up with population growth.
Yet, the economy will have to expand much faster than that just to keep up with the nation's continually mounting debt. The U.S. needs a combination of growth and inflation to pay off years of already accumulated debt.
Long-term projections indicate the debt will grow faster than the economy, which would have to expand by at least 6% annually to keep up. However, the historical average for annual GDP growth since 1948 is only 3.25%.
Given its current constraints, there is absolutely nothing to indicate that the U.S. economy can nearly double the growth rate it experienced over the previous 64 years — a period that saw an enormous post-war expansion.
Net interest payments on the government debt are already one of the fastest rising categories of government spending, yet interest rates are still quite low.
And there's the rub; once interest rates begin to climb, servicing the debt will become quite burdensome and will take precedence over other critical spending needs, such as education and infrastructure.
According to the latest estimate from the Congressional Budget Office (CBO), the federal deficit will be $1.1 trillion this fiscal year. That would mark the fourth straight year of trillion-dollar deficits.
Yes, a significant portion of those deficits has been driven by the recession and post-recession hangover; meaning a shrunken tax base and more safety net payments, such as unemployment benefits and food stamps for the growing number of Americans who have fallen into poverty.
The Census Bureau reports that 44 million Americans were living below the poverty line in 2009, or one in seven people — a rather remarkable statistic. That figure perfectly matches the one-in-seven Americans currently receiving food stamps.
This means that one-in-seven Americans are not supporting the federal tax base, but are instead drawing from it.
The nation is also still paying for the massive costs of the wars in Iraq and Afghanistan. As of two years ago, the cumulative cost of both wars had already surpassed $1 trillion.
According to Defense Department figures, by April of 2011 the wars in Iraq and Afghanistan — including everything from personnel and equipment to training Iraqi and Afghan security forces and deploying intelligence-gathering drones — had cost an average of $9.7 billion a month, with roughly two-thirds going to Afghanistan.
A CBO study said that if the Bush-era tax cuts were allowed to lapse, the deficits would drop sharply. But eliminating these cuts still won't eliminate the deficit, and even eliminating the deficit will not eliminate the underlying debt. That will require years of surpluses, and we are a long way from that.
The U.S. desperately needs economic growth in order to expand its contracted tax base. The nation is still grappling with a serious unemployment problem that will have to be solved by the private sector, not the government.
As economist John Williams of Shadowstats notes, "The January 2012 payroll employment level remains below the level that preceded the 2001 recession, more than a decade ago.”
The government previously reported that 1.3 million jobs needed to be created every year from 2006-2016 just to keep up with the growing labor force. That hasn't happened. Incredibly, job creation was negative for the entire 2000s decade. There's still a long way to go and a lot of ground to be made up.
Even those who have jobs are facing major income hurdles, and that is impacting the tax base.
The median income has declined 7 percent in the last 10 years. More worrisome, Americans' incomes have fallen more during the recovery than they did during the recession. Incomes dropped 6.7 percent during the recovery between June 2009 and June 2011, compared to a 3.2 percent drop during the recession from December 2007 to June 2009.
This decline in incomes is the likely reason that Americans have stopped their debt-spending and are instead beginning to pay down existing debts.
Outstanding household debt in the United States fell by $584 billion (4 percent) from the end of 2008 through the second quarter of 2011. That deleveraging process is still ongoing.
This means that U.S. consumers will not be the powerful growth engine they were prior to the financial crisis and recession.
According to McKinsey, historical experience shows that overextended households and corporations typically lead the deleveraging process. But governments can only begin to reduce their debts later, once they have supported the economy into recovery.
However, the U.S. economy remains weak and is still quite dependent on government support. Unfortunately, that has been the case for many years.
Private-sector GDP is roughly where it was in 1998. The economy has only grown because a substantial portion of GDP the last few years was the result of government debt.
That's about to change.
After the November elections, Congress will have nine weeks to decide on $5 trillion worth of tax and savings decisions. This is the moment Congress has been avoiding for years. There will be more ugly public battles fought by the political class. Regardless, no matter how those battles are resolved, the outcome will be harsh.
As the government begins the absolutely necessary process of deleveraging, it will have serious and unintended consequences. Budget cuts will undoubtedly shrink the economy.
McKinsey gives three recent examples of nations that went through the deleveraging process: Finland and Sweden in the 1990s and South Korea after the 1997 financial crisis.
All of these countries followed a similar path: bank deregulation (or lax regulation) led to a credit boom, which in turn fueled real-estate and other asset bubbles. When they collapsed, these economies fell into deep recession, and debt levels fell.
In other words, the U.S. should have seen this coming.
In all three countries, growth was essential for completing a five to seven-year-long deleveraging process. That's the challenge now confronting the U.S.
Absent a sovereign default, significant public-sector deleveraging typically occurs only when GDP growth rebounds. And that usually doesn't occur until the later years of deleveraging.
That’s because the primary factor causing public deficits to rise after a banking crisis is declining tax revenue, followed by an increase in automatic stabilizer payments, such as unemployment benefits.
That same pattern has played itself out in the U.S. over the past few years. Now Washington is tasked with the challenge of eliminating its mountainous debt burden, potentially allowing the economy to resume more robust growth.
Finland, South Korea, and Sweden could rely on exports to make a substantial contribution to growth. However, due to its massive trade imbalance, the U.S. will not be so fortunate.
U.S. economic growth will be held back by the enormous, and still growing, public debt and by the massive trade deficit, which shrinks GDP.
The Federal Reserve could simultaneously create an export boom and reduce the national debt by devaluing the dollar through the process of money printing, or quantitative easing. And this may in fact be the underlying intention of the Fed.
But every nation seeks to be a net exporter, with an under-devalued currency that is favorable to that goal. Such a strategy can't work for every nation; someone has to buy. Traditionally, that has been the role of the U.S.
As McKinsey notes, during the three historical episodes discussed here, the housing market stabilized and began to expand again as the economy rebounded. However, a similar outcome in the U.S. is not likely for many years to come.
By the end of the third quarter of last year, some 12.6 percent of homeowners with mortgages — or more than 6 million homeowners — were either delinquent on their payments or in foreclosure, according to the Mortgage Bankers Association. And roughly 22 percent of residential properties with mortgages were underwater at the end of the third quarter, according to CoreLogic.
Housing prices have declined to levels not seen since February 2003 and the equity in residential real estate has fallen severely as a result.
According to RealtyTrac, 8.9 million homes have been lost to foreclosure since 2007, the height of the credit crisis. In the process, more than $10 trillion in home equity has been wiped out since the June 2006 peak.
Additionally, lending standards are now tighter and are keeping many people out of the market. In 2010, one-third of American consumers were considered sub-prime and couldn't even qualify for a home loan. When a third of your market is disqualified, that's obviously a very bad sign.
An economic recovery in the U.S. will have to be led by a major rebound in employment and housing. Yet, both appear to be a long way off. Until they bounce back to pre-recession levels, the U.S. will continue to muddle along, at best.
At worst, we could be headed for our own "lost decade", much like Japan, which has actually been economically stagnant for two whole decades.
When the bond market determines that the U.S. debt is unstable, and that economic growth cannot possibly allow the repayment of those debts, it's game over. Finding buyers for Treasuries will become difficult and prohibitively expensive.
At that point, the government will have no choice but to let the Federal Reserve print, print away, destroying our currency and standard of living in the process.
Sadly, such an unthinkable outcome may be just a few short years away, well before the end of this decade.
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