Wednesday, December 16, 2009


US Debt Growth

The chart below shows growth in domestic non-financial debt (pink) up to the end of the third quarter. Financial debt is excluded because this would simply be double counting: the financial sector merely borrows from Peter and lends to Paul. We can see a sharp drop in the first half of 2008 as households and private corporations sold off assets and repaid debt in a falling market. The risk was a deflationary spiral as falling prices spark further sell-offs — which in turn cause further price falls.

The sharp spike in domestic non-financial debt in the second half of 2008 reflects governement attempts to stimulate the economy and prevent a deflationary spiral — funded by increased borrowing. The gap between the pink and blue lines reflects growth in government (federal and state) debt. Private sector debt, however, continued falling — despite a slowing of the decline in household debt.

Debt growth is important because it reveals the level of inflationary pressure in the economy. And inflationary pressure indicates future interest rate policy. Between 2003 and 2008 domestic debt grew between 2% and 2.5% per quarter, or 8% and 10% annually. Subtract real GDP growth (pick a number between 0 and 2%) and what you have left is inflationary pressure. This had little effect on consumer prices (other than oil and gas), but had a massive impact on the housing market — fueling the recent bubble.

The 2009 rise in Treasury debt has been offset by falling private sector borrowing — and rising government debt is unsustainable, without risking hyper-inflation. Overall domestic debt levels are likely to fall — and inflationary pressures ease as a result. Expect the Fed to maintain low interest rates until there is an up-turn in private investment and borrowing — which may be some way off.

With low interest rates and low inflation, downward pressure on the dollar is limited; and upward pressure on gold. Demand for gold is a bet on continued growth in government debt — fueling rising inflation, but the alternative scenario of low growth and higher taxes is just as likely.

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