America’s Debt Overhang Growth or Austerity, and other Policy Choices

September 2009

The Debt Overhang

The bursting of the housing and credit bubble has left the United States with a large debt overhang.

America’s total debt is at a historical high of 373% of GDP.

America’s debt as a percent of GDP has more than doubled since 1980, when it stood at 161%.

Total U.S. Debt as a Percent of GDP

100%

150%

200%

250%

300%

350%

400%

1980 1984 1988 1992 1996 2000 2004 2008

Source: Federal Reserve

2

Household And Financial Sector Debt

Household and financial sector debt has accounted for the lion’s share of the increase in debt since 1980.

Household debt climbed from 48% of GDP in 1980 to 97% in the first quarter of 2009.

Financial sector debt rose from 19% of GDP in 1980 to 120% in the first quarter of 2009.

Household, Financial Sector, and Government Debt as a Percent of GDP

0%

20%

40%

60%

80%

100%

120%

140%

1980 1984 1988 1992 1996 2000 2004 2008

Households Financial Sector Government

Source: Federal Reserve

Financial Sector

Households

Government

3

Household Debt-Servicing Burden

Despite low interest rates, the debt-servicing burden for households has increased, taking a bigger bite out of incomes.

The debt service ratio – the ratio of debt payments to disposable personal income – rose from 11.1% in 1980 to 13.5% in 2009.

Debt Service Ratio

10%

11%

12%

13%

14%

15%

1980

Q1

1984

Q1

1988

Q1

1992

Q1

1996

Q1

2000

Q1

2004

Q1

2008

Q1

Source: Federal Reserve

4

Household Leverage

Residential property accounts for 85% of household debt.

10% of household debt is in installment loans and 3.5% is in credit card debt.

Middle-income households hold more debt as a percent of their disposable incomes than upper or lower income households.

5

U.S. Debt by Type

Credit Card Balances

Installment Loans (Auto,

Education)

Other Residence

Other

Primary Residence

Source: Federal Reserve

Rapid Decline In Household Wealth

The net worth of U.S. households and non-profit organizations fell $13.9 trillion from the second quarter of 2007 to the first quarter of 2009.

The ratio of household debt to financial assets has thus increased, making it more difficult for households to tap home equity and other assets to supplement incomes.

6

Household Net WorthUSD Trillions

$0

$10

$20

$30

$40

$50

$60

$70

2003

Q1

2003

Q3

2004

Q1

2004

Q3

2005

Q1

2005

Q3

2006

Q1

2006

Q3

2007

Q1

2007

Q3

2008

Q1

2008

Q3

2009

Q1

Source: Federal Reserve

Government Debt Is Now Rising More Rapidly

Federal debt has increased because of falling tax revenues and the cost of government rescue programs.

Government debt will need to rise further to offset the effects of the deleveraging of the private sector.

Federal debt held by the public is projected to increase from 40.8% of GDP in 2008 to 68% in 2019, according to the CBO’s baseline projection.

Federal Debt Held by the Public as a Percent of GDP

0%

10%

20%

30%

40%

50%

60%

70%

80%

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

Source: Congressional Budget Office

7

But Is Within America’s Historical Experience

In the period following WWII, federal debt reached a peak of 113% of GDP in 1945 and remained above the projected 2009 level until 1956.

“We’re looking at debt levels that a number of advanced countries, the U.S. included, have had in the past, and dealt with.” Paul R. Krugman

New York Times

Federal Debt Held by the Public as a Percent of GDP

113%

0%

20%

40%

60%

80%

100%

120%

1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Source: Congressional Budget Office

2009 debt level

projections

8

And Is Lower Than Other OECD Economies

U.S. government debt is within acceptable international norms.

In 2008, U.S. government debt was slightly below the OECD average.

After the bursting of Japan’s property bubble, its government debt increased from 47% of GDP in 1990 to 106% in 2000.

9

Government Debt as a Percent of GDP 2008

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

Germ

any

Japa

n

United K

ingdom

United S

tate

s

Belgium

OECD Ave

rage

Source: OECD, National Statistics

America’s Federal Debt Servicing Remains Low

The debt-servicing burden on the federal debt is less than it was during the period from 1980 to 2001.

The debt-servicing burden in 2009 is 1.75% of GDP, down from 1.93% in 1980 and 3.28% in 1991.

It is lower because the government has been able to borrow recently at historically low interest rates.

10

Net Interest Payments as a Percent of GDP

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

1980 1985 1990 1995 2000 2005

Source: Congressional Budget Office

Ownership Of U.S. Government Debt Is Widely DistributedThe three largest holders of U.S. Treasuries are the U.S. government (43%), foreign governments (29%), and mutual funds (6%).

Excluding U.S. government holdings, foreign governments and international investors hold 52% of Treasury Securities. China accounts for 23.5% of total foreign ownership.

Top Three Holders ofTreasury Securities

U.S. Government 43%

Foreign Governments 29%

Mutual Funds 6%

11

Estimated Ownership of U.S. Treasury SecuritiesMarch 2009

Other Investors

Foreign Governments

and International

Investors

U.S. Government

Depository Institutions

U.S. Savings Bonds

Pension Funds

Mutual Funds

State and Local Governments

Insurance Companies

Source: U.S. Treasury

America’s International Debt

America’s international debt has increased because of persistently high current account deficits.

America’s net overseas investment position has deteriorated $2.75 trillion over the past decade.

But, the U.S. has continued to run a positive net investment income balance – because we earn more on our overseas investments than foreigners earn on U.S. assets.

12

Net International Investment Position and Balance on Investment Income

-$4,000

-$3,000

-$2,000

-$1,000

$0

$1,000

$2,000

$3,000

$4,000

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

US

D b

illio

ns

-$140

-$105

-$70

-$35

$0

$35

$70

$105

$140

US

D b

illio

ns

Net Investment Income

Net International Investment

Source: Bureau of Economic Analysis

Deleveraging Takes Time

Economies are slow to recover from financial crises, according to a study by Carmen Reinhart and Kenneth Rogoff.

On average:

• Housing prices decline 35.5 % over roughly six years.

• Recessions after financial crises last 1.9 years.

• Equity prices collapse 56% over 3.4 years.

• Unemployment rises 7% over nearly 5 years.

• Government debt increases by 86% during the three years following a financial crisis.

Real Housing Price Cycles and Banking Crises

-60 -50 -40 -30 -20 -10 0 10 20

Finland, 1991

Japan, 1992

Norway, 1987

Spain, 1977

Sweden, 1991

USA, 2007

Average

Magnitude of Decline % Duration in Years

Source: Rogoff and Reinhart, "Banking Crises: An Equal Opportunity Menace"

13

Why We Must Deleverage The Private Sector

A sustainable recovery, in which private investment and consumption drive growth, is not possible until the private sector has repaired its balance sheet.

Financial institutions must increase their capital in order to resume the scale of earlier lending to creditworthy borrowers.

Households need to increase their savings in order to pay down debts before they can increase consumption on a sustained basis.

“The restoration of normal credit creation should not be expected until the economy has adjusted to the disappearance of shadow bank credit, and until banks have created the capacity to resume lending to creditworthy borrowers.”

George Magnus

Senior Economic AdviserUBS Investment Bank

14

Banks Are Improving Capital Ratios By Lending Less

The drying up of consumer credit has been more severe than in any previous recession.

Consumer credit fell by $21.6 billion in July, the largest drop since the government started to keep records in 1943.

Previous recoveries have benefited from an expansion of consumer credit, but banks are still tightening credit.

15

Consumer Credit and Recessions

-5%

0%

5%

10%

15%

20%

1970 1975 1980 1985 1990 1995 2000 2005 2010

Recessions Consumer Credit, Year-on-Year Change

Source: Federal Reserve

IMF: Banks Need More Capital

As of April, the IMF estimated that U.S. banks would need capital injections of $275 billion to return to pre-crisis leverage ratios.

To reach leverage ratios from the middle of the 1990s, banks would need $500 billion in capital injections.

Given the questionable quality of the assets on their balance sheets, banks will probably need to make more provisions for bad debts from mortgages, commercial real estate, auto and personal loans, and credit cards.

“It is proving difficult to effectively implement measures that fully address the problem of impaired assets on banks’ balance sheets, leaving banks vulnerable to a further deterioration in the quality of these assets if the global downturn is deeper, and more prolonged, than projected.”

IMF Global Financial Stability Report MarketUpdate - July 08, 2009

16

More “Problem” Institutions, More Bank Failures

"Problem" Institutions

0

50

100

150

200

250

300

350

400

450

200

6-I

200

6-II

200

6-II

I

200

6-IV

200

7-I

200

7-II

200

7-II

I

200

7-IV

200

8-I

200

8-II

200

8-II

I

200

8-IV

200

9-I

200

9-II

Source: FDIC

FDIC Bank Failures per Month

0

5

10

15

20

25

30

Dec-0

7

Jan-

08

Feb-

08

Mar

-08

Apr-08

May

-08

Jun-

08

Jul-0

8

Aug-08

Sep-08

Oct-0

8

Nov-0

8

Dec-0

8

Jan-

09

Feb-

09

Mar

-09

Apr-09

May

-09

Jun-

09

Jul-0

9

Aug-09

Source: FDIC

17

The number of “problem” financial institutions is at a 15-year high and increasing.

Commercial Real Estate Exposure

At the end of the first quarter of 2009, banks held $1.8 trillion of outstanding debt associated with commercial real estate.

The May stress tests found that banks would suffer $53 billion in losses on their commercial real estate holdings. Deutsche Bank estimates losses could be $115 – $150 billion, not including losses on Commercial Mortgage-Backed Securities (CMBS).

Commercial real estate prices have fallen 36% and are likely to continue falling as vacancy rates remain high, unemployment rises, and the market for CMBS deteriorates.

Percent of Commercial Mortgage-Backed Securities (CMBS) in Delinquency

0%

1%

2%

3%

4%

Aug-08

Sep-08

Oct-08

Nov-08

Dec-08

Jan-09

Feb-09

Mar-09

Apr-09

May-09

Jun-09

Jul-09

Source: Realpoint

18

Options For Financial Sector Balance Sheet Repair (Other than by Reducing Lending)

1. Profit inflation. A steep yield curve enables banks to borrow cheaply and lend at higher interest rates.

2. Private equity issuance. Banks can issue more equity, thereby increasing their capital.

3. Debt-for-equity swaps.Bondholders can be asked to trade debt for equity, reducing a bank’s debt load and increasing its capital.

“Even a banker can make money with a steep yield curve.”

Larry KudlowCNBC

4. Bank consolidation.Stronger banks can take

over weaker banks.

5. Public recapitalization.

The U.S. government can inject more capital

into banks.

19

How Much Must the Household Sector Delever?

The debt-to-disposable income ratio for U.S. households is currently 127%.

• To reduce the debt-income ratio to 115%, households must eliminate $1.75 trillion of debt.*

• To reduce the debt-income ratio to 91% (1990-2000 average), $4.35 trillion of debt must be eliminated.*

*Assumes constant incomesSource: Bank of America Merrill Lynch

Debt-to-Personal Disposable Income Ratio

115%

91%

0%

20%

40%

60%

80%

100%

120%

140%

1952 1959 1966 1973 1980 1987 1994 2001 2008

Source: Federal Reserve, Bureau of Economic Analysis, Department of Commerce, Bank of America Merrill Lynch

First Quarter 2009 127%

20

Household Deleveraging Has Barely Begun

“At the end of the first quarter of 2009, the ratio of gross household debt to GDP was a mere 2% lower than at the end of 2007.”

Martin WolfFinancial Times

21

Since consumer credit peaked in 2008, Americans have cut just $110 billion worth of credit, leaving much more deleveraging to come.

Total Consumer Credit OutstandingUSD Trillions

$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

$3.0

Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10

Source: Federal Reserve

$110 billion drop

And More Problems Lie Ahead

Mortgage resets — many from low initial teaser rates — will not peak until 2010.

Many households therefore will face rising mortgage payments, putting additional upward pressure on already high foreclosure rates.

Even foreclosures for prime fixed-rate mortgages are on the rise. In the first quarter of 2009, 5.7% of prime fixed-rate loans were overdue or in foreclosure, up from 3.2% a year earlier.

22

Prime Fixed-Rate Mortgage Foreclosures as a Share of Total Foreclosures

0%

5%

10%

15%

20%

25%

30%

35%

Second Quarter 2008 Second Quarter 2009

Source: Mortgage Bankers Association

U.S. Homeowners Underwater and Sinking

Roughly one quarter of U.S. homeowners are underwater.

Today 24% of mortgage holders owe more on their homes than their homes are worth.

Deutsche Bank estimates this number will increase to 48% by the first quarter of 2011.

Underwater Mortgages as a Percent of Owner Occupied Homes

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

NationalAverage

California Arizona Nevada

Source: Moody’s Economy.com

23

Households Will Be Hit Further By Rising Unemployment

Housing prices have shown some improvement recently, but are not likely to stabilize as long as unemployment is rising.

24

“The economy is now moving from a bubble housing crisis to an unemployment housing crisis. According to a study by the New York Times, 60 percent of the mortgage defaults this year will be set off primarily by unemployment, up from 29 percent last year.”

“Not Out of the Woods”New America Foundation

Unemployment Rate and Broader Measure of Unemployment (U-6*)

0

2

4

6

8

10

12

14

16

18

Jan-1999

Jan-2000

Jan-2001

Jan-2002

Jan-2003

Jan-2004

Jan-2005

Jan-2006

Jan-2007

Jan-2008

Jan-2009

*Total unemployed, plus all marginally attached w orkers, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all marginally attached w orkers.Source: Bureau of Labor Statistics

U-6

Official Rate

Household Deleveraging Depends On Higher Savings

Since the beginning of the recession, households have increased their savings.

The personal savings rate has increased from 1.4% to 4.6% since the beginning of the recession.

The savings rate will need to revert to pre-bubble levels of 6% to 8% in order for household debt to decline significantly.

25

Personal Savings Rate Since the Beginning of the Crisis

0%

1%

2%

3%

4%

5%

6%

7%

2007

-01-

01

2007

-03-

01

2007

-05-

01

2007

-07-

01

2007

-09-

01

2007

-11-

01

2008

-01-

01

2008

-03-

01

2008

-05-

01

2008

-07-

01

2008

-09-

01

2008

-11-

01

2009

-01-

01

2009

-03-

01

2009

-05-

01

Recession Begins

Source: Bureau of Economic Analysis

Deleveraging Would Be Facilitated By Rising Incomes

But, increasing savings will constrain consumer demand unless employment, wages, and weekly hours also increase.

If consumption is to remain at current levels and the savings rate is to return to pre-bubble levels, personal disposable income would have to increase by more than 2%.

Household deleveraging therefore depends on rising wages or increased government transfers.

26

Average Weekly Hours Of Production Workers

33

33.1

33.2

33.3

33.4

33.5

33.6

33.7

33.8

33.9

34

Jan

2007

Apr 2

007

Jul 2

007

Oct 20

07

Jan

2008

Apr 2

008

Jul 2

008

Oct 20

08

Jan

2009

Apr 2

009

Jul 2

009

Source: Bureau of Labor Statistics

Other Household Deleveraging Options

BankruptcyThe Bankruptcy Abuse Prevention and Consumer Protection Act passed in 2005 has made bankruptcy more difficult for many households and businesses.

Mortgage ReliefThe current homeowner relief program has had limited effect to date. New measures will therefore be needed.

Targeted Debt ReliefOther than the debt relief granted to the auto and the financial sectors, few other sectors have benefited from debt relief.

Proposed Relief for Student LoansUnder the “Debt Swap” plan proposed by Senator Sherrod Brown, the federal government would give out-of-school adult borrowers with high cost private student loan debt the ability to refinance $8,000 in debt into low-cost, unsubsidized, federal Stafford student loans.

This would save over $2,000 in interest payments over the life of a typical student loan.

27

Can We Grow Our Way Out of Debt?

Our experience after WWII suggests we can.

Federal debt held by the public declined from 80% of GDP in 1948 to 28% in 1970.

The growth rate averaged 3.9% during this period, outstripping almost continuous government deficits.

Public Debt and GDP Growth, 1945-1970

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

1945 1950 1955 1960 1965 1970

% G

DP

Gro

wth

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

Deb

t H

eld

by

the

Pu

bli

c as

% o

f G

DP

% GDP Growth (left) Debt Held by the Public as % of GDP (right)

.

-11%

Source: Congressional Budget Office, Bureau of Economic Analysis

28

But We Need A Growth Strategy For Today’s Private Sector Debt Overhang

Government will need to lever up in order for the private sector to delever.

Public investment (along with global demand) will need to offset weaker demand from consumption and private investment to spur growth.

Economic growth is needed to increase incomes and wages in order for households to increase their savings and pay down debt.

29

“Budget deficits have an important role to play in facilitating the deleveraging process of the private sector so that it does not cause a massive economic contraction.”

Thomas PalleySchwartz Economic Fellow

New America Foundation

Servicing Public Debt Costs Less Than Servicing Private Debt

Facilitating the reduction of private sector debt by increasing government debt to stimulate economic growth would:

• Reduce the overall debt-servicing burden because interest rates on government debt are lower than interest rates on private sector debt.

• Distribute the burden of debt more evenly and more fairly.

• Relieve stress on U.S. banks and put more risk onto foreign debt holders.

30

Interest Rates on Consumer Loans and Government Debt

0

2

4

6

8

10

12

14

16

18

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Inte

rest

Rat

e

Credit (All) 48-Mo. New Car 10 Yr. Treasury

10-Year Treasury Bond

All Consumer Credit Card Loans

48-Mo. New Car Loan

Source: U.S. Treasury, Federal Reserve

Government Sector Debt Has Room To Grow

“Markets should not focus just on government issuance, but look at the bigger debt picture.… Government debt may be ballooning but corporate and household debt is shrinking. So the total stock of debt in the economy is not rising.”

Dhaval Joshi RAB Capital

The government debt-servicing burden remains less than it was in 1991 because of low interest rates.

Overall U.S. borrowing has declined and is expected to grow slowly in the future, allowing the government to issue more debt without the fear of driving up interest rates.

The global demand for U.S. Treasuries remains high because of the role Treasuries play in providing liquidity to the nation’s financial system and because of the principal reserve currency role of the U.S. dollar.

31

A Public Investment Deleveraging And Growth Strategy

32

Public Investment offsets weaker consumer demand and private investment, supporting economic growth.

Economic Growth raises incomes and wages, allowing households to reduce debt without cutting consumption.

Higher Growth Rates increase tax revenues, bringing down the budget deficit and the federal debt.

Demand

from public investment and demand for U.S. exports spurs private investment, further adding to GDP.