This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org
This article is from the September/October 2020 issue.
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The U.S. economy is in a bad way. An unprecedented pandemic-borne recession that saw the highest rate of swift job loss in history has strained a system—marked for decades by almost unfathomable inequality—to a breaking point.
None of this was inevitable. The widespread decimation of livelihoods around the country was aided by an inept and sluggish response to the pandemic by the White House. And the refusal of some states to boost their unemployment insurance reserves following the 2008 crisis, coupled with an archaic approach to benefits for the jobless, made matters even worse. There is, however, another underlying, subtle, and momentous threat that is concerning economists and the Federal Reserve and could endanger millions of Americans. And that threat is high levels of private debt. As I write, the mass of U.S. private debt (debt owned by individuals and companies) is roughly three times the size of U.S. GDP, and the total debt load is higher than it’s ever been—this is true in mortgage, auto, credit card, corporate, and, especially, student loan markets. With such high levels of indebtedness, the current recession has the potential to cause even more severe economic hardship and greater inequality.
Of course, economists tend to argue that some amount of debt is essential to a growing economy. Through moneylending and the extension of credit, the argument goes, countries can be more efficient. It makes sense for an individual to take on debt when that debt can increase their purchasing power in the short run and help them finance investments. After some time, an individual will pay back that debt and will hopefully have more wealth than they began with. Proponents of modern finance argue that the large sums of money the financial sector takes in are justified due to the sector’s overall impact on economic growth through this mechanism. So why the concern about private debt?
Building a House of Debt
The finance-enabled growth in private-sector debt in the last half-century—from 50% of national income in 1950 to 170% in 2006—has also been a force for destabilization and rising inequality. As the credit supply expanded and reached a greater number of people after the 1980s, private debt grew considerably leading up to the 2008 recession. The rise in credit as a percentage of GDP (i.e., leverage) left the economy more vulnerable to economic shocks when, for example, peoples’ debts became unaffordable. And this is precisely what happened in the 2007–2008 financial crisis, when millions of people lost their homes because they could no longer afford their monthly mortgage payments (let alone pay them off).
As debt grew, so, too, did the size of finance in the U.S. economy. In 1947, the finance, insurance, and real estate sectors made up only 10% of GDP. That number has more than doubled since then. And during this same period, finance’s share of nonfarm income increased fivefold to 50% of the national total. The U.S. economy consequently bifurcated, separating into an asset-holding class of creditors and investors on the one hand, and a class of debtors with little wealth on the other. Even though the ratio of credit and debt to GDP declined slightly after 2008, it remains historically high. And the decline in household debt in recent months is largely a consequence of a generous economic stimulus. Now that the $600-a-week unemployment benefits boost has expired, falling household debt is unlikely to continue.
Prior to this crisis, evidence seemed to indicate that, if the U.S. glut of private debt was not an immediate crisis, it would surely contribute to making an already catastrophic pandemic-induced economic crisis even worse. U.S. corporate debt, which some economists argue has contributed to higher volatility, sits at over $10 trillion. That amounts to an unprecedented 47% of 2019 GDP. Meanwhile, U.S. household debt reached a new high of $14 trillion in 2019. According to the Federal Reserve, Americans currently owe almost $1 trillion in credit card debt, which is the highest total ever recorded. Delinquencies and overdue payments were on the rise prior to this past March, especially among young people, and they have increased considerably since then. Mortgage debt also reached an all-time high of $15.8 trillion, although federal relief measures have allowed much of this debt to fall into forbearance.
It is true that, relative to GDP, all of these forms of debt are lower in value than where they were prior to 2008 (see Figure 1). Yet the ratio of private debt to GDP is still double what it was in 1970 and exhibits less stability. Beyond this, there is also little reason to believe that, in a country that is rapidly becoming less equal, GDP gains necessarily imply a smaller relative debt burden for lower income individuals. Since nearly all of the post-2008 income gains went to the top 1%, it makes little sense to say that an increase in aggregate debt among the less-wealthy should be significantly offset by a rise in earnings that was consolidated among the wealthy.
Perhaps the most egregious form of debt, however, is the $1.6 trillion of outstanding student loans, which is at an all-time high in both relative and aggregate terms and was entirely unsustainable even prior to the crisis. This particular story has a kind of tragic irony to it; college used to be billed as a nearly certain way to obtain a decent middle- or upper-income life. Yet, instead of proliferating opportunity, higher education, much like the rest of the economy, has seen a stark inequality of outcomes emerge. On the one hand, elite universities can give students chances to earn high salaries. Yet many students take on high levels of debt for degrees that are far too expensive and give them far too little in financial return. This second group of students struggles to find decent employment that can help them pay off the debt. The situation has become even worse in the past few years, as higher returns on college degrees became concentrated among an even smaller pool of graduates than a decade ago. With rising tuition costs and dismal earnings potential, it is unsurprising that as much as 40% of U.S. students were on track to default on their debt by 2023.
An Income Shock ... and Deflation, Too?
All of this was before the “Great Lockdown” of 2020. This current recession and pandemic may induce both enduringly higher inequality and a deeper downturn through two mechanisms. The first of these deals with the shocks to people’s incomes. It has been widely reported that social distancing measures have disproportionately hurt low-income workers, who are more likely to work jobs that require being in close contact with others. Higher-wage workers, by contrast, are more likely to have the option to work from home. Low-income workers also tend not to have savings—famously, 40% of Americans could not afford an unexpected $400 expense. Moreover, lower-income workers are also heavily indebted. This debt burden, coupled with an income shock, could severely reduce the financial well-being of the least wealthy Americans, leaving them vulnerable to defaults, massive declines in spending, and a deeper recession.
Beyond this, however, some economists are worried about the possibility of deflationary pressure producing a severe debt crisis. Deflation—that is, when the price of goods and services declines—has been rare in U.S. history. It occurs when either demand collapses relative to supply and/or when supply increases relative to demand. In the 19th century, deflation was generally caused by an increase in supply rather than a collapse of demand; however, the first four years of the Great Depression were as bad as they were in part because the decline in prices was spurred by a demand-side collapse as well.
The United States hasn’t seen deflation since then; however, the current crisis is rekindling fears of its resurgence. Economists are exploring the conditions under which deflation might occur today. A recent study out of M.I.T. by Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Iván Werning, for example, showed that a “negative supply shock”—a sudden reduction in supply—could catalyze a “negative demand shock”—a reduction in how much consumers are spending—that is far greater than the initial supply shock. Perhaps the most important finding of the study, however, is the observation that deflationary pressure on prices is more likely when shocks are concentrated in certain sectors more than others. If this thesis holds up, the social distancing practices that have been put in place could catalyze deflationary pressure.
For now, this point is mostly theoretical. At the beginning of the lockdown in March and April, consumer prices fell by 0.8% (the largest monthly decline since December 2008). That drop was largely due to a collapse in oil prices; however, prices did fall sharply in the sectors most affected by the lockdown, such as air travel, restaurants, housing, and hotels. Since then, the slow reopening of the economy has corresponded with a rise in consumer prices by 0.6%. Yet, if lockdown measures are brought back in the fall amidst a second wave and an atrophied political appetite for stimulus funding, deflation may be possible in the final two quarters of 2020. Though it’s unlikely right now, if deflation did occur, it would be threatening to an economy with high levels of private debt because the real value of debt would rise, making it harder to pay off. As the Financial Times summarized, “Deflation would make high corporate and government debt loads even harder to manage as interest payments stay fixed but wages, prices and tax payments all fall in cash terms.” So, if I borrowed $10,000 to fund a year at college, deflation would mean that the real value of that $10,000 is now greater than the $10,000 I initially borrowed. And so that debt has just become harder to pay off. Another way of putting it is that deflation makes real interest rates (corrected for inflation) for borrowing higher and counteracts the Fed’s attempts to get the economy going by lowering interest rates. This is good for people who hold hard cash or are creditors, but it can be disastrous for people or organizations with high levels of debt.
Inequality by Design
In addition to making debt potentially intolerable, this recession’s shocks to income (especially low-wage incomes) and possible deflationary pressure may widen inequality. This is true for two reasons because, just as low-wage individuals are more likely to lose their source of income, they are also more likely to be victims of excessive debt. It seems increasingly likely that things improve faster for higher-income households. Meanwhile, lower-income households (especially heavily indebted ones) may struggle to recover as quickly, especially as stimulus provisions continue to dissolve.
This reinforced widening of inequality is not accidental. It is a consequence of an economic and financial system that has sought to reinforce existing power structures and uphold the towers of privilege that have existed throughout U.S. history. These high levels of debt are also both a consequence and partial cause of a historically unequal economy. From 1980 to 2014, the share of incomes for the bottom half of the U.S. population declined from 20% to 12%. Meanwhile, the top 1% saw their share grow by the same amount—from 12% to 20%—during that same period. And today, the wealthiest 20 Americans have as much wealth as the bottom half of households combined. This inequality increases the demand for credit among lower-income households, which struggle to keep up. And it can also equally reduce total spending, producing deflationary pressure and making longer-run growth weaker.
On the other side, this high inequality creates clear divisions in who can save money (see Figure 2). With a greater share of their incomes spent on consumption and on financing debt, ordinary people have been increasingly unable to save. The weakened ability of the bottom 90% of the income distribution to save has meanwhile been matched by a spike in savings among the rich. And contrary to what conservative commentators argue, this glut in savings, which amounts to between 2.5% and 4% of national income, is often held as unproductive cash that is not funneled into investments that grow the economy.
These high levels of debt also contribute to inequality because it provides an opportunity to earn money through interest for the higher-income households that are able to save and invest. Consider, for instance, the capital Wall Street investors have spent purchasing student loan debt in the form of student loan asset-backed securities (SLABS). The financial instruments at work here are similar to the ones used in the mortgage market that catalyzed the 2008 financial crisis—student loans are packaged into massive securities, bundled alongside many other students’ debts into one investible item. So far, $600 billion worth of SLABS have been issued, with another $170 billion still outstanding. This creates opportunities for individuals who have access to additional cash to directly profit off of an unequal economic system with the knowledge that the government will likely bail them out if their investments turn sour (in the case of student loan debt, which is generally guaranteed by the government, that promise is even explicit).
That is partly why the rise of debt and credit amounts to a distinct transfer of wealth and power, with credit and debt growing in congruence with the collapse of savings for the bottom 90% of the income distribution. The impact of inequality is self-reinforcing because the rise in the income and wealth gap since the 1970s—on account of technology, trade, shifts in tax and social security policy, and financialization—has increased demand for credit. Meanwhile, the extension of credit in real estate markets where housing is scarce—e.g., urban centers—led to higher home prices and increased demand for further credit. The resulting spike in leverage led to higher private debt and further transferred ownership to a more rarified group of individuals. This, in turn, made inequality worse, which necessitated more credit. And then the process repeats.
A Moment for Progressive Change
America’s private debt problem can help us explain why this recession is so damaging. Too many people are burdened with debts they cannot afford to pay back, and the threat of those debts increasing in value during this crisis could bring the U.S. economy to a breaking point. Moreover, social-distancing practices have disproportionately hurt low-income workers, who many of whom work in the industries that have been hit the hardest, including manufacturing and hospitality. These workers also tend to hold more debt as a percentage of their earnings, and so the dual combination of a loss of income alongside high indebtedness and a potential for deflation could be catastrophic. If the United States does not continue its stimulus regime, we may well see something similar to what happened in the Great Depression, when the loss of incomes and the rise in unaffordable debts led to a decline in spending and a cascade of asset liquidation. This amounted to a massive collective loss of wealth. It doesn’t need to be this way. Greater debt relief, continued large direct transfers to America’s most vulnerable, profit caps on firms benefiting from the crisis, and penalties for executives who enriched themselves while not building a sufficient rainy-day fund would be a good start. Yet in order to address the structural problems that make the United States uniquely unfit to deal with this recession, we must consider far more substantive changes to the very nature of our economy. This begins with greater attempts at wealth and income redistribution as well as universal access to health care and the proliferation of affordable quality education.
Beyond all of this, the United States should also reconsider the way that it approaches credit and debt. Lower inequality would likely decrease the need for such heavy financialization, and it is worth pursuing a system that is less dependent on credit. Rather than forcing low-income households to fund their participation in the modern economy through indebtedness, a new progressive spirit bending toward equal opportunity could bring stability to the economy and a higher quality of life to more people.
Despite understandable pessimism, there is precedent for this kind of shift. The New Deal and Great Society programs of the 1930s and 1960s, respectively, reduced inequality and helped usher in a stronger middle class, leaving the United States better prepared for a downturn and to maintain long-run growth. This crisis provides both an ample and urgent opportunity to pursue ambitious progressive reforms once again.
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