incomes rise. Rising incomes further support debt accumulation. Additionally, the value of our assets increases through this leveraging phase of the cycle because we have a greater ability to spend on assets such as stocks and real estate. The boosted spending on assets pushes their prices higher. The cycle is virtuous in nature: More borrowing leads to increased spending, which improves incomes and asset values, which are the key factors used by lenders to assess creditworthiness of borrowers.
Therefore, the short-term business cycle (three- to seven-year boom-bust economic cycles) operates within this longer-term debt cycle (50- to 75-year leveraging-deleveraging cycles). Each time the Fed lowers rates, the amount of debt in the economy increases; when it raises rates, debt growth slows. The level of debt generally does not materially decline during this phase; the growth of the debt merely pauses temporarily. Then the economy requires additional stimulus and debt levels go up once again. This continues until the total amount of debt in the system is too high and can no longer rise. In other words, balance sheets go through a long period of leveraging as they are constantly supported by higher asset values and incomes. This cannot continue forever as the cycle ends when debt limits are reached. We collectively hit our debt ceiling when we can no longer make interest payments on our debt and our assets have become impaired. At that point, we are no longer creditworthy and have difficulty refinancing our debt and increasing our borrowing. Our aggregate balance sheet is too highly levered relative to our assets and income and must be repaired over time. The typical dynamic is illustrated in Figure 1.3.
Figure 1.3 The Virtuous Cycle of Debt Growth
The virtuous cycle continues until the system collapses under its own weight. Bad loans are made to bad borrowers; defaults pick up and the cycle finally turns. The Fed, in its normal response to weakening growth, predictably lowers interest rates to stimulate more borrowing. This time it does not work. More borrowing is not possible simply because the borrowers are no longer creditworthy and the lenders, after recently being burned with massive defaults, have stopped lending. Rates fall to zero and the business cycle unexpectedly does not revert this time. The market is stunned and the economic machine literally stalls. Since total spending must come from money plus credit, and credit growth has reversed, total spending falls precipitously. This surprise creates fear, and those with money significantly cut their spending, which further exacerbates the problem. The cycle reverses after decades of going in one direction and the deleveraging process begins. It's akin to a speeding car on a crowded freeway suddenly shifting into reverse. Horrific accidents are inevitable. This is exactly what happened to the U.S. economic machine in 2008, and it is the exact same experience that captured the nation in 1929 at the onset of the Great Depression. These periods are normal responses, but they just don't repeat frequently enough for people to fully recognize and understand them.
The deleveraging process is just that: a process. It is inescapable and will repeat over and over again. The process is a largely unavoidable part of the economic machine because it is fundamental to how the machine is built. A credit-based economic system like ours is dependent on increased borrowing to finance spending, and there is great incentive to keep the cycle going as long as possible. It works well for a long time until the debt cycle reverses. When the cycle changes course, the process is self-reinforcing, just as it was during the upswing. In contrast, the normal business cycle is self-correcting. When the economy is too strong, tight policy causes it to slow, and when it is too weak, loose policy promotes an improvement. The long-term debt cycle feeds off of itself, however. I have already covered how this is the case on the way up. The opposite set of conditions drives the self-reinforcing process on the way down. I can't borrow any more so I spend less than I spent before. My reduced spending brings down your income so you spend less and that in turn negatively impacts someone else's income. The reduced overall spending and selling of assets to pay down debt also drives down asset prices, which hurts the value of borrowers' collateral, further degrading their ability to borrow. I spend less because I am earning less but also because I recognize that I have too much debt and want to take some of my income and pay down debt to gradually repair my balance sheet. This self-feeding dynamic causes a severe economic contraction in the beginning stages of the deleveraging process. The weak economic climate exacerbates conditions and confidence and can quickly lead to an economic depression. This is why a depression is not simply another variant of the normal business cycle recession. It is caused by a reversal of the debt cycle, not by the Fed tightening interest rates too much, which is precisely what causes normal recessions. Most people fail to appreciate this critical distinction because of a general misunderstanding of the mechanics of the economic machine and a lack of appreciation of the difference between the short-term business cycle and the long-term debt cycle.
How does all this relate to where we are in the cycle currently? The simplest way to measure the total debt to income ratio of a country is by taking all the debt in the economy and dividing it by the country's income, called the gross domestic product (GDP). This is a very basic measure of how indebted a nation is. You would follow the same logic to assess whether you personally have too much debt relative to your income. The country as a whole is merely a sum of its parts and is no different.
Figure 1.4 illustrates the debt level of the United States over the past century. The last deleveraging process in the United States took about 20 years to run its course. The country reached its debt ceiling in 1929 (after the Roaring Twenties) and deleveraged until around 1950. It subsequently enjoyed the tailwinds of the leveraging cycle from the early 1950s until 2008 and is likely now once again saddled with the headwinds of the deleveraging process, and will likely be for a decade or two. The ratio of debt to GDP in 1929 was about 175 percent (it jumped to 250 percent during the Great Depression because GDP fell faster than total debt). In 2008 the ratio hit 350 percent, twice the level that caused the Great Depression! It took about 60 years of leveraging to achieve such a high ratio. Last time it took 20 years to bring the debt-to-GDP ratio back to a normal level; how long will it take this time, given the more extreme starting point? It certainly will not happen in a few years.
Figure 1.4 U.S. Total Debt as a Percentage of GDP (1900–2013)
Source: Bridgewater Associates.
In most cases throughout history, economies live through a painful depression during the deleveraging process as the self-reinforcing negative feedback plays out. This process produced Japan's so-called lost decade, which began in the early 1990s. Europe is suffering through the same fate today, and even countries like Australia and Canada remain vulnerable to that critical inflection point, given their high debt levels.
Given this discouraging backdrop, why has the U.S. economy not fallen into a depression during the present deleveraging process? What makes the current period seem not as bad as the Great Depression or other similar depressionary environments? Deleveraging produces a persistent headwind for the economic machine and prevents it from functioning in its normal fashion. This force is exceptionally powerful and if left alone to run its course, extreme economic and social hardship is a near certainty. Fortunately the central bank has the tools to manufacture a smooth deleveraging, one in which the debt ratio gradually declines over time, but with positive growth through the process. Recall that the Fed's main policy tool is having control of short-term interest rates. Thus, their first step is to lower rates to zero. Normally during the deleveraging process this does not work because high debt levels prevent the normal leveraging response to lower rates. People can't borrow more, even though rates are extremely low, because they already have too much debt and are no longer creditworthy.
Recall that spending must be financed by money or credit. The credit pipelines have been impaired so the Fed is not able to increase spending by stimulating borrowing. Therefore, it must create money to make up for the spending falloff from declining credit. If spending must be financed by money or credit, and credit is constrained, then the only tool left to stimulate more spending is to
