Debt Excess and the Liquidation Process in a Historical Context

We are proud to say this article was published on Casey Research’s The Room this Friday. If you are not familiar with the work of Casey Research we suggest you check it out.

Note; we use the conventional GDP typology as opposed to GDC, since readers unfamiliar with will not recognize GDC as a term.

While some people believe there is no such thing as “good debt,” any more than there is “good cancer,” we disagree.

That’s because pooling resources to invest in capital-intensive projects is an essential component to economic growth. Under most circumstances, an economy without debt would be both poor and stagnant.

One contributor to the misconception about debt has to do with the Keynesian aggregate—the idea that all that matters in economic analysis is the sum of individual actions, not the individual actions themselves—as it fails to distinguish between various types of debt. Yet one kind of debt is self-sustainable, in that it produces more capital than it consumes. By contrast, unproductive debt consumes capital without the prospect of producing a future return.

If such debt becomes excessive relative to the underlying productive capacity, it will inevitably trigger a massive reallocation of resources. That’s because it drains capital from the economy, requiring companies and people to sell assets or reduce expenses in an effort to meet current obligations.

If the misallocation of resources is allowed to be resolved through normal market actions, the process—as painful as it may be—will typically take only a year or two. On the other hand, if the government steps in and takes extraordinary efforts to avoid reckoning day, the consequences can be decades of economic underperformance such as has been seen in Japan. In the worst case, it can lead to the sort of collapse experienced by the Soviet Union.

Simply put, systems based on human behavior need constant volatility in order to remain viable and vibrant.

Nassim Taleb’s new book Antifragile discusses this point in some detail, explaining that every act taken to manufacture economic stability exponentially increases its fragility.

The idea that central bankers can create eternal bliss by targeting an arbitrarily compiled index of price is the height of hubris. Gordon Brown, Chancellor of the Exchequer for 10 years under New Labour, went so far as to announce the end of boom and bust cycles because of the clever interventions of the Bank of England.

The situation could be compared with two continental plates that push against each other for hundreds of years. On the surface everything seems fine. The ground is literally rock solid, but brewing underneath is latent capriciousness. All of a sudden something gives, and the system goes from perfect tranquility to massive volatility.

This is why economies need to adjust every single day and relative prices must be allowed to perform their function. Which is very much not the case in today’s world.

Which begs the question, “How long can the status quo be maintained in an economy with an excess of unproductive debt?”

In the case of Greece, the country’s government was able to kick the can down the road for the better part of 20 years before suffering seismic collapse.

For capital-rich societies such as the United States, excesses in unproductive debt can go on for decades before the system breaks down. That’s because, in addition to the stock of capital in place that allows for massive capital consumption, the creditworthiness built up during the expansion phase allows the country to continue attract lenders who believe the country will always honor accumulated obligations.

As they will ultimately learn to their chagrin, at the end of a debt cycle credit is allocated increasingly to consumption, which will at some point exhaust the system’s ability to maintain the status quo… after which, the manufactured stability comes crashing down.

Various Forms of Debt

Trying to answer the question of “how long,” we find it constructive to divide debt into three categories based on the criteria of capital consumption.

We’ll start with liabilities taken on with the intent of making a subsequent sale at a profit: in other words, debt that increases the capital base, such as business loans. We call this “good” debt.

In the second category, we have mortgages, financial sector loans and foreign debt, all of which are classified as “bad” debt. It may make sense to take on a mortgage to buy a house closer to work, but the process does not create additional capital. On the contrary, it is consumptive in nature. Such debt can be detrimental to prosperity if capital allocation into “bad” debt becomes systematic, as witnessed during the housing bubble.

In the third and last category, we have debt that allows pure capital consumption, such as consumer credit and government debt. This kind of debt decouples the process of production from consumption, and is parasitic on the productive structure. We label it “destructive.”

It should be obvious that consumptive debt cannot exceed productive debt for an indefinite period of time. At some point, production must be allowed to outstrip consumption for society to grow. At a minimum, production and consumption must equal each other to avoid collapse.

However, a system that coercively allocates debt into consumption to maintain the semblance of prosperity, such as seen in fiat money systems, will be prone to booms and busts.

Which brings us to the present. Looking at debt aggregates based on our definitions, and studying the US in the post-WWII era brings us to a shocking conclusion. The debt buildup has been exclusively in the “bad” and “destructive” categories, while “good” debt has remained relatively constant as a share of GDP.

Even worse, when markets tried to cleanse society of bad debt in 2008, the government took action and used destructive debt to bail out the defaulting bad debt.

Sources: Federal Reserve Flow of Funds Accounts; Bureau of Economic Analysis; own calculations

So How Long Can Excess Debt Be Sustained?

To answer the question, we started by putting debt cycles into a historical perspective by searching for long-enough time series of total credit market debt to allow proper study.

Unfortunately, private debt data prior to 1916 does not exist, so we made a proxy based on various balance sheet items from the banking industry. Still, it is impossible to make the classification based on our three debt categories pre-1916, so we rely on economics 101, telling us that the incremental capital-output ratio will drop for a marginal increase in debt. In other words, as leverage exceeds a certain point, it is fair to say that the proportion of bad and destructive debt rises relatively to good debt.

In our data series, we find that the US Civil War collapsed private credit to such a magnitude that, despite rapidly rising public debt levels, overall leverage fell to only 50% of GDP. After the war ended, leverage rose virtually without interruption for almost 70 years until the 1930s, peaking at an unsustainable three times GDP, thus making the subsequent resource reallocation inevitable.

Total leverage then fell for almost 20 years, until it reached 1.3 times GDP in 1951. From trough to trough, the cycle lasted close to 90 years.

As you can see in the chart below, the current cycle—which kicked off in the 1950s—is similar in duration, as it took almost 60 years to reach peak leverage levels; but this time the peak was 3.8 times GDP!

In terms of deleveraging, we are only three years into the cycle. Over that brief period, only 20 percentage points’ reduction in the total debt ratio has been achieved. In the 1930s, the same ratio fell more than 80 percentage points over an equal period.

Sources: Historical Statistics of the United States, Colonial Times to 1970This Time Is Different: Eight Centuries of Financial Folly; Federal Reserve Flow of Funds Accounts; Bureau of Economic Analysis; own calculations

Our second chart shows a clear negative correlation—and we dare say causation—between leverage and growth. When credit is flowing to self-sustainable projects, growth is high due to a low level of capital waste.

However, as leverage rises, the marginal efficiency is bound to drop ever lower until it becomes a drag on the productive parts of the economy. When credit allows people to go on vacation or enables government boondoggles, scarce capital is wasted, and growth will be affected.

We note that the US economy seems to work well on a leverage ratio between 1.2 and 1.6 times GDP. The late 1800s and mid 1900s were periods of high growth, while the early and late 1900s, where the leverage ratio was high, were characterized by low growth.

This is easy to understand. When the leverage ratio increases, the composition of debt becomes increasingly unproductive, which drags growth down. Since productive projects must not only fund themselves, but also help fund the unsustainable capital consumption emanating from unproductive projects, capital waste increases.

Sources: Historical Statistics of the United States, Colonial Times to 1970This Time Is Different: Eight Centuries of Financial Folly; Federal Reserve Flow of Funds Accounts; Bureau of Economic Analysis; own calculations

In light of the recent debacle around Reinhart and Rogoff’s claim that growth is adversely affected by government indebtedness, we suggest a look at total credit will be more fruitful. It does not matter if the government consumes capital or if it is the private individual—what matters is the level of capital consumption relative to production.

If we create a system with explicit bailout facilities that allow debt to be allocated into unproductive economic activity, we must not be surprised when the very same system implodes in a wave of volatility. The very act of collectively guaranteeing and consequently bailing out unsustainable debt in the name of preserving a flawed system and suppressing volatility exacerbates capital consumption, which inevitably leads to cataclysmic results.

When leverage rises above, say, 1.6 times GDP, the additional debt becomes a drag on economic growth. However, the share of productive debt will still be able to maintain the unproductive part, but growth is increasingly jeopardized. If leverage is allowed to continue even higher, it will lead to outright retardation, as a parasitic capital structure will eventually kill its host. This is the ultimate cost of a managed system!

Investment Implications

With the debt-to-GDP ratio currently upwards of 3.5, the idea that we are on the precipice of a 20-year-long debt-deflation period certainly gives credit to the many pundits predicting deflation. In the decade following 1929, consumer prices in the US fell by an average of 1.7% annually, and leverage levels did not rise again until 1951.

Are we not facing the same situation today? Once again we have witnessed a massive buildup in debt which will have to be liquidated, akin to the situation in the 1930s. How do we get down to a sound leverage ratio without facing massive deflation? Remember, credit and debt is money; and if credit and debt contracts, it follows that money also contracts, which of course is the very definition of a deflation.

The major difference, of course, is the changed role of the Federal Reserve. In the 1930s, the Federal Reserve was a reactive organization which would lend money against good collateral at a penalty to avoid a liquidity crunch. Today, on the other hand, the Federal Reserve is a proactive organization tasked with managing the economy. Specifically, the Federal Reserve is mandated to avoid deflation at all cost.

This means that all outstanding financial liabilities with a negative NPV must be monetized in order to elude a cascading debt deflation that would occur were the market left to itself.

In the 1930s, the mainly fiscal and regulatory policy responses stopped the economy from correcting excesses. Today, policy makers are leaning much more toward an activist monetary policy to sort out the mess. The buildup was similar; the response by the Fed is different.

While we see the merit in both schools of thought, until we see some semblance of evidence to the contrary, we believe the Federal Reserve will err on the side of too much inflation that at some point will spin out of control.


The idea that a social system should be deprived of volatility creates perverted incentives which firmly place the system on a path to self-destruction. In terms of leverage levels, it allows extremes to be reached.

We are currently at the peak of a 60-year-old debt supercycle that is imploding before our eyes. The question we need to ask ourselves is what this implosion will look like. When a system is managed to the extent it is today, a free float of market forces would undoubtedly lead to a massive liquidation of outstanding debt.

However, a proactive central bank coupled with a political elite that find it expedient to rely on monetary manipulation rather than structural reforms is historically a well-trodden path toward rampant inflation.

It all comes down to this: Do you think the Federal Reserve has the political will to monetize trillions in bad debt? If yes, then you need to invest for inflation, i.e., buy precious metals, real estate and other hard assets. On the other hand, if you think the Federal Reserve will stand by and allow the undeniable deflationary force to get the upper hand, you should be long cash and bonds.

We find it fitting to end today’s missive with a quote from the great Austrian economist Ludwig von Mises (Human Action, page 572):

“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”


  1. How does one draw a precise distinction between, say, good and bad debt? In my mind, a debt can be placed within the continuum of “goodness” based on its ability to create capital. Anything that inherently (or more readily) creates capital also tends to involve objects with low liquidity that require or induce savings. For example, a business owner who borrows money for a piece of technology and subsequently must save in order to expand and build upon his business versus a person who takes a cash-type loan for immediate consumption. Am I on the right track here? But that doesn’t necessarily answer the question of drawing precise distinctions — what of purchasing real estate as an investment in a bull market like today? Why couldn’t one consider that good debt? Also, regarding student loans: this seems partially dependent upon the economic conditions of the time period. Clearly, an empirical investigation shows that a large percentage of recent students are failing to pay their loans or have salaries that are negligibly able to pay off the debt. This is at least in part due to a poor job market — not necessarily a generality though. Can you elaborate?

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