The chart below shows household debt relative to the gross domestic product of the United States. I use the term household debt to refer to the sum of consumer credit and residential mortgage debt.

Household debt levels increased steadily relative to GDP after the Second World War and stabilized at around 40% of GDP in the 1960s. For twenty years thereafter, from about 1965 to 1985, debt as a percentage of GDP remained relatively constant. During that time nominal debt levels increased, but no faster than the economy grew.

During the 1970s the average annual compound increase in money supply, as measured by M3, was 11.4% -- the highest level of monetary inflation in the history of the US other than now. By the way, if anyone believes that standards of living improve when governments create money, consider that median personal income levels declined by 5.5%, short term interest rates more than tripled, commodity prices soared and the dollar lost considerable ground on foreign exchange markets during that period, resulting in a severe reduction in living standards.

The fall of the US dollar and rise in the oil price during the Seventies put an enormous amount of US dollars in foreign hands. These petro-dollars were then recycled back into the US economy when foreign holders of US dollars deposited them into US bank accounts, and the US banks lent them to US consumers, boosting household debt relative to GDP in the 1980s. Roughly speaking, household debt relative to GDP increased by 25% from 40% of GDP to 50% of GDP between 1984 and 1989.

The increase in available US dollars stimulated spending and investment that drove up stock and bond prices. New and innovative investment tools were created, in particular “portfolio insurance” that purportedly would prevent losses in large portfolios from stock price declines, and arbitrage strategies that attempted to gain from price discrepancies between stock indices and futures contracts. All of these combined to fuel a stock market boom that ended in October 1987. But instead of letting the market deflate the excesses the Fed stepped in and supplied emergency liquidity to banks and pressured them, in turn, to supply emergency liquidity to brokers and dealers. The Fed also quickly lowered the overnight Federal Funds rate and engaged in very visible open market transactions to boost the liquidity of the financial sector. The Fed was very concerned about systemic risk to the financial sector and, by extension, the broader risk to the economy. However, by intervening, the Fed then and there set a dangerous precedent: investors and businessmen learned that no matter how irresponsible they get, the Fed would step in to save them.

Fast forward to the 1990s, when a series of currency crises resulted in a tremendous influx of foreign capital into the US. During a currency crisis capital seeks a safe haven and at the time US economic growth was robust, US interest rates were competitive and the US was deemed to be the safest and largest economic jurisdiction making it an attractive destination for flight capital. It started in 1992 with the collapse of the Brazilian real and was followed by the Mexican peso crisis, which was followed by the Japanese yen devaluation and by the Southeast Asian crisis, the Russian ruble default, the euro collapse, and several other currency crises of lesser note. The end result is that the US dollar exchange rate more than doubled and in excess of a trillion dollars of foreign capital moved into US bank accounts.

The effect was similar to the recycling of petro-dollars, only at a much grander scale. The influx of capital caused US interest rates to fall, spending to increase, fueled a bond and stock market rally, and laid the foundation of the tech bubble.

When the tech bubble burst the Fed made good on its unwritten promise and rewarded businessmen and investors by lowering interest rates, creating more money, and laying he foundation of a brand new bubble to speculate on: real estate. As a result of innovative new financial structures invented during the 1990s that allowed for the securitization of debt and convoluted derivative instruments that promised there would be no risk no matter how poor the credit quality of the debt had become, household debt levels relative to GDP increased almost 80%, from 50% of GDP to a hair under 90%. It was like the 1980s but on steroids.

Bull markets and their resulting bear markets since the 1950s and up until about 1985 were accompanied by relatively little debt creation and were thus easily corrected without material systemic risk to financial institutions or the general economy; nor were there many dangerous, innovative new financial structures and investment tools that put financial institutions at risk of collapse. The pain of those bear markets did not last very long and economic growth soon resumed. The 1987 crash should have been worse for the massive increase in debt and the financial instruments used, but instead of letting the market sort the mess out, the Fed stepped in.

The rapid increase in debt relative to GDP meant that the stock market crash of 1987 posed more risk to the general economy and financial institutions in particular (brokers, banks and clearing houses) as consumers and investors were far more leveraged and a series of defaults and bankruptcies could therefore have had a more profound impact on the economy, hence the justification for the Fed to do something.

In comparison to the crash of 1987, the current level of household debt to GDP is more than twice as high and thus the systemic risk to the economy is substantially greater. This bear market is unlike any other in recent history.

Debt creation over the past ten years has allowed US consumers to live substantially above their income levels, and their spending provoked capital allocations in manufacturing and other sectors of the economy that will now translate into massive increases in excess capacity. Whenever a bull market results in excess capacity, as opposed to merely excess inventory, an economic depression is required to cleanse the system, as during the Great Depression that followed the Roaring Twenties. It is why I believe the current economic downturn will not merely be a recession.

A big difference between now and 1987 is that interest rates in 1987 were more than twice as high as they are today. That meant the Fed had greater flexibility than it now has. The real risk to the economy and consumers is not that the Fed won’t do enough, but that the Fed is incapable of controlling medium to long term interest rates.

The Fed can set the overnight interest rate but to directly influence longer term interest rates the Fed has to go into the market and buy bonds. When the government runs a fiscal surplus this is possible, but when the government runs a deficit, it funds that deficit by constantly issuing new bonds. It therefore becomes impossible for the Fed to materially impact the market since it has to soak up any surplus supply of bonds in excess of what the government needs to issue to fund its deficit -- a practical impossibility.

Consider now that during the 1970s, when monetary inflation was running at just over 11%, the ten-year interest rate on government bonds increased from 7% and peaked at over 15% in 1981. The ten-year interest rate is currently 3.52% while the year-over-year increase in M3 for February was 16.9% (and over 17% for the first two weeks of March). Current monetary inflation is 50% higher than the average during the 1970s yet interest rates are only 50% of what they were in 1970 and less than 25% of where they were in 1981. It will be impossible for the Fed to keep long-term interest rates at current levels and as interest rates rise, so will the cost of servicing all that debt.

If interest rates rise to 15%, which is where they were in 1981 when monetary inflation was much lower than it is today, then it would require almost 14% of GDP just to pay the interest on household debt. That would seriously hurt consumer spending, which accounts for 70% of GDP, and so the downward spiral is clear: an increase in interest rates would reduce consumer spending, which would reduce GDP, which would reduce incomes, which would make the debt burden more burdensome, which would further reduce consumer spending…

Total US debt (household, corporate, federal, state and local government, and financial sector debt) is approximately $53 trillion. That does not include the unfunded liabilities of the government, such as Medicare, Medicaid, Social Security and Pension liabilities; this is the direct outstanding debt only. At a 15% interest rate, the interest on the US outstanding debt would come to approximately $8 trillion per year. That is almost 60% of GDP -- clearly it would be impossible for the US to pay the interest on its debt, which means the Fed will inflate and devalue the dollar thereby devaluing the debt itself.

Foreign holders of US debt are not stupid. At some point we will see a panic out of the dollar and out of US debt and that will drive interest rates up. The combination of declining real incomes and rising interest rates on historically high debt levels that cannot even be serviced at the current low interest rates is going to decimate Americans’ living standards and since they are the most ferocious consumers on the globe, will impact virtually every economy.