A Bit of Economic History: GD Part 4.12

A Bit of History

There were a series of economic shocks in the 1970's as the US reached peak oil production and became more reliant on imported oil (despite Pres. Carter's initiatives to reduce US dependence on oil imports). This culminated in two oil shocks/energy crises- in 1973 and 1979- which led the US economy into recessions. 

Beginning in the late-70's, interest rates were sky-high. Prime Rate in 1980 reached 21.5%! That's unbelievable in today's economy. It was expensive to borrow money, and Prime Rate (Prime Rate is a bank lending rate, not a personal savings rate-- but it directly affects personal rates) didn't get below 10% "permanently" until 1990, although it did return to more reasonable levels in the mid-80's.  

There was a high correlation between inflation rates and Prime Interest Rate from 1962 until 1992, with both rates peaking during the late 1970's and early 1980's.

This had a stressful effect on the economy as unemployment was high. People who did have jobs were less willing to make big purchases and more likely to save their money, even though intense inflation was eliminating portions of their gains from savings.

The election of President Ronald Reagan in 1980 became a pivot point for the US economy: tax rates were slashed, financial regulations were relaxed, and interest rates were lowered- mostly due to his policies. Americans were offered credit. This was not new, it was just more available-- and much cheaper than before. 

During the 80's and 90's, international trade agreements (like NAFTA) had been struck and industry had been drastically downsized in the US. Manufacturing jobs had fled overseas to take advantage of the embarrassingly low labor costs, and much of the domestic workforce had become engaged in the service sector of the economy. Meanwhile, the financial sector was ballooning to unprecedented proportions (see: The Crash of 1987).

Despite the reduction in manufacturing jobs, by the mid-1990's more Americans were employed than ever before (mostly because of a strong showing of women entering the workforce), the median income had risen, and technology industries were making fantastic gains. 

Beginning in 1991, Prime Rate fell below 7%, and has not been above 10% since then. By the mid-90's inflation had fallen to more reasonable levels and individuals were able to shore up savings, making them more optimistic about their finances. 

In that environment, you'd be crazy not to borrow- especially after the stranglehold the high interest and inflation rates of the late-70's and early 80's put on individuals and businesses.

Instead of saving up your salary to make a large down-payment on a house with a modest mortgage, you could now more comfortably become a homeowner (see: the American Dream) with a smaller down-payment. Trouble paying your monthly bills? No problem-- put them on the credit card. Want a fantastic job with a high salary and benefits? Take out a student loan and get an advanced education. Call it "investing in yourself."

Or invest in your business. Businesses could now "afford" to build the new wing of the office building, expand the payroll (or finance the existing one), engage in aggressive advertising campaigns, put more money into research and development-- anything.

With the onset of cheap lending rates, it was suddenly very attractive to borrow one's way into prosperity, and economic stimulation was not just a convenient side-effect: it was the whole point. 

If borrowing money is cheap, then everyone can afford to do it. If everyone can afford to borrow, then people can buy more things even if they can't afford them now. If everyone can buy more things, then the economy grows, more people can have better paying jobs, and they can afford to buy more things! You can't lose!

Note how almost every increase in Prime Rate is met soon after with a contraction or slowing of GDP growth, and almost every lowering of Prime Rate precedes increased GDP growth (except for the 1950's).

The underlying danger is that for all the perceived gains, the overall state of private wealth and income had not really improved for the average American; all the while, borrowing had sharply increased in virtually every sector of the economy.


Individual/Household Debt

All figures in this next graph are inflation adjusted to 2011 dollars, and are shown in actual dollar amounts. The year 1967 appears on the far right and the most recent year, 2011, appears on the far left.

Debt per Household is obtained by dividing the raw amount of Household Debt, as recorded by the Federal Reserve in the Flow of Funds Accounts of the United States 2012 report, divided by the number of households in the US:

Median Income is as defined here: 

The actual "Median Income Per Individual" in the US is currently around $36,000. Median Income often refers to a "Household Income" which may represent more than one income earner, as long as they share residence. Many, if not most, US households include more than one income earner. The household Median Income (as of 2011) is around $50,000.

We will look at the household rates, because the rest of the data from the US Census and the Federal Reserve is by household, not by individuals.

In the above graph, we can see that the fluctuation in median income (the blue line) has been minimal- about 19% since 1967- while the amount of debt held per household (the red line) has increased 386% during the same period.

For a family or an individual making the median income in the US- $50,054 in 2011- the average amount of debt owed per household is approximately $106,785-- or about 213% of the median income.

As a historical comparison, the inflation-adjusted median income in the US in 1978 was $47,659. The average debt per household at that time was $49,574-- or about 100% of the median income. Clearly, the income gains after inflation have not been significant, but the amount of debt held by households has more than doubled.

If you suspect that a great deal of this debt is wrapped up in the housing market-- you are correct. Here is a graph of overall figures for the same period. Dollar amounts are in billions of dollars inflation adjusted for the year 2011. The blue line represents "Home Mortgage Debt," while the red line represents "Consumer Credit," or a catch-all category for credit cards, personal loans, student loans, etc.:

Of course, not all Americans are homeowners-- only about 66% (as of the 2010 Census), although many states have home ownership rates approaching 70%. Of those who "own" homes, a significant amount of them obviously still owe money on their mortgages. The bank (or mortgage lender) owns the other "portion" of the home.

See that decline in the years following 2007? It is not the case that Americans suddenly paid-off large portions of debt-- it was mainly due to the bursting of the Housing Bubble, and subsequent foreclosures on homes. For former homeowners, that debt didn't really reduce or disappear; the debt obligation was cancelled and exchanged for terrible credit ratings.

Normally, when an individual approaches a debt default, he can sell off his assets. This will probably work out okay if his net worth is a positive figure. But when his biggest asset- his home- isn't yet fully paid for, and it's no longer worth what he bought it for, his net worth has probably crossed into a negative figure. 

After the Financial Crisis of 2007, many people found that nearly all of their assets had lost a significant amount of value, credit markets were frozen, and nobody wanted to buy a home for fear that prices would fall further.

This led to increased debt and massive layoffs in the Private Sector, putting many Americans on Unemployment Insurance and government assistance programs like Food Stamps and Medicaid.

The thing to remember is that the situation was very bad for everyone in the US- but particularly for the Middle Class and the poor. While the very rich had seen only a fraction of their wealth disappear (estimates are around 10%-15%), the Middle Class lost over 40% of their net worth. The biggest losses were in the value of their chief asset: their home. The Middle Class also suffered severe losses in private pensions, 401(k)s & stock investments, while the poor became considerably poorer.

Table 1: Income, net worth, and financial worth in the U.S. by percentile, in 2010 dollars Wealth or income class Mean household income Mean household net worth Mean household financial (non-home) wealth Top 1 percent $1,318,200 $16,439,400 $15,171,600 Top 20 percent $226,200 $2,061,600 $1,719,800 60th-80th percentile $72,000 $216,900 $100,700 40th-60th percentile $41,700 $61,000 $12,200 Bottom 40 percent $17,300 -$10,600 -$14,800 From Wolff (2012); only mean figures are available, not medians.  Note that income and wealth are separate measures; so, for example, the top 1% of income-earners is not exactly the same group of people as the top 1% of wealth-holders, although there is considerable overlap. Source: http://www2.ucsc.edu/whorulesamerica/power/wealth.html

As a supplemental, here is a pie chart depicting the proportion of Americans at their respective incomes:

When politicians talk about "The Middle Class," they are referencing the 45% of Americans who earn between $35,000-$479,999 per year. Percentages add up to 101% due to rounding.

Just so that we can visualize the incomes in the above pie chart, the following bar graph shows the relative amounts. Two different scales are necessary, since the average (mean) incomes of the top percentiles dwarf those of the bottom 90%:

Additional information parses the Top 1% into 3 more categories. As we can see, there is a stark division even within the Top 1% of income earners.

While top income earners have since made back a considerable amount of their original net worth since the Financial Crisis, the Middle Class, Working Class and the Poor have not.

Mostly this is because while the cost of nearly everything- but especially fuel and higher education- has increased, incomes have not. How do the Middle Class, Working Class and Poor make ends meet? By borrowing.