Our January 2000 issue of Economic Education Bulletin analyzed trends in debt growth in the United States across various sectors of the economy since 1950. As the updated chart below shows, overall debt relative to GDP stayed nearly level at 1.35 dollars of total debt per dollar of GDP for the thirty years preceding 1980. In contrast to behavior during previous business cycles, the ratio of the total debts of nonfinancial borrowers to GDP began to increase markedly after the 1981-82 recession ended. Strong GDP growth and slower rates of borrowing by nonfinancial businesses slowed the increase of the ratio of debt to GDP in the 1990s, but the rate of growth has since accelerated. Use of debt may have eased because nonfinancial firms were flush with cash and because they made greater use of public equity markets or private capital markets. Recent growth has been driven by financial businesses and by households, with modest increases in the government and nonfinancial business sectors. Between 1997 and 2007 the ratio of total dollars of debt to dollars of GDP had risen by 37 percent to more than 3.33. In other words, total domestic debt outstanding in the United States in December 2007 was $47 trillion while GDP was approximately $14 trillion.

We wrote in 2000 - a time, like now, when economic activity had slowed - “a ‘soft landing’ could be possible if the Federal budget remains in surplus, if mortgage and consumer borrowing is curtailed, and if businesses reduce their use of debt.” None of these conditions have been met and recent events suggest that many would have been well advised to exercise some measure of caution in their borrowing. Instead, investment firms such as Bear Stearns have made it a part of their business model to borrow and invest up to thirty times their actual holdings, while a growing number of households, through a mixture of optimism about home price appreciation and misleading loan practices, have had to default on their mortgages. Though the percentage of borrowers who have engaged in risky or overly speculative activity is small, it is an unfortunate consequence of the complexity of the modern financial system that their actions can have far-reaching effects on the well-being of the economy as a whole.

This situation has prompted the Federal Reserve to take an activist role in attempting to mitigate the impact of the current crisis rather than allowing a market-directed solution. Fed action to maintain adequate market liquidity is warranted in the face of a severe drainage of liquidity, but we hope that appropriate reforms will be coupled with the Fed's actions in the aftermath of the current crisis.

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