The economic outlook, Part 2

Picking up where we left off, what was the ratio of Debt/GDP for other sectors of the economy?

Using the same sources as before (BEA and the Fed), we can calculate Debt/GDP ratios.

For households, Debt/GDP was 47% of GDP in 1977, skyrocketing to 100% in 2007, for a total of $14 trillion.

For the financial sector, Debt/GDP was 17% of GDP in 1977, also skyrocketing to 116% by 2007, for a total of $16 trillion.

Both of these figures are absolutely shocking. Ultimately, it is these extreme leverage numbers that caused today's financial crisis. With debt levels like these, households and financial institutions were basically insolvent - that is, not making enough money to pay off their debts (well, maybe when times were great, but the slightest problem, and then everything crashes). Also, the ridiculous leverage versus the equity base meant that both households and financial institutions could see their net worth wiped out - which is exactly what we're seeing happening now. And finally, it's also likely with extreme leverage like this that most of it was wasted - buying houses in Phoenix or Miami that are no longer wanted, or buying super-senior ABS CDOs that are now called "toxic securities."

Why calculate these ratios? First, to understand what went wrong; second, to understand how we can watch out for problems in the future; and finally, to figure out what we need to fix to heal our economy. The news here is not good - we need to return leverage ratios to what they used to be, which would be trillions of dollars lower than where we are now. The problem is, the assets that households and financial institutions bought with all that debt are worth 20%-40% less now.

In the short term, the multi-trillion loss caused by the sharp declines of late are cascading through the system now, and the main reason why the government has already committed over $1 trillion to fix this problem.

In the long term, only saving, by businesses, household and government alike, will reduce these debt ratios. That reduced amount of consumer spending and business investment will likely lead to sluggish economic growth for a long time to come. Yet, like the Fed-induced recession in the early 1980s that Paul Volcker introduced to squash the inflation of the 1970s, this may be the only way we can wash our hands of this extreme leverage. I wish I had happier news - I really do.

Next up...real estate...