The 1930s saw a major global recession and a decade of debt default and restructuring, sovereign, corporate and personal. The 1970s saw a series of mild recessions, accompanied by inflation; debt defaults and restructurings were far less severe. Today we are likely due for a recession of uncertain length and depth (though unlikely to match the U.S. 1930s) and inflation that seems likely to match the 1970s. However, for structural reasons I shall explain, the pattern of debt restructurings seems likely to resemble the 1930s rather than the 1970s.
There were some international debt restructurings in the 1930s, but the foreign debt issue volume in the 1920s had been down from pre-1914 levels, as London houses were partially restricted by “guidance” from the Bank of England’s Montagu Norman, while the U.S. houses were only gradually taking up the slack. Indeed, Wall Street’s mindless hype and aggression was demonstrated by the overall long-term return on international debt issued during the 1920s, including restructurings, which was 5% for London-issued debt and only 1% for debt issued by the intellectual powerhouses of New York.
The principal debt restructurings in the 1930s were in the U.S. corporate sector, particularly the railroads. U.S. railroads had been overbuilt in the boom years to 1873, and thus suffered a rash of restructurings in the deflationary late 1870s and 1880s. The default rate on those bonds was indeed higher than it ever reached in the 1930s, with a peak 35.9% default rate in 1873-75 on non-financial corporate bonds outstanding. Two more nineteenth century recessions also exceeded the worst three years of the 1930s, with 1892-94 having a total 18.69% default rate and 1883-85 a total of 16.06%. The Great Depression produced two of the top ten default periods: 1933-35, ranking fourth with a total default rate of 12.88% and 1938-40, ranking tenth with a total default rate of 6.67%. Since 1945, there have been no “top ten” default periods, but 2000-02 ranks twelfth, with a total default rate over the three years of 6.15%.
Some of this is natural. Default rates have declined gradually over time, as credit assessment has improved. More important, until 1933 the United States was on the Gold Standard, and the 1873-1896 period was one of substantial deflation, which naturally produced debt defaults since debts are stated in nominal money. That does not however mean that the fiat currency of the post-1945 period has made all rosy; there are other measures of recession beyond debt defaults (for example, unemployment) and the post-1945 period has produced plenty of recessions by those measures. Nevertheless, the deflation of the early 1930s (which had begun to reverse in 1938-40) gives an adequate explanation for the high defaults in those years.
The 1970s were very different. While there were three or four recessions during the period (1970-71, 1973-75, 1979-80 and 1981-82, with the last two often combined into one double-dip downturn) there was also persistent inflation during the period and real interest rates that were mostly negative until the final Paul Volcker catharsis of 1979-82. Thus, despite the spectacular bankruptcy of Penn Central in 1970 at the beginning of the decade, the level of debt restructurings and defaults was far below that in earlier periods.
Optimists would make the same point about the current period. Inflation has declined from its near-double-digit peak, but seems unlikely to decline further in the short-term, while real interest rates are barely positive. Certainly, given the Fed’s inflation target of 2% and its institutionalized paranoia about deflation, any even transient signs of deflation would be met by a flood of free money sufficient to sink the Titanic. Thus, at first sight a repetition of the 1930s debt defaults, let alone those of the 1870s-1880s, seems remote indeed.
There is another factor, however, which explains why this period will not be a simple repetition of the 1970s: the level of debt in relation to GDP. The earliest Federal Reserve figures we have for the debt to GDP ratio show that in 1952, Federal debt was 63% of GDP, household debt was 24% of GDP and business debt 29% of GDP. Total debt in the economy (including state and local government debt) was 123% of GDP. With the exception of Federal debt, which was only 16% of GDP in 1929, private sector debt in 1929 was above the 1952 level, but even so total debt probably only spiked above the 1952 level in 1931-32 as the Great Depression reduced GDP and increased debt.
In the first quarter of 1973 Federal debt, reduced by a quarter century of inflation and interest rates that did not take account of it (but also by sound budgetary policies until 1965) was only 28% of GDP, while household debt had crept up to 43% of GDP and business debt to 49% of GDP. The total non-financial debt in the economy was only a little higher than in 1952 at 132% of GDP.
Today, it is a different story. Federal debt in the second quarter of 2023 was 104% of GDP, higher than in 1952 and in all but a couple of years around the end of World War II. Household debt has soared to 73% of GDP and business debt to 76% of GDP, both around three times the healthy 1952 level. Total non-financial debt in the economy was 266% of GDP, more than double the levels in 1952 or 1973 and above any reasonable estimate of its early 1930s peak.
The implications are clear. The 1970s did not see debt restructurings and defaults at the level of the 1930s, because debt levels were somewhat lower and the inflation during the decade meant that there was no collapse in asset values causing lenders to panic, while the recessions were fairly shallow, so cash flows held up adequately. Companies who had excessive debt in 1973 had a good chance of securing adequate cash flows by 1980 simply through inflation operating on their revenues and assets. Even those companies for which the further recession was fatal (such as International Harvester) still had sufficient asset coverage that they could declare bankruptcy, restructure, and see their creditors come out with only modest losses. In the personal sector, credit cards were not yet common, so debts tended to be secured against cars or household goods, which could be repossessed in case of difficulty. The government could easily run deficits in the 1970s because it started from a budget that was nearly balanced and benefited each year from inflation and GDP growth reducing the real burden of its debt.
None of that is the case today. The inflation level is similar to that of the 1970s, but both business and personal debt are around two thirds higher, as a share of GDP. Far from being able to smooth any recessions, the Federal government is currently running a budget deficit of around 7% of GDP and itself has public debt three times the 1970s level. Thus, debts of companies and individuals that goes wrong will not be sufficiently reduced by inflation, nor will cash flows rise sufficiently to service them.
Austrian economists have a concept of “malinvestment”: the foolish investments made in the enthusiasm of a market bubble, whose debt must be restructured as their value is far less than the debt they incurred. The office leasing speculation WeWork, bankrupt this week with $3 billion of debt and $13 billion of leases, is just one example of an enterprise that would never have been blown up to its peak $47 billion valuation without a decade of “funny money”. FTX, Sam Bankman-Fried’s crypto exchange, was another such venture; that had a peak valuation of only $32 billion, but its losses may be more than WeWork’s. Silicon Valley Bank, last March, was yet another. There will be many more such collapses, because the rate of inflation is nowhere near sufficient to bail out speculations that became so outrageously over-inflated and are now collapsing.
Not all debt collapses result from “malinvestment.” In the 1930s, the railroads had become a senescent transportation form, hugely overbuilt in the previous century but now suffering from massive competition from cars, trucks and potentially airlines. When the economy turned down, the nimble truckers could undercut the high fixed costs and manning levels of the railroads, causing a death spiral of bankruptcies that resulted from the world having moved on, rather than from initial malinvestment (most of which had been shaken out in the 1880s defaults.)
On the personal debt side, today people are a lot more indebted on average than they were in 1973, and incomes no longer have the robust growth born of a healthy economy that enabled 1973’s deadbeats to work their way out of trouble. The $1.7 trillion of student debt is just one example of a liability class that barely existed in 1973 (yes, in 1973 I had a student debt; it was paid off with my first decent bonus in 1977.) Credit card debts are also far above their 1973 levels, although finance company personal loans are less common. Personal indebtedness has also been inflated by “funny money” although less so than business debts because the finance companies never allowed “ordinary people” to borrow at negative real interest rates like the billionaires could.
The next decade is likely to be pretty unpleasant – and debt restructurings and losses therefrom are likely to be a significant part of that unpleasantness.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)