Understanding the Risk of Economic Downturns: Debunking the 73 Trillion Debt Concern

The concern about the 73 trillion in corporate and consumer debt posing a significant risk to banks during the next economic downturn has been widely discussed. However, it's crucial to dissect this issue through a factual and analytical lens. This article aims to clarify misconceptions and provide a balanced view on the real risks associated with such a massive debt figure.

Double-Counting and Net Debt Misconceptions

The 73 trillion figure often cited in discussions about corporate and consumer debt includes multiple layers of double-counting. For instance, a person borrows money to buy a house, and the seller uses that money to purchase treasury notes. This transaction creates debt in two places: the mortgage lender and the federal government through the treasury notes. However, the same money is not actually created twice; it merely gets counted twice as debt. Similarly, when the government spends money, it can be lent out multiple times, leading to further double-counting.

These complexities mean that the net debt is effectively zero, as the original money supply remains constant. Therefore, while the debt figure appears staggering, the practical impact on the economy and financial stability is not as dire as it seems.

Bank Solvency Analysis During Economic Downturns

While the sheer volume of debt is concerning, it is important to assess the bank solvency rates during past economic downturns. The chart below clearly illustrates that net loan loss to total loans for banks has historically averaged around 0.5 during good times, spikes to 1 to 1.5 in normal recessions, and can reach up to 3 in historic credit crunches, such as those experienced in 2007-2009.

Data: Net Loan Loss to Total Loans for Banks over Time

Note: This reference to a chart is illustrative. In a practical context, this would be accompanied by a visual graph or diagram.

Additionally, the graph showing bank equity capital to total assets, with figures consistently over 11, provides a significant cushion. This means that even in the worst-case scenario of a 3% loss rate from the Great Depression-worse financial crisis, banks have a robust 11 equity reserve to cover potential losses.

Uneven Distribution of Bank Health

However, it is essential to acknowledge that not all banks are in the same condition. While the aggregate numbers suggest a safeguard, individual bank health can vary widely. During the 2007-2009 crisis, many banks encountered severe issues not because their average equity capital was only 10%, but due to significant losses on assets beyond loans and non-lending risks, such as off-balance sheet derivatives.

Recession Scenario Analysis

In an ordinary credit crunch, some weak banks are expected to face challenges, but these can usually be managed through standard resolution methods. However, a crisis as severe as 2007-2009 was buffered by higher capital reserves and the removal of non-lending risks, factors that helped banks survive the crisis. It would need to deteriorate significantly beyond the last crisis before any discussion around bank implosion could be validated.

Therefore, on the whole, the current level of debt in the economy, held by banks, is not a major cause for concern regarding bank solvency. While the future undoubtedly holds many surprises, most of which may be adverse, it is unlikely that these will be the same reasons leading to a bank implosion. Conversely, if a bank implosion were to occur, it would probably not be due to high general levels of debt.