The disastrous fortunes of the stock market and the ever-expanding analyses of the credit crisis have brought fixed-income investments, and indexes, renewed attention among investors. While most analysts recognize that the range of debt instruments has expanded dramatically in the last three decades, few realize how much the quantity of debt—our indebtedness—has grown. Since the early 1980s, debt in the U.S. economy has more than doubled as a proportion of gross domestic product. In the same period, Financial sector borrowing has grown from a modest footnote to a third of the total debt.

Economywide levels of debt are usually measured by their proportion to GDP rather than in absolute dollars. First, inflation shrinks the real value and burden of debt, so any measure should not depend simply on nominal dollars. Second, the key question for debt is the ability to service it. By measuring debt as a proportion of national output, we gauge the drain debt service may place on the economy. Since both the debt and the GDP figure are measured in nominal (as opposed to inflation-adjusted) terms, the ratio will not be skewed by changes in the price level. Figure 1 offers a picture of debt over the last 56 years using data from the Federal Reserve’s Flow of Funds Accounts. The chart divides debt into funds borrowed by the Financial and non-Financial sectors. Non-Financial borrowing is by households, businesses, government, farms and foreign borrowers. The last two groups are minimal compared to the others. Further, all these are often treated separately from Financial borrowers.

Until the early 1980s, the ratio of either total or non-Financial debt to GDP was surprisingly stable, at about 1.5 times. In fact, there were analysts who sought to find some “economic law of nature” that would explain this stable pattern. More likely, the apparent stability reflected a combination of regulations that limited leverage with traditions that taught about fears of debt. There is no economic law of nature that sets the ratio of debt-to-GDP or explains when debt service becomes unbearable. Indeed, the lesson of the last few quarters is that debt that looks easily manageable at one moment may look absolutely terrifying in another time or climate—this applies to companies as well as countries. Moreover, while the data are less reliable, debt levels in the 1920s rose as high, or higher, than they are today.

In good economic times, when the economy is expanding, debt is rarely a problem. Rising incomes help to make rising debt manageable, and the optimism that comes from rising incomes makes lenders willing to work out any difficulties faced by borrowers. The danger comes when incomes slide and markets collapse. Collateral, if there were any demanded of borrowers, often shrinks as markets fall. Lenders become increasingly nervous and loans are called. Initially, this process of de-leveraging proceeds with only modest difficulties and a few small bankruptcies. However, external factors may cause the process to go out of control. If prices rise more slowly than before, or begin to fall, the values of real assets drop, while the pain of servicing debt, especially fixed-rate debt, rises. This puts more pressure on borrowers and encourages aggressive de-leveraging. In the extreme, a cycle of debt deflation is generated—everything but the debts deflate. Any available cash is devoted to only one cause—retiring debt—and that leads to further economic contraction. Debt deflation may be possible in any economic contraction, but the potential damage and the time needed to recover are much greater if debt levels are high than if they are low.

So how did today’s debt levels get so high? In the aftermath of the 1981–1982 recession and the Fed’s successful efforts to conquer inflation, attitudes to debt began to shift. Financial sector debt began to climb as securitization grew in popularity. The 1980s saw the beginning of mortgage-backed securities, and these were soon followed by other forms of securitization covering credit cards, auto loans and just about any other form of borrowing that lent itself to statistical analysis and packaging. The 1980s also saw an increase in the ratio of federal government debt to GDP. While many decry government spending as the cause of all our debt, some perspective is needed here. In the second world war, federal debt expanded many times over as the government borrowed (as well as taxed) to pay for the war, and most nondefense economic activity shrank. The next 30-plus years were spent gradually working down that mountain of federal debt. While there were plenty of years with deficits, the growth in federal debt was less than the growth of GDP, so the ratio of federal debt to GDP declined. This process drew to an end in the early 1980s.

Figure 2 shows when and where the debt grew. The data show the annualized percentage growth in the ratio of debt-to-GDP, not debt levels. A positive figure means debt grew faster than GDP. The two periods of sustained debt growth were the presidential terms of Ronald Reagan and George W. Bush. Reagan came to office promising to cut taxes, increase defense spending and reduce the deficit. He succeeded on two of the three, a good record for any politician. However, federal debt climbed in the Reagan years, adding to the overall debt load. During George W. Bush’s administration, the debt increase was paced by household borrowing and by the Financial sector. Home mortgages pushed up household borrowing, and mortgage securitization boosted Financial debt. On top of that, Bush reversed the absolute decline in federal debt seen in the latter part of Clinton’s presidency. The size of municipal and other (foreign and farm sector) borrowing in the Bush years was not large enough to make much difference.

What happens next? De-leveraging will shrink debt going forward and the debt-to-GDP ratio will stabilize and then decline. Most likely, the largest shrinkage will be in the Financial sector, followed by households, while the federal government sector will see debt increase in the near term. Debt won’t vanish, nor would we want it to: It is a critical component to innovation and growth. But as with anything, it’s best in moderation.