SERIOUS MONEY:ONE UPON a time, in a land far, far away, there existed an economy called "Goldilocks", that was neither too hot nor too cold. The seemingly unending economic stability encouraged the private sector to leverage its balance sheet and it was allowed to do so at relatively low interest rates, writes CHARLIE FELL

Outstanding non-financial private sector debt jumped from an amount equivalent to less than 120 per cent of GDP to more than 140 per cent by the end of the first year of the new millennium in 2001.

The first bear duly turned up uninvited as significant business malinvestment became apparent, and the corporate sector found itself face-down in the porridge.

However, ill-advised monetary policy which allowed US interest rates to remain too low for too long enabled the fairy tale to continue, as rising asset prices created a sense of increasing wealth that allowed households to borrow-and-spend in the face of stagnating real incomes. Outstanding household debt surged by an amount equivalent to more than 25 per cent of GDP in just seven years.

The music came to a halt in 2007 as it became clear that households were experiencing significant financial stress.

The second bear that subsequently arrived, proved grizzlier than the first. Private sector deleveraging began in earnest and both households and the non-financial corporate sector cut their debts in 2009, an unprecedented development in the post-second world war era.

The roughly nine percentage points swing in the private sector finance balance – the gap between income and expenditure – placed enormous strain on the economy, but the public sector stepped in with massive stimulus to absorb private sector savings and prevent the beleaguered economy from sliding into a 1930s-style depression.

Efforts to stabilise the economy have proved successful and asset prices have responded enthusiastically, but the ratio of outstanding private sector debt to GDP remains high by historical standards, while the current public debt trajectory is on an unsustainable path.

Federal debt is set to exceed 70 per cent of GDP in 2012, and without fiscal restraint could approach dangerously high levels within a decade. President Obama notes: “In the long term we cannot have sustainable and durable economic growth without getting our fiscal house in order.”

The need for remedial fiscal action is not in dispute, but it needs to be recognised that any such action would likely prove extremely damaging to the economy and precipitate a recession unless the private sector has completed its balance sheet rehabilitation and is in a position to run a financial deficit. This follows from the economic identity which states that the sum of the financial balances of the private, government and foreign sectors must equal zero.

Fiscal restraint and an improvement in the public sector financial balance must be offset exactly by a decline in the aggregate financial balance of the private and foreign sectors. Given that the US faces a structural foreign sector financial surplus or current account deficit of some 4 per cent of GDP, the bulk of the adjustment would likely be borne by the private sector. This would interrupt the deleveraging process and return the economy to the old model that failed in 2007 and 2008.

Households are simply not in a position to leverage their balance sheets. The ratio of outstanding debt to disposable income remains more than 20 percentage points above where it stood less than a decade ago.

Median household income declined in real terms over the last 10 years, the first full decade since at least the 1930s that income gains failed to materialise, and the medium-term outlook is hardly encouraging.

The US labour market is some 12 million jobs shy of being at full employment, roughly 18 cents in every dollar of personal income today comes from the federal government in the form of transfer payments, and almost one-in-seven Americans is on food stamps.

It is widely argued that the corporate world is in sound financial shape, but recent data from the Federal Reserve reveal that outstanding debt for the non-financial sector reached an amount equivalent to 77.5 per cent of GDP, a post-second World War high.

Meanwhile, the savage decline in asset values over the past 2½ years has seen the ratio of debt-to-net worth at market prices climb by 13½ percentage points since 2007 to the highest level in years. The deterioration continued in the fourth quarter of last year due to the travails in commercial real estate.

The non-financial corporate sector has accumulated large holdings of cash and short-term investments over the past 18 months as firms slashed expenses, squeezed their balance sheets and reined in growth initiatives. Indeed, the cash pile for the 382 non-financial firms in the SP 500 amounted to more than 10 per cent of total market capitalisation at the end of 2009. However, SP data also reveals that the ratio of net debt-to-Ebitda has jumped from 3.4 to 4.5 since the crisis began in spite of the large liquidity cushion. Corporate balance sheets are simply not as flush as the bulls believe.

Belief in the “Goldilocks” economy has returned once again, but close examination of balance sheets reveals that a vibrant private sector credit cycle is unlikely anytime soon.