The US Economy: How Did we Get Here? Where are we Headed?

For years now I’ve been working under the Balance Sheet Recessionary theory – the idea that the private sector has experienced an unusual slump due to a debt based bubble that impaired balance sheets and slowed aggregate demand to a crawl.  In such an environment the private sector cannot sustain growth because spending is diverted towards balance sheet repair – spenders become savers.  This is inherently deflationary if it plays itself out naturally.  But clearly, that’s not what occurred.  Instead, the government stepped in and picked up the slack.

In order to visualize what’s happened in the USA it’s helpful to take a step back.  The following charts will help communicate the above concept.

Stage 1: Private sector debt bubble and inevitable implosion.

That big surge in the ratio from 0.80 to 1.15 is the result of the housing bubble and the irrational exuberance over the idea that housing prices cannot go do down.  The subsequent decline has been the result of the de-leveraging cycle.

It’s led to healthier balance sheets, but the process has coincided with very weak aggregate demand and a sluggish overall economy as a result.


Stage 2: Private Investment Collapses Bringing the Economy to a Screeching Halt.

The US economy normally ebbs and flows with private investment.  Private investment has always been the lifeblood of the US economy, but when the housing bubble burst it took private investment down in a way that was unprecedented with declines over 30% year over year.


Stage 3: The government steps in.  Did they rescue a dying patient?  

 When the private sector collapsed in this unprecedented way there were a few options.  We could have done nothing and just let the bubble collapse play out naturally.  This likely would have resulted in a far deeper and potentially more prolonged depression.  What’s going on in Greece and Spain is closer to this scenario and those nations have full blown depressions with continually declining GDP and unemployment well over 20%.

The other option was to use the government to improve balance sheets.  This was achieved in part via QE1 and the Fed’s various lending programs which helped bring some semblance of normalcy to the markets and helped bolster bank balance sheets.  It’s my opinion that QE2 & the QE^n’s have been less impactful, but none impactless (though I do worry that the risks outweigh the rewards).

The other big help was the government’s budget deficit.  As you can see in the chart below the private sector experience a massive surplus position as a result of the government’s deficit.  Remember, when the government deficit spends Peter buys a bond from the government, the government deficit spends Peter’s bank deposits into Paul’s account and Peter ends up with a t-bond.  The t-bond is a net financial asset for the private sector because there is no corresponding private sector liability attached to it.  (See here for more on this).

In a balance sheet recession deficit spending serves like a double dose of stimulus.  Not only does it increase the flow of spending in the economy, but it also improves private balance sheets by providing the private sector with a risk free asset that has no corresponding private sector liability.  We can quibble over the efficiency of the government’s “flow” (deficit spending), but we can’t really argue with the accounting.


Stage 4: Where do we go from here?  

Understanding the balance sheet recession and the economic recovery has been all about understanding the process of de-leveraging and balance sheet improvement.  And the budget deficit has been, arguably, the key component to all of this.  So, looking ahead, the deficit continues to play a key role.  As private investment picks up the slack and the private sector starts to run with the baton the government’s deficit becomes less important.

The problem is, we’re not close to being out of the woods.  The economy might being starting to feel a bit better, but the reality is that it’s still quite weak.  Yes, the de-leveraging has started to turn into a re-leveraging, but that’s just the beginning of a normal healing process.  And private investment is still lower than its been at any point in the previous recessions.


Goldman Sachs estimates that the budget deficit is set to come in at $775B this year.  That’s down from their earlier estimate of $900B and way off the consistent $1T+ deficits we’d seen in previous years.  But it’s still a rather large budget deficit at about 5% of GDP.  We were at risk of experiencing much larger cuts.  Still, this will likely impede growth going forward as the reduced deficit works against two trends – it reduces the flow through the economy that is still on life support AND it reduces the additional net financial asset contribution which has played a crucial role in the balance sheet repair process.  These are not good developments, but they’re also not going to send us into a Greek-like scenario.  In short, it looks like muddle through is probably here to stay.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.
Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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  • DanH

    Great post. Thanks, Cullen.

  • SS

    Nice. It’d be nice to see a corporate profits update as it pertains to all of this.

  • Dennis

    Thanks for this Cullen. The very first point you made “That big surge ….is the result of the housing bubble and the irrational exuberance over the idea that housing prices cannot go do down.” I think you could add a reason for this surge: the marketing of credit which was relentless in 2007-2008. I don’t recall observing “irrational exuberance” at that time. What I recall is being “cold called” every single night for months and months with offers to refinance a mortgage which (by the way), I didn’t even have. The Fed’s dual mandate could be better carried out if control of credit generation was in focus. MR now clearly understands the huge impact of fiat currency creation by the BANKS together so-called non-banking institutions with thousands credit sales people. This far outstrips deficit spending of the government, especially if you look at year-by-year changes.

  • jmf1928

    What do you view as a ‘sustainable’ household debt/income ratio? Clearly it is dependent on interest rates, but does it make sense for that ratio to continuously increase?

  • Chris H

    Nicely written article and I see the points.

    I think most of the debate around government spending comes because, unlike the private sector, the stockholders (taxpayers)

    1) Have a very hard time measuring the NPV or ROI of government spending.
    2) Don’t trust the management

    Clearly these two things could go a long way towards justifying goverment spending (or not).


    Cullen, I don´t mean to diverge from the main focus of this post, but I disagree with one of your assertions in point #3. You have argued in a number of your posts that austerity and lack of government spending has caused the European peripheries current day depression. I think this is a huge over simplification of our reality.

    I think it is the national tax payer backed bailout of the banking system and our banking systems access to low interest loans from the ECB that is destroying the economy and putting us deeper into this depression. These measures are also drawing out inevitable failure of non-viable banks. It is also allowing the banks to hold off selling distressed properties on their books.

    Once again, I understand that in Europe we are currency users and are restricted by this system. Yet, it is the banking system that is destroying the country today with tax payer backed bail outs and severe credit restrictions to individuals and small business. Take this together with increased taxes and you have all of the ingredients for economic collapse.

    I do not agree with you that increased government spending would rectify our situation. It would only further delay the inevitable. We need organized bankruptcy and for asset prices to come back to terms with their market value. Only then will private investment begin to trickle in and hopefully a more rational and sustainable model will be achieved.

  • godot10

    Did the household debt to income ratio really decline?

    Or was it just shifted to a different “entry” on the balance sheet?

    i.e. Future tax liability to income ratio.

    Has the (debt plus future tax liability) to income ratio come down?

    So private sector and household debt has been socialized. Are we really any further ahead? Arguably the bankster class and the 1% have been kept whole, but wages for the vast majority have stagnated, and now they face a higher future tax liability.

    The government saved the 1%. The 99%, not so much.

  • Matt McOsker

    The current account is still high relative to the deficit. It has improved since the 6% CAD we ran in 2007-8, but it nets the budget deficit to a paltry 2% of GDP.

  • Blobby

    The UK government seems to be playing the same tune. Deficits are of a similar size. Circa 7% IIRC. Corporate taxes are being cut to 20% by 2015, so that should help attack Euro and perhaps even some US companies..

  • Blobby

    .. make that attract.. ;) Freudian slip

  • Rob T

    I hope no one is surprised at that development. The “Occupy” protests were met with derision in the media and police brutality on the ground. I’ll never forget what my international finance professor told me during my senior year after listening to me identify contradictions in the purported intentions of politicians and their corresponding actions for half an hour: “Listen, Rob, you’re operating under the assumption that we’re a democracy. We’re not. We’re a plutocracy with democratic trappings.”

  • Johnny Evers

    The other version: the banks went broke with leveraged investments that fell apart when housing prices went back to normal and the Fed bailed out the financial sector and wealthy investors.
    Very little was done to help the private sector beyond some added unemployment benefits and reduced mortgage payments. People still lost their houses and had to use their own money to pay down debt. Unemployment and underemployment are still high.
    The chart showing that the private sector experienced a massive surplus — please stop! — the surplus there is a trillion-plus pumped into banks and financial institutions as a result of QE. Very little of that got to the working class or the median-income class.
    The median-income class is in worse shape now than 10 years ago — retirement balances are smaller, wages are the same.
    I’d like to see the whole sector balances paradigm modified to include a sector called regular Americans.
    By the way, I can subscribe 100 percent to MR and still disagree with the analysis here.
    If we do not have a solvency constraint, which I accept, then surely we could have done more with the trillions now on the Fed’s balance sheet rather than prop up the balance sheets of banks.
    We could have completely bailed out the median-income sector — allowed people to write off their mortgages, their student loans, their credit cards, mailed a $10,000 check to every man, woman and child, launched a massive public works program and hired only Americans, etc., etc.
    If economic recovery truly depends on median-income Americans being able to borrow again, we have to help them directly.

  • Pacioli

    @ JE – your comment are prescriptive. Cullen’s post is descriptive.

    You seem to begin to acknowledge it – “I can subscribe 100% and still disagree…” – but then you finish off by jumping off the rails again.

    There is some place for policy debates (though not here), but Cullen’s post was aimed at providing an in-depth descriptive account, as misunderstanding of the mechanics and dynamics involved is still so widespread.


    Pacioli, so may be you can help me answer a few doubts on the descriptive elements of the BSR. I don´t understand what is the transmission mechanism in government spending that directly helps cure the private sector balance sheet recession. And my second doubt is how do you repair the confidence of the private sector who has to make financial decisions is what is a self-described CB monetary experiment and a very difficult real world economic situation.

  • Johnny Evers

    I disagree 100 percent that the private balance sheets have been improved.
    In aggregate, yes, but for the median, no, which I stated.
    MR is going to have difficulty getting traction if it appears to put a rubber stamp on current policy. Cullen has basically stated that the system exists to support the banking system first and foremost. I can accept that, but I don’t have to like it, or think it is the best way to use the system.

  • Pacioli

    @ indignado –

    On your first question, the transmission mechanism is fiscal (Congress), not monetary (the Fed). But, more importantly, your characterization of “cure the private sector BSR” implies that something is wrong or amiss with the BSR. The balance sheet recession was completely necessary, given the excesses that had built up. So it is completely healthy, IMO, and not something that needs a “cure”.

    On the second question, similar to the first – “repair the confidence” implies that more confidence is needed. IMO, one of the reasons that the previous excesses reached such staggering levels was due to over-confidence and complacency. So again, a healthy level of caution in the private sector is not something that needs “repair” IMO.

  • fin

    well said…

  • http://pragcap Michael Schofield

    Plutocracy, yes, I hate to admit it but that is one of the closer definitions. Money being power (if you don’t believe that you’re a moron) it has always been that way to an extent. But after unions were sacked, the dems no longer had a source of middle class support, something had to fill the void and that thing was money. Money always owned the gop (not a bad thing, everybody needs to be represented) but they have thier hooks in the dems too. And so all this power is used to….get more money! And if you don’t believe that you’re a moron.

  • Steve W

    Consumers, savers, workers, etc. are a diverse group, with differences at all levels. It seems to me that those same people (at all levels of income and wealth) all made decisions — some good, some bad — based on their knowledge, beliefs, and (in some cases) emotions. Some people were stupid, some were greedy, some were lucky (and successfully flipped some real estate). Private balance sheets — in the aggregate, have improved, as you have agreed. Is a large segment of the “median” still struggling? I suppose, but just like the others above and below, some made mistakes, others didn’t. Many people got swept up in the whole real estate speculation craze and I understand why one might feel that the “system” was faulty. I just don’t quite understand how, in the course of working through this BSR, you can realistically expect “equal” results for such a complex problem. Cullen has tried to remain descriptive on this whole topic, but you seem to be asking him to be prescriptive. Are you advocating special targeted tax cuts or some other financial programs for the “median”?

  • midas2

    Johnny Evers, yes, this is the way it is, not the way it ought to be. The problem is knowing just what it ought to be. That is not Cullen’s role. I am searching for a solution, but have not discovered a possible one that is likely to ever be adopted. If you know the real solution please let us know.

  • Johnny Evers

    midas2, SteveW … this is an ongoing argument, we’ll just have to agree to disagree.
    No doubt the consumer borrowed too much and suffered losses. The problem was, for every dollar the consumer lost, the lenders lost more, because of their stupid investing practices (which Taleb once described as ‘rushing in front of a bulldozer to pick up pennies.’
    The median is critical. Putting it baldly: If you have 10 workers and nine go slightly backward and the 10th gets an infusion of money, it will seem that the private sector is doing well.

    I am not quite sure as to what Cullen’s views on the wisdom of what was done.
    Does he support what happened? Or by describing system without comment, does he mean to undermine it?
    Interesting question for me.

  • http://pragcap Michael Schofield

    Johnny I think you’re right about the middle class but wrong about Cullen. I say that in the same way Government policy transferred wealth up the ladder it could also transfer it down the ladder. For me, it is not about “fairness” but instead economic balance and common sense. Start with the tax code, the bottom half owns nothing so they pay nothing. The top half owns everything so they pay the bill. The idea that there is a lack of money is bull-.

  • Cullen Roche

    I frequently try to explain to you that I am not here to play judge and jury. I get the feeling you think I don’t do enough. That I should be much more vocal about my personal preferences perhaps? I don’t know. I have always tried to avoid the politics. I don’t enjoy it and I don’t like to impose my beliefs on other people. I just don’t think that’s my responsibility.

  • Will

    love it. great post Cullen. come teach at you know where!

  • Cullen Roche

    I’d love that. Now go convince the Dean of the Business school that I’m capable and worthy. Good luck, you’ll need it. :-)

  • Indignado

    Thanks for the response. I agree with you that the BSR was necessary given the excesses that had been built up. I also agree that a big reason that the BSR was through over-confidence and complacency.

    Therefore, it is logical that we are due for a period of a very necessary de-leveraging period and a psychological change towards thrift and over caution in the years ahead.

    Increased spending by a short term minded congress is not a cure IMO. In fact, the moral hazard brought by “a spend our way out of a BSR” congress in comparable to the troubles brought on by the TBTF financial institutions. Policy makers with no skin in the game will lead to moral hazard and more problems.

  • Art

    I’m going to risk asking a question I’m sure has been asked in many ways before by others, but I am having a difficult time understanding the flow of funds between Treasury (the issuer), the Primary Dealer network and their ultimate buyers (Peter), and the ultimate recipient of the govt spending (Paul). I undertand how Paul got the money from the govt, and I understand (I think) how the dealers buy the bonds (new issues). What confuses me is how the Fed pays for the bonds they buy? My understanding currently is that they can buy bonds from the dealers (with money they created) and that money is added to the reserves of the dealers. Am I right about that? And those reserves can be lent back to the Fed, or they can become part of the monetary base which could theoretically be lent out into the private sector provided there was sufficient demand and credit worthiness. So my question is this. Is the Fed adding to reserves with all of their purchases, or are they draining funds somewhere else so as not to explode the reserves? If Peter is a private buyer, then money is just moving from one private pocket to another via govt spending, but if Peter is the Fed, is that a roundabout way for the Fed to inject newly created money into the economy? I have read your paper but I still have trouble getting my head around this issue. Thanks for listening. I admit a lot of this is above my pay grade. I just read a piece by Lacy Hunt (via Mauldin) and he makes his arguments for strong deflationary forces and no inflation coming.

  • Tom Brown

    The electronic entries in the Fed’s deposit-liability accounts, are just that: liabilities, whether they are for Treasury (this deposit is called the TGA), or deposits for the banks (reserve deposits). You’re right up till you state “reserves lent back to the Fed.”

    Reserves don’t need to be lent back to the Fed. These deposits are always a liability to the Fed. When these deposits return to the Fed they are eliminated. Just like if you pay a bank (say interest for a loan) that holds your deposit, they can simply debit your deposit (reduce the deposit liability they hold for you on their account).

    Reserves are also not lent out to the private sector (private non-bank entities). Here’s a short list of the places reserves can go:

    And here’s a longer list of how they can leave the banking system:

    So aside from cash, reserves can basically only go to entities w/ deposit accounts at the Fed (non-bank businesses, organizations, and individual people don’t have those)

    Here is a balance sheet illustration of QE if that helps:

    Yes, as in Example 4 above, the Fed is adding to the excess reserves on bank balance sheets with QE. They drain it when they reverse QE with open market sales (OMSs).

  • Tom Brown
  • Ray Purdy

    Indignado, Increased spending by the gov’t of Alabama, or Texas, or California, would not prevent a recession here either, and that is the situation in Eurozone. Only if there was a central agency that could issue risk-free debt, such as the US treasury can do, will it work. Sovereign debt of the Eurozone countries is not risk-free (obviously). I doubt that Cullen would argue with you on your points, but he would say this is an apples to oranges comparison. Eurozone does not have any way to create and distribute more euros into the system in an equitable manner. Cullen has said for (the 2) years (I have been following him) that Eurozone MUST do this or must break up. Eurozone still hasn’t decided…

    good luck to you in your front row seat!


  • Ray Purdy

    Cullen would argue that increased spending by congress HAS helped out with this BSR, altho’ he heartily disagrees with some of the waste and way that the monies have been allocated. Transfer payments from fiscal spending of congress in the form of soc security, medicare, Medicaid, defense contractors, have put money into the private sector where it can circulate, facilitating the buying and selling of goods, or the paying down of debts from private households to (mainly) the financial sector. This has helped the US economy stay afloat better than the Eurozone austerity countries. HOWEVER… I liken the problem to a patient with congestive heart failure. The pump is not working well, so much of the money is not circulating effectively, but ending up in a smaller and smaller compartment of the economy (financial sector). this is not healthy and if the trend continues, the patient will not do very well!



  • marx-reloaded


    I was wondering if you would be willing to comment on a possible limitation to your analysis in this post?

    In the first section of Part IV of your MR paper (Understanding the Economic “Machine”), you state, “Economists often talk about aggregate supply and aggregate demand”; you define aggregate supply as, “the total amount of final goods and services produced by an economy over a given time period”; you grant that supply and demand need not equal each other, thus leading to the statement, “When the economy is depressed during a downturn aggregate supply can exceed aggregate demand.” Also, throughout your paper you emphasize the importance of the relationship between the value (and quantity) of money in a system and that system’s productive output. In other words, the sphere of production plays an essentially important role for MR.

    In this post, you seem to be emphasizing a failure of aggregate demand: the BSR theory suggests that “the private sector has experienced an unusual slump due to a debt based bubble that impaired balance sheets and slowed aggregate demand to a crawl.”

    In your paper, you emphasize production, whereas your commitment to BSR in this post emphasizes demand. What is the relationship between these two, assuming that equilibrium may be a goal of the market but one rarely, if ever, achieved?

    You do not seem to have a concept of OVERproduction. Marxists do. For them, there is a chronic tendency towards overproduction in the global capitalist economy as a result of (1) increased efficiencies due to capitalist competition and investment and (2) the political inability among states to allow the least efficient lines of production (the “losers”) to collapse and disappear completely (because it would result in a catastrophic social crisis). It is this initial tendency towards overproduction (as a result of the particular nature of competition in a capitalist economy) that generates the need for debt-fueled consumption and higher overall societal debt, whether in the form of government or private sector spending.

    Can you comment on how you would explain the cause(s) of an (unprecedented) high level of debt spending, which is the condition of possibility for a BSR in the first place? It seems to me that blaming it on greedy or unethical consumers living beyond their means is not persuasive because it fails to adequately explain the systemic importance of debt-based consumption of recent decades. The concept of overproduction explains it more elegantly, in my opinion.


  • Art

    Thanks for the reply. I will study your links.

  • hangemhi

    and #3 they think that a large gov debt/deficit means they will pay for it with higher taxes in the future.

    That belief, of course, is in the face of many decades of declining taxes, not to mention the illogical idea that somehow destroying the economy of today will somehow help our grandchildren, or taking care of our economy today will somehow hurt our grandchildren.

  • hangemhi


    The moneyed elite and large corporations lobby/spend to write tax and other laws to entirely favor themselves over everyone else – and hire ad agencies to spin bad ideas into pseudo-logic that convinces half the country that its also good for them.

  • InvestorX


    “When the private sector collapsed in this unprecedented way there were a few options. We could have done nothing and just let the bubble collapse play out naturally. This likely would have resulted in a far deeper and potentially more prolonged depression. What’s going on in Greece and Spain is closer to this scenario and those nations have full blown depressions with continually declining GDP and unemployment well over 20%.”

    Probably you guess that I disagree with you:
    1. Greece and Spain have tax hikes and austerity imposed from the EU. Had they defaulted, they would have had a sharp, but shorter depression than now.
    2. It is not given that a US depression would not be relatively short (e.g. 2-3 years like in 1920-1921), although it would be deep. But after the excesses are flushed from the system you get another 20-year bull market like 1982-2000 in markets and growth.
    3. The current policies will:
    a. retard the necessary adjustment of the economic structure
    b. reward imprudent stewards of capital and crony capitalists
    c. widen the wealth inequality further
    d. spread the pain over 10-20 years (Japanification) plus increase the amount of total paint because of a) above
    4. What I am saying so far is that the system needs a reset. Another thought branch would be that the system additionally needs a change:
    a. better capital / leverage regulation of banks as a price for bail-outs or no regulation-no bailouts. Whatever.
    b. Ban FRL, which is a fraud.

  • InvestorX


    “The other option was to use the government to improve balance sheets. This was achieved in part via QE1 and the Fed’s various lending programs which helped bring some semblance of normalcy to the markets and helped bolster bank balance sheets.”

    Note that they did not improve the HH balance sheet, but the banks’ balance sheet, whereas you show the former above as a reason for the crisis.

  • InvestorX

    Show me evidence of declining taxes over the years – all I see is rising taxes. Maybe the W era as president brought some cuts, but that is all. The LT trend for taxes everywhere is up.

  • InvestorX

    This is not descriptive. This is a unprovable counterfactual, pushing for a certain policy choice indirectly:

    “When the private sector collapsed in this unprecedented way there were a few options. We could have done nothing and just let the bubble collapse play out naturally. This likely would have resulted in a far deeper and potentially more prolonged depression. What’s going on in Greece and Spain is closer to this scenario and those nations have full blown depressions with continually declining GDP and unemployment well over 20%.”

  • InvestorX


    you are right:
    1. Goods and services in the BSR (which is the same as Keynesian) view are treated as one homogeneous pulp, which is not the case. The economic structure is mal-adjusted (e.g. too much resources and skills of workers diverted towards housing production) and cannot easily and quickly be readjusted, while demand (e.g. for housing) has rightfully dropped. Now a lot of the fiscal stimuli are often directed at trying to reinflate aggregate demand and thus the over-grown sector as a part of the structure, which is just keeping the status-quo and prohibiting re-adjsutment. It seems to work over the short-medium-term, but increases the efficiency losses due to the mal-adjustment over the long-term.
    2. Amazingly nobody seems to recognize that constant creep up of private (HH) sector / debt to GDP is:
    a. an artificially higher level of consumption
    b. unsustainable over the long-term

    Well, guess what it creates OVERproduction to meet artificially inflated demand (which has been say 5% higher than otherwise over 20-30 years each year!). And guess what, we reached a point where debt/GDP growth seems to not grow anymore in 2008. Now they may reinflate it again to even a higher rate, but it will blow up again (and maybe even worse than in 2008). Additionally nobody discusses the future taxation increases due to public debt increase, as everyone assumes that it will be rolled-over indefinitely, if needed through the Fed (basically what MR assures us). But aren’t the banks one day (probably not soon) going to say – enough reserves for us, we cannot plough them in the economy through lending, enough zero yield assets on our balance sheets?


    In better times the EU spent billions of euros in development projects here in Spain. In retrospect, many of the investments made were based on irrational growth prospects and by pork barrel politics. IMO government funds are spent without a real sense of return on investment. Here today and gone tomorrow as they say.

    In a sense, the U.S of E helped to build over capacity in public works and also orchestrated artificially low interest rates for our economy at that time.

    If euro bonds became a reality tomorrow, I don´t understand what would change in this formula. Is the EU going to build roads on top of the existing roads here? Or will they tear down all of the underwater development projects to invest in new development projects? I don´t see government expenditures being a panacea.

    However, if the government lowered taxes and freed up even more labor laws I think we would see organic growth from the private sector. This is real and sustainable and insures better allocation of capital. It would reduce unemployment and decrease government deficits.

    Regarding the front row seats, I will try and keep you all updated as the show runs its course. :-)