The Z1 report released earlier this week looks superficially positive from a mainstream perspective. Total credit increased from $52.3 trillion to $52.6 trillion, which is nearly back to the pre-bust level of $52.9 trillion in Q1 2009. This is in keeping with the theme of a fragile, but real economic recovery. However, a closer look at the debt by sector reveals that it is merely more of the same pretend-and-extend at work, with public debt filling in the gap created by deflating private debt. Whereas the financial sector debt has contracted $2.9 trillion (16.7%) and the household sector has contracted $500 billion (3.7%), the federal government sector debt has nearly doubled with an increase of $4.1 trillion (78%). This means that the government debt (federal, state, and local), has now increased from 16% of the total debt market in 2005 to 22.5% now.
Notice that state and local government debt has been increasing even as their ability to service their debt has dramatically declined. This increase cannot continue, which is why more political conflicts like the one in Wisconsin can be expected and why more state and local governments will be expected to default on their debts. Moreover, we can expect the decline in household debt to pick up speed in the near future, since many defaults are not being registered yet and the only area of growth has been student loans. As more home defaults enter into the system and more prospective students begin to understand the declining value of university credentials, we can be confident that the household sector will begin to contract at a rate approximately 5x faster than before.
This will put more pressure on the federal government to increase its rate of debt expansion beyond the 5.5 percent per quarter growth that it has been averaging since the crisis began in Q3 2008. I estimate that in 2011, the federal government will have to continue expanding its debt at a rate of at least 6% per quarter in order to prevent total credit from contracting.