Now to Dr. Woody Bock's essay. It's called, "The End Game Draws Nigh - The Future Evolution of the Debt-to-GDP Ratio." We've picked some of our favourite parts of the essay. You can read the whole thing here, although we'd advise you to turn off the TV and turn on the coffee pot.
He first puts paid to the idea that a revival of consumer demand (which can be stimulated with transfer payments) is the key to recovery from a credit bust. "According to standard business cycle theory," Dr. Bock writes, "pent-up demand on the part of consumers is a principal driver of recovery-but it will not be this time around. The shift towards less consumption and more savings due to the implosion of household balance sheets and to demographics is most probably permanent. If so, this bodes poorly for hopes of a pent-up demand-driven recovery."
This reinforces the unique nature of this recession as a "balance sheet recession." In a balance sheet recession, businesses and households devote most of their resources (extra income) to paying off liabilities and reducing debt. They deleverage. Lowering interest rates, then, on the hope that it will revive a mythical pent up demand, ignores the psychological and economic reality of the desire and the need to reduce debts. The recent retail sales figures in America bear this point out.
So in comes the government, under Keynesian orthodoxy, to fill the consumption gap. Yet there is evidence, according to Dr. Bock, that rising government deficits as percentage of GDP actually neutralise the effects of stimulus spending on GDP. Put that in your pipe and smoke it IMF.
As Dr. Bock puts it, "When fiscal stimulus exceeds a certain level (e.g., 7%), the financing of deficits is likely to cause a sharp increase in real longer-term interest rates. Importantly, this holds true regardless of whether the huge deficits are monetized for reasons we carefully articulated. Higher real yields in turn neutralize the original fiscal stimulus, thus causing the curve to flatten out."
The "curve" he mentions is below. But in laymen's terms, Dr. Bock is pointing out that when deficits grow to a certain size of GDP, it costs money just to pay interest on the debt. Just ask America. It means that over time, an increasingly large share of government resources go merely to pay interest on the debt that's been accumulated. That's tax revenue that doesn't produce anything.
Government Stimulus: The bigger it gets, the less it accomplishes
"If the Debt ratio [as a percentage of GDP] continues to rise, then it tends to accelerate due to the ever-rising cost of servicing this ever-rising 'primary"' deficit. Not only does the increasing debt-load itself cause ever-higher servicing costs, but the rising real rates that typically result from ever-greater debt make the spiral ever worse. The result can be economic and social collapse."
So at a certain percentage of GDP, more government borrowing not only leads to rising interest rates for households and businesses, but it has less of an effect on the economy. And what level is that? Dr. Bock's chart says it's around 10%. We know if it gets bigger it won't help. But what if it doesn't decrease from that level? What if just stays the same?
"If debt-to-GDP ratio stagnates, it tends to be associated with very low real growth, political paralysis, and a degree of social disenchantment. If the ratio falls, it is usually because of a combination of two developments: higher real growth and vigorous fiscal discipline. Rising living standards, dreams of a better future, and a sustained belief in democracy are associated with this happiest of trajectories."
It does sound happy. Lower government spending. Productivity growth in the real economy. These things probably would happen once household and business balance sheets de-levered. Newly healthy and well-balanced, the demand for credit to finance new projects would grow. But it requires reduced spending AND policies that promote growth. And to be fair, the Rudd government's budget does project much lower spending and "above trend" growth in 2010 and beyond.
"We can deduce from the foregoing analysis," Dr. Bock says, "that sustainable long run economic recovery from a debt overload requires two sets of policies: One set must be dedicated to curtailing the growth of government spending and hence, the growth of the deficit. The other set must be dedicated to maximizing real economic growth. In this way, both the numerator and the denominator of the killer Debt-to-GDP ratio will be managed so as to maximize future social welfare."
"Policies aimed at augmenting real growth are arguably the more important here. This is because more rapid growth not only reduces the Debt ratio, but also causes swelling tax revenues which can help to reduce the deficit each year. That is, stronger growth drives both the numerator and the denominator in the right directions."
"This reality underscores why 'It's the real growth rate' must become the mantra of recoveries not only in the US, but almost everywhere else as well. Note that this 'strong growth' mantra is a far cry from the Obama administration's counsel to the world at the recent G-7 conference: 'Stimulate everywhere by running higher deficits!'"
"Finally, and perhaps most importantly, productivity-driven strong growth alone increases living standards that boost the hopes and dreams of people everywhere for a better tomorrow for their children. When citizens have realistic hopes of a better tomorrow, social unrest is minimized. Conversely, when prospects for the long run are grim, voters are easily swayed by demagogues to vote for the Hitler of their day."
So how is Australia going to increase its real, productivity driven growth rate, over the next five years? And if it does, which businesses are likely to deliver the most growth and the biggest gains to shareholders? More on that tomorrow.
Dan Denning
for The Daily Reckoning Australia
P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.
Related Articles:
- Only Thing Rising Faster than Demand for Government Debt is Supply of It
- The Shiller P/E Ratio
- In the Name of Debt
- U.S. Economy: Jobs Up, Income Down
- Price-to-Earnings Ratio of the S&P 500 Index
About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.
Comment by Lachlan on 20 May 2009:
"Conversely, when prospects for the long run are grim, voters are easily swayed by demagogues to vote for the Hitler of their day."
Yeah, probably true Dan but here in Australia we vote for dictators even when the future looks bright.
Comment by David on 21 May 2009:
I've only caught on to your articles this year, and are fascinating reading.
If the US government got itself in a situation where it couldn't pay it's debts to overseas investors, and took a protectionist attitude and defaulted on borrowings to non-US creditors, who or what could do anything about it? WWW3. You'd want to be backing US to win that with it's armed forces and weaponry.
We read that China has the US by the proverbials with the amount of debt they have purchased.
In this scenario, who has who by the proverbials?
It's the Alan Bond motto, if you owe the bank $50K, you've got a problem, and if you owe them $500M, they've got the problem.
Love to hear your thoughts on this.
Regards
Comment by Lachlan on 21 May 2009:
USD 2Trillion wont be worth much soon anyhow and anyhow the whole problem will help justify doing what both sides really want to do anyhow which is to bring about a new world currency.
Comment by Robert on 21 May 2009:
Productivity will only grow with increased efficiency, and Lean Thinking is the best known improvemnt method. I am sure most investors dont realise that companies are operating at almost 50% waste in their costs. The acknowledged best operator is Toyota.
Look at their financials vs GM, that is productivity not goverment rubbbish about more people to grow the economy, it is the yield per capita that determines wealth per capita.
I would love you to provide a finance view of Lean and how it should be applied to industry.
Comment by Pete on 22 May 2009:
David: Shame you only started reading this year. I've been reading for about 18 months and the articles and advice saved me from the stock market shenannigans big time.
Hang about and hear about how things will unfold...before they do.
Comment by Pete on 22 May 2009:
"rising government deficits as percentage of GDP actually neutralise the effects of stimulus spending on GDP. Put that in your pipe and smoke it IMF"
Haha, good one Dan.
Debt to GDP level "And what level is that? Dr. Bock's chart says it's around 10%"
Rock-on. We're headed for more than that already. My guess is that we'll actually go well above 40%. Also consider that the GDP level will probably fall. That really messes things up.
"Conversely, when prospects for the long run are grim, voters are easily swayed by demagogues to vote for the Hitler of their day"
Completely agree with that. Now perhaps we shouldn't worry about an Australian Hitler too much, because we are international lightweights. But an American Hitler on the other hand (some would argue that Bush was part way there) would be a real mess for the world. And America is going down the gurgler in a hurry.
It's also worth noting that the only thing that pulled America out of the Great Depression was WWII. I think they remember that lesson quite well.
Comment by Biker Pete on 22 May 2009:
Ah, but I was reading it _long_ before Dan arrived in Australia, Pete. There's no shame in climbing aboard during the journey. As the lone Ratbiker on this ark, I welcome you aboard, David! Mind where you step
Comment by David (Brisvegas) on 22 May 2009:
Good to be here.
I managed to avoid the stock market crash- sold out in Feb 07.
More good luck than market insight, but glad I dodged some of the problems that would have come my way.
Comment by Unpopular Truth on 22 May 2009:
Lets not forget that those in power can change the rules when it suits them. It wont take much for the USA to decide to 'neutralize the debt' or freeze interest payments or something else if it really becomes a problem for them. That'll happen when those who are owed money start to get more aggressive, and it's politically viable.
Comment by Biker Pete on 22 May 2009:
David: Yes, we sidestepped the crash too (at 6200, anyway); largely thanks to DR (rather than DRA) which I've read daily for years. The World Bank helped, too. We were yachting near Lakes Entrance when a radio report basically confirmed what Bill had been saying that week. I'd already signalled my intentions, but WB confirmation helped convince my partner (granddaughter of a legendary BC broker). We emailed instructions to WA to sell... and saved megabucks.
Comment by Ned S on 22 May 2009:
Pete - The US might like a war. But the trick is to get someone else to fight it while they provide the bullets. And apart from Sitting Bull and Cochise they've definitely been away players since they got a good taste of what a home game was like back in the mid 1800s.
I doubt Europe is interested - They don't have any empires to pinch off each other anymore. Plus they tried it a couple of times anyway and decided they didn't like it.
I suppose Pakistan could get its IMF handout and decide to spend it nuking India and getting nuked back - Doesn't sound too likely though. Or India might decide it wants Pakistan back - Even less likely - Who'd want Pakistan?
Plus no money to be made from nuclear holocaust anyway - All over way too quick. No value in that. It has to be conventional war dragged out over a lot of years with lots of bullets sold and lots of property destroyed that needs to be rebuilt to be an effective stimulus package.
Who else might play?
Russia lining up against China might be handy - But it seems a bit fanciful - The CIA would have to do a lot of leg work in less than friendly territories to make that happen.
Isreal jumping on Iran is one of the more promising alternatives. With Russia backing Iran and the US backing Isreal? But I doubt Russia cares that much about Iran really - The Russians have got plenty of their own oil. And Americans cry a lot every time they get a flag draped aliminium box delivered airmail - Doubt they'd cut it psychologically against anyone who hits back.
Still, give the world 8 or 10 years of global recession and lots of angry young men and desperate old politicians and anything is possible I suppose? Cheers!Must admit, inflation sounds better though?