Sovereign debt is a serious problem around the world. Today, I’d like to share a thought-provoking column from Real Investment Advice about the U.S. national debt. I’m usually bullish on stocks, so I’ll disclose up front that I’ve organized this post for a balanced view.
Below is an interpretation of the column above. The chart is imported as is, and if it’s a problem, I’ll remove it.
Washington continues its seemingly reckless spending with the following assumptions. To better understand the impact of debt and deficits on economic growth, we need to know where we are in history. This chart shows the 10-year average annual growth rate of an economy over time.
It’s immediately noticeable that from 1900 to 1990, with the exception of the Great Depression, the 10-year average economic growth rate was about 8%. Since then, however, economic growth has declined significantly.
The question is, why? Of course, this question has been a point of contention over the past few years as the level of debt and deficit in the United States has skyrocketed.
Causality? Or correlation?
As we’ll see, it can be argued that a surge in debt is responsible for slowing economic growth. However, we should start our discussion with Keynesian theory, which has been the primary driver of fiscal and monetary policy for the past 30 years.
“Keynes argued that “when there is insufficient aggregate demand for a commodity, a general glut occurs, leading to a recession, which, due to the defensive (or reactive) decisions of producers, results in a loss of potential output with unnecessarily high unemployment”.
In these situations, the Keynesian economics argues that government policies can increase aggregate demand, which increases economic activity and reduces unemployment and deflation.Government investment increases income, which results in more spending in the general economy, which in turn stimulates more production and investment, which entails more income and spending. The initial stimulus starts a chain of events, and the total increase in economic activity is a multiple of the original investment.”
Keynes was right. For deficit spending to work, the rate of return must be higher than the debt used to fund the investment.
The problem was twofold.
First, “deficit spending”was to be used only during recessions and then turned into a surplus during expansions. But since the early 80s, the powers that be have only stuck to the deficit spending part.
Second, deficit spending has moved away from productive investments like infrastructure and development that create jobs. Politically, it was used primarily for social welfare and debt repayment. Funds used in this way will have a negative rate of return.
According to the
Center on Budget and Policy Priorities,
about 88% of all taxes are used for unproductive spending.
Here’s the real key. In 2022, the federal government spent $6 trillion, or nearly 20% of the total U.S. nominal GDP (19.74% to be exact). Of the total spending, only $5 trillion was financed by federal revenues, and $1 trillion was funded by appropriations. It was financed through debt.
In other words, if 88% of all spending is social security and interest on debt, we need $5.3 trillion (or 105%) of the $5 trillion in revenue.
Do you see the problem here?(In the financial markets, borrowing money from others to pay off debts you can’t afford is known as a “Ponzi scheme.”)
Debt is the cause, not the cure
This is one of the problems with MMT. Assume that “debt and deficits don’t matter” unless there is inflation. However, this premise is no longer valid if we pay attention to debt and economic growth trends.
The word deficit has no real meaning. Let’s take the example of two countries.
Country A spends $4 trillion and imports $3 trillion. This causes country A to have a fiscal deficit of $1 trillion. To make up the difference between spending and revenue, the Treasury needs to issue $1 trillion in new debt. This new debt is used to cover the overspending, but it doesn’t generate any income, leaving a hole that will need to be filled in the future.
Country B spent $4 trillion and earned $3 trillion in revenue. However, the excess $1 trillion in debt financing was invested in projects and infrastructure that generate positive returns. There is no deficit because investment returns make up the “deficit” over time.
There’s no disputing the need for government spending. It’s just that we disagree on what constitutes abuse and waste.
The United States is Country A
The increase in national debt has long been wasted on increased social programs and ultimately higher debt service, which effectively results in a negative return on investment. Therefore, larger debt balances are more economically destructive for the following reasons. This is because it diverts more and more money from productive assets to paying down debt.
The connection between debt and economic growth is clear, as shown in the figure below. Since 1980, the overall growth rate of debt has soared to the point where it is now eating up the entire economic growth rate. With economic growth currently at an all-time low, these changes have had the following consequences The rise in debt is diverting more taxes from productive investment to debt and social welfare.
The irony is that debt-fueled economic growth constantly requires more debt to cover diminishing returns on future growth. We now need $4.47 of debt to generate $1 of real economic growth.
But the federal debt isn’t the only problem. All debt is a problem.
Households are responsible for about two-thirds of economic growth through personal consumption expenditures. Debt was used to maintain a standard of living well beyond what income and wage growth could support. This was only possible with the ability to leverage debt. Eventually, debt reaches a level where it cannibalizes economically productive consumption.
For 30 years, from 1952 to 1982, debt-free economic growth was in surplus. However, since the early 80s, the growth rate of total debt in credit markets has sharply outpaced economic growth. The cumulative economic deficit is now over $74 trillion.
From this perspective, we can understand the more important issues plaguing economic growth.
Debt endgame
Unsurprisingly, Keynesian policies have failed to spur broad-based economic growth. Fiscal and monetary policies, from TARP to QE to tax cuts, have only delayed the ultimate recovery process. Unfortunately, these delays only create bigger problems in the future. As Zerohedge points out
“The IIF pointed to the obvious fact that lower borrowing costs due to central bank monetary easing have pushed countries to take on new debt. Interestingly, this has made rising interest rates even more impossible, as the world can’t service 100% of its debt, let alone three times its GDP.”
Ultimately, the liquidation process will be very substantial. To get back to structurally manageable debt levels, we’d need to cut nearly $50 trillion from current levels.
This is the “Great Reset” that many people are calling the “endgame.”
The economic consequences of this debt reduction could be devastating. The last time such a regression occurred, the period is known as the “Great Depression.”
This is one of the main reasons why economic growth will continue to be low.
If so, here’s what you can expect going forward
- Recessions may occur more frequently,
- Stock market returns fall.
- A stagflationary environment persists, where the cost of living rises while wage growth is suppressed.
Changes in deflationary pressures due to structural employment, demographic, and productivity changes will amplify these challenges.
Correlation or causation? You decide, but $32 trillion may be more important than you think.
