Debt Delusion: The Bankrupt Financing the Bankrupt

Before we get into this weekend’s Markets and Money, your opinion on the following thought experiment would be helpful. It’s about a unique situation presented by a debt to GDP ratio of 100%.

America’s debt to GDP ratio is now above 100%. Assume it’s exactly 100% for the moment. And to keep things simple, we’ll use $15 trillion as the total debt and the GDP. So the debt to GDP ratio looks like this: 15:15 (or 100%).

According to some economists, more government spending labelled ‘stimulus’ should have a multiplier effect of more than one on GDP. That means, for every dollar spent by the government, more than $1 in GDP is created.

In a situation where stimulus has to be funded by debt, that means stimulus should spur on GDP more than it increases debt.

So say another trillion dollars is borrowed and spent on stimulus in the US. There are three possible results:

  1. The increased borrowing increases GDP by the same amount as what was borrowed, leaving the debt to GDP ratio at 16:16 (100%). This wouldn’t change the debt to GDP ratio.
  2. The increased borrowing increases GDP more than the amount borrowed, leaving the ratio at, say, 16:17 (94%). This is a reduction in the debt to GDP – a successful stimulus effort.
  3. The increased borrowing causes GDP to grow less than the amount borrowed, leaving the ratio at, say, 16:15.5 (103%). This increase in debt to GDP would show the stimulus didn’t work, for whatever reason.

The question is, if stimulus advocates are right and government spending does stimulate the economy, how could the debt to GDP ratio ever rise beyond 100%? Each time more is borrowed, the economy should grow more than debt.

There are plenty of things missing in this analysis, like interest rates, but the logic seems to hold. Let us know what you think at

The Answer Is Debt

Never mind what the question might be.

Not earning enough? Borrow some money! Can’t afford a deposit on a house? Get a ‘no deposit home loan’! Can’t afford the furniture to fill your home? Get a 120% loan!

Want to invest in the stock market? Get a margin loan! Want to speculate? Use CFDs! Want to make a buck on Wall Street? Just borrow more money than the next guy and buy his company!

Want a car? Get a 2000 day interest free personal loan! Can’t afford the camera at ‘Cash Converters’? Get a loan and a camera at the same time! Can’t afford all your personal debt? Get a GE debt consolidation loan!

Got to raise welfare payments for your upcoming election? Borrow some money! Want to spend money on some air force jets? Issue some bonds! Got sub-par economic growth? Issue some bonds to pay for infrastructure spending! Got to bail out a bank? Issue some bonds…to the banks!

What nobody seems to realise is that debt has to be repaid…with interest. For the moment, it’s popular to pay that debt and interest with more debt. But if more debt was the answer to debt, debt wouldn’t be a problem in the first place!

Just how bad are the world’s debt problems really? Let’s do a global debt tour.

The Solution to Debt isn’t More Debt

You might think Europe is in trouble when it comes to sovereign debt, but Japan is actually far worse off. The country’s government currently spends around 25% of its tax revenue on interest payments. And that’s with interest rates near 0.

If interest rates rise, the proportion of tax going to interest will skyrocket. Rates could easily quadruple, leaving Japan with an interest bill bigger than its tax revenue. And that may happen soon, now that the government has announced inflationary policies. With higher inflation come higher interest rates.

Ironically, Japan has announced it will buy Europe’s bailout fund bonds. Just to be clear about what that means; Europe set up a bailout fund, financed by debt, to bailout countries with too much debt. But the money for the bailout fund is coming from the country with the highest debt to GDP ratio in the world!

In America, they’re performing this incredibly stupid feat without international help. Here’s how it works. There’s so much debt that more must be borrowed not just for spending, but to pay off old debt.

Take 2010 as an example. The government only borrowed about $1 trillion to finance new spending. But, according to Zhang Monan, researcher at the China Macroeconomic Research Platform, America borrowed $4 trillion in total. The difference was $3 trillion in borrowings to repay old debt. Put the two back together and government debt churning is almost one-quarter of US GDP.

For some more amusing stories about government financial lunacy, let’s go to Greece. The country’s new tax enforcer recently admitted he couldn’t pay his own property taxes.

His former boss, Deputy-Prime Minister Pangalos, had the same issue with his 50 residences. In France, the labour minister admitted, ‘There is a state but it is a totally bankrupt state.’ That hasn’t stopped the French from gallivanting around Timbuktu.

One thing that has everyone in Europe confused is whether the banks or the governments are more bankrupt. When in doubt, Europe’s policy is for everyone to bail out everything. Zero Hedge made fun of the results with this headline: ‘As Euro Banks Return €137 Billion In Cash, Moody’s Warns “European Banks Need More Cash”.’

At least the debt problems in much of the world are public. In China, the mother of all cover-ups is underway. Local governments have figured out that all their construction projects will never be able to pay back the debt that financed them. And the banks have figured out that the loans are too big to allow default.

The solution, you might have guessed, is to lend out more money to pay off the old loans. What’s impressive in China is the scale of the operation. The Financial Times reports that $482 billion in loans have been ‘extended’ in 2012 because of a lack of revenue to repay. That’s over three-quarters of the loans!

The worry for Australians is that China needs to continue building stuff for our resources to be in demand. If existing projects aren’t paying off, will the Chinese build more? How will they finance more construction?

Here in Australia, the real debt story has yet to break. Many countries only landed in a pickle once they had to bail out their banks. We haven’t had to, yet. But if we ever do, we’ll have an enormous banking system to save.

Credit Card Declined?

So at what point can debt no longer solve too much debt? Well, more debt never could solve a problem of too much debt. The real question is at what point will investors realise this? Will it be when Japan pays its entire tax revenue in interest? Will it be when Chinese banks stop lending to bankrupt developers? Will it be when Australians simply can’t borrow any more to buy overpriced homes?

The famous investor Marc Faber isn’t sure what will be the crucial moment. But here’s what he did say:

‘The only thing I know is one day the markets will punish the interventionists, the Keynesians and the monetary policy that the Federal Reserve and ECB has enforced because the markets will be more powerful one day.’

When they are more powerful, the idea that more debt can solve debt will be bankrupt.

Until next week,

Nickolai Hubble
Markets and Money Weekend Edition

PS. If you’re struggling with your own debts now that the Aussie property market is flatlining, keep an eye out for a special report on how to cancel your mortgage.

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