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.
for Markets and Money