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IS AGGREGATE DEBT EXCESSIVE?
The Obama administration is looking at the wrong ratio
A paper presented at the Santa Colomba Conference on the International
Monetary System at the Palazzo Mundell, July 2009.
Antal E. Fekete
San Francisco School of Economics
E-mail: aefekete@hotmail.com
The Obama Administration has raised the ante in combatting the recession by
increasing the debt of the government to levels that were previously considered
unthinkable. It is explaining away the weakening financial structure of the
country by saying that aggregate debt has not increased much relative to GDP
and is therefore not excessive.
This argument is false to the core. One cannot take comfort in past
increases of GDP to justify future increases of debt. The fact is that the increase
in debt has been the major motive power behind the increase in GDP and prices.
It cannot, therefore, be tested by its own results. The real test is the burden of
debt. The economic advisers of president Obama forget that the GDP and prices
may well decline, but the debt remains fixed. This means that, given the decline,
even without further increases in aggregate debt the financial structure will
deteriorate. How much more must it then deteriorate when all caution
concerning the threat from excessive debt is thrown to the winds!
The argument about stimulating the economy with the proceeds of selling
more government debt is equally false. It misrepresents the long-run economic
effect of debt on the capacity to produce. If we stimulate the economy beyond
its natural level by increasing debt, then we create a capacity that will not be
required, and we induce a price and wage level that will not be possible to
maintain when the debt spiral ceases. In this way government stimuli create
latent pressures for future price, wage, and output declines, increasing the debt
burden to a much greater extent than was originally envisaged.
Some people say it does not make any difference whether the money
spent has come from debt or equity. This is fallacious because debt creates
rigidities that are hard to adapt to declining prices and output. There will be
some very unsettling effects. When people are scrambling for liquidity in self2
defense, as they do now, debt will make them extra cautious about increasing
their spending. This, in turn, makes conditions worse which will then make the
debt more burdensome still, etc., creating a snowball effect. In adapting to
adverse conditions the greatest enemies are fixed costs, such as interest,
depreciation and, above all, debt which is not only hard to refinance but it also
limits flexibility. If equity was used instead of excessive debt, then the snowball
effect of adjusting to adverse conditions would be far less.
By virtue of pricing power the granting of “cost-of-living adjustments” to
labor is easy and logical, provided that the cycle is in its upswing, so things are
kept in fair balance. By contrast, reverse adjustments are very hard to make on
the downswing. Therefore rigidities and maladjustments accumulate much
faster, and they result in a much more precipitate decline as compared to the
preceding rise in output.
The Obama administration is looking at the wrong ratio. Instead of the
ratio of total GDP to total debt it should watch the ratio of additional GDP to
additional debt, that is, the amount of GDP contributed by the creation of $1 in
new debt. This ratio shows how effective debt is to make the economy grow at
the margin, and for this reason it may be called the marginal productivity of
debt. As long as it is well above 1, the creation of new debt has an economic
justification. It shows that the economy can have a healthy growth. But a falling
marginal productivity is a danger sign. It shows that the quality of debt is
deteriorating. Should the ratio fall below 1, it is “red alert”. The volume of debt
is rising faster than the national income. The country is living beyond its means
and is consuming capital.
In the worst-case scenario the marginal productivity of debt may fall into
negative territory. This means that the economy is on a collision course with the
iceberg of debt. Not only does more debt add nothing to GDP, in fact it causes
contraction and greater unemployment. Debt creation must cease at once as a
matter of utmost urgency. The condition of the economy can be compared to
that of a patient suffering from internal hemorrhaging that must be stopped
immediately.
Several observers calculated the marginal productivity of debt tracing it
back for the past fifty or sixty years. One of them, Barry B. Bannister of
Baltimore published his results on his website bbbannister@stifel.com. While
the calculations of various observers have yielded various results, they all agree
that the marginal productivity of debt has been falling and will reach 0 if it has
not already done so. The discrepancy is due to the difference in defining net
financial debt to avoid double counting. For example, Bannister is netting out all
except the first round debt in the derivatives tower and, as a consequence, his
calculations predict a further decline in the ratio but it will not become negative
before 2015. Others argue that the layers of the derivatives tower are essentially
higher levels of debt re-insurance which cannot be netted out because every
higher level means the introduction of new risks. Accordingly, their calculations
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show that zero marginal productivity of debt was reached back in 2007 and
since then the ratio has been negative and falling further.
In spite of disagreements and discrepancies, these studies agree that the
present crisis is a debt crisis, and any further addition to aggregate debt runs the
risk of making the economy contract further. Under these circumstances the
Obama administration’s economic policy is self-defeating. More debt is poison
to the economy. The internal hemorrhage will continue, nay, it will get worse.
The correct policy should allow insolvent firms and banks to be liquidated
without interference from the government. There should be a resolute policy to
strengthen the capital structure of the remaining firms and banks. It is imperative
that the level of aggregate debt be progressively reduced until a marginal
productivity of 1 or higher is restored. It follows that the balance sheet of the
Federal Reserve banks should be contracted rather than expanded.
Why is a negative marginal productivity of debt a sign of an imminent
economic catastrophe? Because it indicates that the economy is literally
devouring itself through the consumption of capital. Production is no longer
supported by the prerequisite quantity and quality of capital goods. The
responsibility for this belongs to the fast-breeder of debt. It may give the
economy a sense of euphoria during the upswing of the cycle, but is devastating in a downswing.
In March, while he was the president of the European Union, the Czech
prime minister Mirek Topolanek publicly characterized president Obama’s plan
to spend nearly $2 trillion to ease the U.S. economy out of its recessionary hole,
as “a highway to hell”, and he predicted that “it will undermine the stability of
the global financial market”. While undoubtedly it was an undiplomatic gaffe
and a display of extreme impoliteness, the caretaker prime minister did nothing
but blurted out unpleasant truths.
It would have been more polite and diplomatic if Mr. Topolanek had
couched his comments in the following tenor: “the stimulus plan was made in
blissful ignorance of the marginal productivity of debt which is negative and
falling. In this situation more debt will only stimulate deflation, economic
contraction, unemployment, and it will lead to further weakening of the global
financial structure.”
References
by the same author, see www.professorfekete.com
Falsifying bank balance sheets, April 21, 2009
Marginal productivity of debt, March 28, 2009
A critique of the quantity theory of money, April 15, 2009
June 24, 2009.