Risky Simplicity: Debt is Growth

Some of my friends and colleagues in the "orthodox economics" camps have tried to make the case that debt is necessary at times for growth, or at least stability. While there is merit to this line of reasoning, it is also a risky simplification of economic realities. To argue their point, these traditionalists point to household spending.

One friend, a left-leaning political scientist with solid economics knowledge, described it thusly:
All of us assume debt to improve our lives, and government is no different. We take out loans on homes, cars, our educations, and to finance our businesses. Government has to do the same. You've taken on debt, I've taken on debt, and we did it for better futures.
Arguments for a larger stimulus and more investment in some projects would have made sense ten years ago, but today those arguments ignore the experiences of Japan and southern Europe, where "investments" by the government did not revive flagging economies. I do plan a long post on the Japanese example because it demonstrates you can spend twice the money you have and get nothing in return.

However, Keynesian as it might sound, there are times when going into debt is a reasonable risk. Businesses and people do go into debt to weather tough times and to improve their futures. That debt is not without risk, or consequences. Cities, states, and nations also go into debt for good reasons. The simple reality is that most families, business, and governments cannot afford to make major investments without some debt. The question is, "How much debt is too much?"

Roads? Probably a good investment at the right long-term interest rate. Schools? Another likely good investment. Wise government projects, financed with bonds, can benefit a regional or national economy. The problem is that governments have gone beyond basic investments and taken too many risks.

The "family to government" comparisons don't quite work. Most Americans do purchase homes via mortgages, not cash. Most of us finance higher education costs. We take calculated risks that some investments are safer than others.

Yet, the reality is that people lose their homes, default on business loans, and can be trapped for life with student debt. Economic ruin is the worst case scenario of assuming debt. Great business owners and investors go broke, often more than once in a lifetime. My wife and I have had businesses close, and it is emotionally difficult, but it is a risk you assume when you open a business.

It is easy to end up in a debt-propelled death spiral. American consumers have, sadly, mirrored their national spending trends. In the two years in which household debts hit roughly 100 percent of income, there was a sudden and sharp recision (Depression): 1929 and 2007.

From a 2009 NPR report:
David Beim, a former banker who is now a professor at the Columbia Business School, has something to say to people who want to pin this whole thing on the banks. 
He has a chart illustrating how much debt American citizens owe, how much we all owe — with our mortgages and credit cards — compared with the economy as a whole. For most of American history, that consumer debt level represented less than 50 percent of the total U.S. economy, as measured by gross domestic product.
And then ...
"From 2000 to 2008, it's almost a hockey stick. It just goes dramatically upward," Beim says. "It hits 100 percent of GDP. That is to say, currently, consumers owe $13 trillion when GDP is $13 trillion. That is a ton."
This has happened before. The chart shows two peaks when consumer debt levels equaled the GDP: One occurred in 2007, the other in 1929.
And that scares Beim.
"That chart is the most striking piece of evidence that I have that what is happening to us is something that goes way beyond toxic assets in banks. It's something that has little to do with the mechanics of mortgage securitization, or ethics on Wall Street, or anything else," Beim says. "It says: The problem is us. The problem is not the banks, greedy though they may be, overpaid though they may be. The problem is us."
It is a misconception that Austrian and Chicago schools of economics don't believe in debt. The problem is that there is a debt "tipping point" at which a person, business, or government falls into an abyss of red ink. I'd rather government be as frugal as possible and avoid the same debt risks the private sector might assume. Unfortunately, we have a government in fiscal crisis mode.

As any individual or group approaches the debt crisis point there are usually clear warning signs. Among these signs are:

  • Credit becomes more difficult to secure. 
  • Interest rates due creditors rises. 
  • Loan amounts are smaller and cover shorter terms. 
  • Requirements start to include cosigners, collateral, and more.

Credit worthiness is a market determination, and it applies even to states and nations. Governments have more tricks to avoid default than do other entities, but eventually the tricks give way to the stark reality of being insolvent.

What is that point of no return? No one knows, at least not with any certainty. That goes back to trusting the market. While imperfect, the market is more accurate than any textbook formula. For modern governments, that market is bond purchasers. As demand declines, bond rates rise. To entice people and other nations to support rising debt, a country must offer higher and higher interest. Eventually borrowing costs exceed available revenues, refinancing the debt becomes impossible, and the debtor defaults.

The market can and does treat debtors with similar debt to income ratios differently, which is why U.S. treasury bonds still sell and rates are low, while Greece or Italy must entice the bond market. The U.S. is perceived by investors (lenders) as having too many options to fail. At some point, though, investors will decide the US debt is beyond any safety net.

My guess is that instead of a slow rise in interest rates, at some point the bond market will boycott the U.S. treasure market and rates will spike. It won't need to be a big, dramatic spike to hurt the U.S. because we have so much short-term debt that constantly needs to be refinanced. An interest rate point or two would severely cripple the federal budget — something few seem to realize or admit.

Consider the following chart (23 Dec 2011):

AuctionPrice ChgYield ChgPriceYield
US3M T-Bill-0.00500.00000.00250.0076
US6M T-Bill0.00750.00760.03750.0305
US2Y T-Note-0.01560.007899.67970.2785
US5Y T-Note0.31250.064399.50000.9135
US10Y T-Note-0.65630.073499.78131.951
US30Y T-Bond-1.37500.0692101.42192.9828

What this chart tells us is that the market perceives more risk over 30 years than ten years. Over the next two years or so, negligible risk is perceived. The problem is, these bond rates can and do change quickly during a crisis. Italy, Spain, Portugal, Greece, and other nations have seen borrowing costs rise. Consider this article from the Financial Times:
A peak of 8.13 per cent was reached on [Italian] three-year bonds, according to Reuters data, as Italian debt traded deeper into territory associated with bail-outs of Greece, Portugal and Ireland in the past 18 months.
"Rates have skyrocketed. It's simply not sustainable in the long run," said Marc Ostwald, strategist at Monument Securities in London.
Investors demanded a yield of 7.81 per cent for the two-year bond, up from 4.63 per cent last month. The six-month bills saw yields of 6.50 per cent, up from 3.54 per cent. That was significantly higher than Greece paid for six-month money earlier this month when it issued bills at 4.89 per cent.
By comparison to Italy's 7.71 percent three-year, the U.S. two-year note is yielding only 0.28 percent. This means that most investors view the U.S. as much, much safer than Italy over the next two to three years. The bond market trusts the U.S. government to pay its bills. Italy? Not so much.

But, read the article closely and you'll find the important nugget: the Italian bond rose from 4.63 to 7.81 percent in less than a month. One month and rates increased by 67 percent. The result of such an increase is rapid inflation and pressure on national spending. It could happen here and likely will.
How can I write that? Because the U.S. is already spending in the same range as the troubled European nations.

According to a U.S. Treasury Department report released this Friday, 23 December 2011, the U.S. debt is now $17.5 trillion, while gross domestic product (GDP) is $15.18 trillion. In other words, our liabilities exceed the value of all goods and services sold by Americans, and that (here's a mind-bender) includes items sold to the government.

CountryDebt to GDP

The U.S. debt burden, as percent of GDP, places us between two faltering economies, Greece and Italy, while still trailing hyper-Keynesian Japan where two decades of national spending ("investing") hasn't helped restore economic growth.

If current trends continue, over a 75-year period the national debt will balloon to $65 trillion. To illustrate the absurdity of that debt, it would be $550,000 per U.S. household. There is definitely a "tipping point" to U.S. deficit spending.

Will our leading economists and politicians admit this tipping point is real? I'm doubtful. Too many are calling for more spending, including in areas that go beyond proven infrastructure investments. We should be focusing our recovery efforts on basic, existing infrastructure and education, but we won't. We're already on the path to a Japanese-style lost decade or two (or three).

Debt is not always growth. Sometimes, it's simply debt.


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