Debt-to-GDP and Misdiagnosing a Bubble Economy’s Ills

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A few economists seem to be catching on, but not nearly enough…

About a year ago, St. Louis Fed President James Bullard wondered whether too much faith was being placed in what models say economic growth should be but, as detailed in When Models Trump Common Sense, he was rebuffed by nearly the entire establishment (or at least “a small army of bloggers with PhDs in economics”).

Now, in a story at Project Syndicate, Raghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and the IMF’s youngest-ever chief economist tries to explain Why Stimulus Has Failed and, in doing so, questions whether the root cause of our current economic troubles is simply a lack of demand, casting himself as an Austrian sympathizer in the process:

What if the problem is the assumption that all demand is created equal? We know that pre-crisis demand was boosted by massive amounts of borrowing.

project syndicatePut differently, the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand.

The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand … The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.

Not surprisingly, it didn’t take long for one commenter to call Rajan out:

Raghuram Rajan’s article sounds awfully close to me to a defense of Austrian Economics, a la Ludwig von Mises. Even though Mr. Rajan might not want to portray it that way. [Austrian Econ is not all too popular these days in the venerable halls of the top departments of Economics, where Mr. Rajan circulates.]

For reasons that make no sense to anyone who isn’t an economist, it has long been accepted as conventional wisdom amongst the dismal set that demand is demand – it doesn’t matter where it comes from – and, once it appears, it forms the basis of an economy’s “potential” output or “potential” GDP.

Once an economy’s actual output dips below its “potential” output (as extrapolated from past activity, regardless of what drove that past activity), then you have what’s called an “output gap” as shown below, and this is what leads to the massive amounts of money printing and borrowing seen today.

Output GapWhat Rajan is suggesting above is that policymakers may have misdiagnosed the problem – that the mid-2000′s demand wasn’t really sustainable demand – and, as a result, they are now applying the wrong solution by trying to close this “output gap” via more money printing and more government debt.

In effect – Gasp! – the Austrians could be right about this – there is no easy solution to a debt-driven boom.

You either take your medicine or you take steps that could end up destroying your currency (in our developing global currency war, perhaps all the worlds currencies).

Clearly, the world’s economists are opting for the latter.

How this all relates to debt and deficits is important because a big part of the rationalization for all the borrowing and spending that is going on in the U.S. and in other developed nations around the world these days is that these debt-to-GDP ratios are only high because GDP is low.

Once we restore economic growth back to its early-2000s glory, the debt won’t seem so bad anymore.

The thinking goes that, once a strong recovery takes hold, tax receipts will go up, fewer people will collect jobless benefits, and the government’s books will look much better, but that will only happen when heady rates of growth return, growth rates that have, in recent decades, required a heady expansion in credit.

Coming at a time when consumers and businesses are trying to get out from underneath an already hefty debt load, that doesn’t seem likely, but, that’s not stopping policy makers from taking this approach.

That’s all they know – we have a shortfall of aggregate demand, therefore, we need more demand.

Debt to potential GDPOne well known Nobel Prize winning economist and New York Times columnist has gone so far as to recommend no longer looking at the real economy when assessing the nation’s borrow-and-spend ways, but to look at “potential GDP” which, of course, isn’t such a scary picture.

As shown to the right, when viewed this way, government spending as a share of “potential” GDP is just about back to where it was in the days prior to the bursting of the housing bubble that led to the precipitous decline in “actual” GDP.

The conclusion?

All that extra debt the government has been piling on is no big deal.

The basic problem here is that the vast majority of the world’s economists don’t seem to even consider the possibility that a good portion of the demand (and, hence, strong economic growth) seen in the early-2000s and in prior decades has been debt-driven.

Home equity driven consumer spending around the middle of the last decade is probably the best example of this and how anyone can just blindly extrapolate from this point to calculate “potential output” is beyond me.

More importantly, having expanded credit about as far as it could go six or eight years ago before the wheels fell off of the global economy and financial system, we’ve surely come to the end of the road when it comes to strong credit expansions, yet few economists seem to acknowledge this reality.

It’s highly unlikely that the “bubble economy” levels of growth can be restored (and slowing population growth makes this even more difficult), yet governments continue to borrow and spend while central banks continue to print money with abandon, all of these efforts all aimed at doing so.

Of course, the unacknowledged solution here is that all this borrowing and money printing will lead to another asset bubble and, an even briefer period of debt-driven prosperity. That this is, basically, being sanctioned by the world’s economists is probably the most disturbing aspect of all of this.

We are, in effect, trying to create more “artificial” demand to close the “output gap”, all the while fooling everyone into thinking that debt-to-GDP is the only thing that matters when talking about the national debt.

In a bubble economy, perhaps the more important part of debt-to-GDP is the nature of the GDP, not the debt.

Source: Iacono Research

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About Tim Iacono