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Posted by Steve Markowitz on October 21, 2015

Macro-Economic Consequences of Excessive Debt

During the past three and half decades the United States and other countries have been on a debt binge.  At an increasing rate the Country has used debt not to finance needed infrastructure or future growth, but instead to increase the lifestyle and wealth of the current generation, most notably Baby Boomers.  Examples include the United States running significant deficits to fund its social programs and crony capitalism.

DebtIn the private sector, individuals and corporations now use a similar philosophy for debt.  Instead of using debt in the traditional role of financing growth, companies use it to increase distribution to executives, employees and shareholders.  Similarly, individuals who in previous generations used debt mainly to fund the purchase homes, vehicles and other big-ticket necessities, now use it to purchase any product that offers instant gratification.  Debt is also used, with governmental support, to fund higher education that no longer offers income growth.  The significant increase in worldwide debt is depicted in the chart.

Although politically incorrect to state in today’s world, excessive debt has consequences.  On the consumer side it often leads to bankruptcies and loss of assets.  A more insidious problem occurs when debt is sovereign, the consequences that we are now seeing in the lethargic economic growth that is occurred since the end of the recession nearly 6 years ago.

Dr. Lacy H. Hunt, Ph.D has published a lengthy report on issues created by excessive debt in the Hoisington Quarterly Review and Outlook – 3Q2015.  This report advises investors to stay in long-term government bonds given the likelihood of long-term \ continued low interest rates.  The report also includes reasons why the debt has been, and will continue to be, a drag on economic growth.  Hunt’s conclusions include:

  • Future business activity will reflect two economic realities: 1) the over-indebted state of the U.S. economy and the world; and 2) the inability of the Federal Reserve to initiate policies to promote growth in this environment.” Translation – The Fed’s easy money policies have not and will not fix the economic problems brought on by excessive debt.
  • S. government debt now stands at 103% of GDP. If private debt is included, the ratio climbs to about 370% of GDP.  Scholarly studies indicate that real per capita GDP growth should slow by about one-quarter to one-third from the long-run trend when the total debt-to-GDP ratio rises into the range between 250% and 275%.  Since surpassing this level in the late 1990s, real per capita GDP has grown just 1% per annum, much less than the 1.9% pace from 1790 to 1999.”  Translation – Excessive debt has led to lower economic growth.
  • These results indicate that the relationship between debt and economic growth is non-linear, or progressively negative, as debt advances to higher levels, a pattern confirmed by academic research (Chart 2). The latest information further supports this relationship.  The current expansion began in 2009, and since then real per capita GDP growth has been 1.3%, less than half the 2.7% average growth in all expansions from 1790 to 1999.”  Translation – This recovery is different and historically weak and seems related to the growing debt.
  • The Bank of International Settlements released a report last month stating that total public and private debt relative to GDP for the entire global economy stands at 265%, up from 219% at the peak of the prior credit cycle. Additionally, the global rate of growth is decelerating significantly while debt levels are continuing to rise, indicating an increasing debt drag. Researcher Chris Martenson calculated that since 2008 total public and private debt rose by $60 trillion while GDP gained only $12 trillion.”  Translation – While the huge deficit spending by governments have not led to proportional economic improvement.
  • Despite the unprecedented increase in the Federal Reserve’s balance sheet, growth in M2 over the first nine months of this year fell below its average rate of growth over the past 115 years, a time when the growth in the monetary base was stable and quite modest (Chart 3).” ….  “The drop in velocity to a six decade low is consistent with a misallocation of capital and an increase in debt used for either unproductive or counterproductive purposes.”  Translation – While the Fed has increased its balance sheet significantly, it has not led to a real increase in the money supply, a requirement for economic growth.
  • The current zero interest rate policy has rendered mass distortions in the allocation of capital and mispricing of risk assets. Such repressed interest rates have contributed to more excess capacity that, in turn, has reduced inflation.  The ZIRP policy allows low quality borrowers access to debt markets, creating untenable balance sheet exposure when economic activity slows”  Translation – The fed’s policies are leading to imbalances in the markets that will ultimate have to rebalance, which always involves pain.
  • An extended period of negative interest rates would lead to many adverse unintended consequences just as with QE and ZIRP. The initial and knockoff effects of negative interest rates would impair bank earnings.  Income to households and small businesses that hold the vast majority of their assets with these institutions would also be reduced.  As time passed a substantial disintermediation of funds from the depository institutions and the money market mutual funds into currency would arise.  The insurance companies would also be severely challenged, although not as quickly.  Liabilities of pension funds would soar, causing them to be vastly underfunded.”  Translation – The coming consequences of the Fed’s policies will not be pretty.

Lacy concludes by saying: “History, economic studies and practicality of politics suggest this is just another red herring trying to solve over-indebtedness with more debt.”  In normal times the obviousness of this conclusion would be laughed at.   But these are not normal times for the world’s economies.

Hoisington Quarterly Review and Outlook – 3Q2015

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