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Is Aggregate Debt Excessive?

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Professor Fekete.com
From the Archives : Originally published June 24th, 2009
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The Obama Administration has raised the ante in combatting the recession byincreasing the debt of the government to levels that were previously consideredunthinkable. It is explaining away the weakening financial structure of thecountry by saying that aggregate debt has not increased much relative to GDPand is therefore not excessive.

This argument is false to the core. One cannot take comfort in pastincreases of GDP to justify future increases of debt. The fact is that the increasein 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 ofdebt. The economic advisers of president Obama forget that the GDP and pricesmay well decline, but the debt remains fixed. This means that, given the decline,even without further increases in aggregate debt the financial structure willdeteriorate. How much more must it then deteriorate when all cautionconcerning the threat from excessive debt is thrown to the winds!The argument about stimulating the economy with the proceeds of sellingmore government debt is equally false. It misrepresents the long-run economiceffect of debt on the capacity to produce. If we stimulate the economy beyondits natural level by increasing debt, then we create a capacity that will not berequired, and we induce a price and wage level that will not be possible tomaintain when the debt spiral ceases. In this way government stimuli createlatent pressures for future price, wage, and output declines, increasing the debtburden to a much greater extent than was originally envisaged.

Some people say it does not make any difference whether the moneyspent has come from debt or equity. This is fallacious because debt createsrigidities that are hard to adapt to declining prices and output. There will besome very unsettling effects. When people are scrambling for liquidity in self2defense, as they do now, debt will make them extra cautious about increasingtheir spending. This, in turn, makes conditions worse which will then make thedebt more burdensome still, etc., creating a snowball effect. In adapting toadverse conditions the greatest enemies are fixed costs, such as interest,depreciation and, above all, debt which is not only hard to refinance but it alsolimits flexibility. If equity was used instead of excessive debt, then the snowballeffect of adjusting to adverse conditions would be far less.

By virtue of pricing power the granting of “cost-of-living adjustments” tolabor is easy and logical, provided that the cycle is in its upswing, so things arekept in fair balance. By contrast, reverse adjustments are very hard to make onthe downswing. Therefore rigidities and maladjustments accumulate muchfaster, and they result in a much more precipitate decline as compared to thepreceding rise in output.

The Obama administration is looking at the wrong ratio. Instead of theratio of total GDP to total debt it should watch the ratio of additional GDP toadditional debt, that is, the amount of GDP contributed by the creation of $1 innew debt. This ratio shows how effective debt is to make the economy grow atthe margin, and for this reason it may be called the marginal productivity ofdebt. As long as it is well above 1, the creation of new debt has an economicjustification. It shows that the economy can have a healthy growth. But a fallingmarginal productivity is a danger sign. It shows that the quality of debt isdeteriorating. Should the ratio fall below 1, it is “red alert”. The volume of debtis rising faster than the national income. The country is living beyond its meansand is consuming capital.

In the worst-case scenario the marginal productivity of debt may fall intonegative territory. This means that the economy is on a collision course with theiceberg of debt. Not only does more debt add nothing to GDP, in fact it causescontraction and greater unemployment. Debt creation must cease at once as amatter of utmost urgency. The condition of the economy can be compared tothat of a patient suffering from internal hemorrhaging that must be stoppedimmediately.

Several observers calculated the marginal productivity of debt tracing itback for the past fifty or sixty years. One of them, Barry B. Bannister ofBaltimore published his results on his website bbbannister@stifel.com. Whilethe calculations of various observers have yielded various results, they all agreethat the marginal productivity of debt has been falling and will reach 0 if it hasnot already done so. The discrepancy is due to the difference in defining netfinancial debt to avoid double counting. For example, Bannister is netting out allexcept the first round debt in the derivatives tower and, as a consequence, hiscalculations predict a further decline in the ratio but it will not become negativebefore 2015. Others argue that the layers of the derivatives tower are essentiallyhigher levels of debt re-insurance which cannot be netted out because everyhigher level means the introduction of new risks. Accordingly, their calculations3show that zero marginal productivity of debt was reached back in 2007 andsince then the ratio has been negative and falling further.

In spite of disagreements and discrepancies, these studies agree that thepresent crisis is a debt crisis, and any further addition to aggregate debt runs therisk of making the economy contract further. Under these circumstances theObama administration’s economic policy is self-defeating. More debt is poisonto the economy. The internal hemorrhage will continue, nay, it will get worse.

The correct policy should allow insolvent firms and banks to be liquidatedwithout interference from the government. There should be a resolute policy tostrengthen the capital structure of the remaining firms and banks. It is imperativethat the level of aggregate debt be progressively reduced until a marginalproductivity of 1 or higher is restored. It follows that the balance sheet of theFederal Reserve banks should be contracted rather than expanded.

Why is a negative marginal productivity of debt a sign of an imminenteconomic catastrophe? Because it indicates that the economy is literallydevouring itself through the consumption of capital. Production is no longersupported by the prerequisite quantity and quality of capital goods. Theresponsibility for this belongs to the fast-breeder of debt. It may give theeconomy a sense of euphoria during the upswing of the cycle, but is devastatingin a downswing.

In March, while he was the president of the European Union, the Czechprime minister Mirek Topolanek publicly characterized president Obama’s planto 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 ofthe global financial market”. While undoubtedly it was an undiplomatic gaffeand a display of extreme impoliteness, the caretaker prime minister did nothingbut blurted out unpleasant truths.

It would have been more polite and diplomatic if Mr. Topolanek hadcouched his comments in the following tenor: “the stimulus plan was made inblissful ignorance of the marginal productivity of debt which is negative andfalling. In this situation more debt will only stimulate deflation, economiccontraction, unemployment, and it will lead to further weakening of the globalfinancial structure.”

 

Antal E. Fekete

San Francisco School of Economics

aefekete@hotmail.com

 

Read all the other articles written by Antal E. Fekete 

 

DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR INFORMATION AND AMUSEMENT ONLY. THE AUTHOR IS NOT SOLICITING ANY ACTION BASED UPON IT, NOR IS HE SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A RECOMMENDATION TO BUY OR SELL ANY SECURITY. THE CONTENT OF THIS LETTER IS DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR MAKES NO REPRESENTATION THAT IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT BE RELIED UPON AS SUCH. IT IS TO BE TAKEN AS THE AUTHORS OPINION AS SHAPED BY HIS EXPERIENCE, RATHER THAN A STATEMENT OF FACTS. THE AUTHOR MAY HAVE INVESTMENT POSITIONS, LONG OR SHORT, IN ANY SECURITIES MENTIONED, WHICH MAY BE CHANGED AT ANY TIME FOR ANY REASON.

Copyright © 2002-2008 by Antal E. Fekete - All rights reserved

 

 

 

 

 

 

 

 

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Professor Antal E. Fekete is a mathematician and monetary scientist., with many contributions in the fields fiscal and monetary Reform, gold standard, basis, discount versus interest and gold and interest.
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