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
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 email@example.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
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.”
San Francisco School
all the other articles written by Antal E. Fekete
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