By Ron Rimkus, CFA
Are we there yet? Is this what the new normal feels like? The US economy — the most important driver of economic activity in the world — remains sluggish. The latest GDP print came in at 2% during what is supposedly a recovery, in which GDP would normally print in the 6–8% range. While politicians and pundits may debate the merits of 1.5–2.0% growth, what remains absent from this discussion is the escalation of debt that has driven this growth. Why? I have yet to find an adequate explanation. Yet the situation is crystal clear: the growth in GDP we have seen since hitting bottom in 2009 has been a function of debt.
Just as when a person increases his use of credit cards, he can spend other people’s money and create the appearance of growth up to a point, but eventually he will hit a limit. It pretty much works the same way with countries, but there is at least one major difference between a country and an individual: Most countries have a central bank that can reduce interest rates, print new money, and influence asset prices through market operations.
What are the trade-offs? What are the limits? Printing money (and other central banking activities) typically allays the immediate fears of an outright debt default, but such easy money comes at price. Newly printed money often leads to rising prices in primary demand areas (e.g., commodities, food, fuel, and farmland). And in a weak economy, assets that people typically want to be strong in price appreciation are weak, like housing for example.
While this phenomenon mollifies the reported inflation figures, it also squashes the average consumer who is wedged in the middle — the price of buying necessities goes up and the value of personal assets goes down. But easy money also leads to more debt across the whole economy. By setting interest rates artificially low, central banks stimulate the economy to grow aggregate credit — from household debt to business debt to state and local government debt to Federal government debt, albeit for slightly different reasons.
This phenomenon is relatively well known. However, what is less well-known is its limit. How much is too much? What is the tipping point? That’s the trillion-dollar question. Carmen M. Reinhardt and Kenneth S. Rogoff’s work suggests that on average countries get into trouble when government debt-to-GDP ratios exceed 80%. What is clear to me is that the US is moving forward as if we will never hit a limit. Let me save you the suspense — there most definitely is a limit — even if no one knows precisely what that limit is.
As total debt-to-GDP grows, the needle moves ever closer to the limit — whatever that is. The US Federal Reserve’s zero interes-rate policy (ZIRP) is indeed stimulating credit growth, which in turn drives — or at least is driving — GDP growth. According to the latest data from the Fed, aggregate credit outstanding was $55.031 trillion on 30 June 2012 (as noted in the following graph).
United States: Total Credit Market Debt Owed ($ in Billions)
Sources: St. Louis Federal Reserve, CFA Institute.
That’s up 2.3% from a year earlier, placing the total debt-to-GDP ratio at 3.6. What is absent from this discussion is how a dollar actually flows through an economy. Every incremental dollar in debt the US takes out (which was $1.3 trillion for the year ending in 2Q 2012) flows through GDP as either consumption, investment, government spending, or net imports/exports. But this only accounts for debt-driven investment, and investment can be financed with equity too. So, if debt is growing faster than the economy, what does that say about equity-fueled investment? What does it say about the return on total investment?
It means that some GDP is being destroyed each year and offset with fresh investment activity. Creative destruction is normal in any economy, and during healthy times the gains of the winners will more than offset the losses of the losers. That is not happening now. A healthy economy should produce economic growth that is faster than credit growth, if for no other reason than at least some of the total investment came from equity. That is not happening now either. Instead it’s as if the Fed is intent on escalating debt across the whole economy specifically to grow GDP.
Put another way, central banks are acting as if there is one giant demand curve for GDP. But the economy is comprised of many discrete markets in which people buying goods and services make trade-offs based on their scarce resources. Moreover, today’s central bank policy presumes that all credit growth is good so long as it increases GDP. And ZIRP — which means interest rates are below where the supply and demand for money would set them — is in place for a considerable horizon. As such, credit growth is likely to continue outpacing economic growth. As long as debt grows faster than the economy, the US incurs ever greater misallocation of resources. Where does this end? The longer this game slides from the short term to the long term, the more people will adapt their behavior to fit the new norm. This is where we are. The world’s largest and most important economy is drowning in debt and sowing the seeds of yet another bubble.
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