The Declining Usefulness of Debt

A recent article presenting an essay by Jim Welsh contained a graph showing the declining marginal return to GDP of increasing debt over the past 42 years. Jim says the graph was supplied to him by a third party, who attributed the data to Antal Fekete.

Professor Antal Fekete is an Austrian School economist associated, since 2005, with the Intermountain Institute for Science and Applied Mathematics. He retired from a distinguished career as a university professor in 1993. He has appeared recently as a guest on CNBC.

Prof. Antal Fekete argues that the creation of excess new money in the current situation is deflationary, because we have entered an era of negative marginal returns on added debt. In this condition, the more debt created, the lower the GDP growth (or the greater the GDP shrinkage).

Professor Fekete writes:

The key to understanding the problem is the marginal productivity of debt, a concept curiously missing from the vocabulary of mainstream economics. Keynesians take comfort in the fact that total debt as a percentage of total GDP is safely below 100 in the United States while it is 100 and perhaps even more in some other countries. However, the significant ratio to watch is additional debt to additional GDP, or the amount of GDP contributed by the creation of $1 in new debt. It is this ratio that determines the quality of debt. Indeed, the higher the ratio, the more successful entrepreneurs are in increasing productivity, which is the only valid justification for going into debt in the first place.

Conversely, a serious fall in that ratio is a danger sign that the quality of debt is deteriorating, and contracting additional debt has no economic justification. The volume of debt is rising faster than national income, and capital supporting production is eroding fast. If, as in the worst-case scenario, the ratio falls into negative territory, the message is that the economy is on a collision course and crash in imminent. Not only does more debt add nothing to the GDP, in fact, it causes economic contraction, including greater unemployment. The country is eating the seed corn with the result that accumulated capital may be gone before you know it. Immediate action is absolutely necessary to stop the hemorrhage, or the patient will bleed to death.

The year 2006 was the watershed. Late in that year the marginal productivity of debt dropped to zero and went negative for the first time ever, switching on the red alert sign to warn of an imminent economic catastrophe.

The graph from Jim Welsh’s essay does not show the decline to zero, perhaps because the data in the graph is quarterly and the dip had too short a duration to show.

Plotted below is the marginal return data from the Jim Welsh article graph. The following table shows the nine occasions that a rise of more than 10% occurred in the marginal GDP return. This happened for all six recessions, as well as three times not closely associated with a recession. The first five recessions (1969 through 1991) all showed dramatic increases in the marginal GDP returns for increased debt. Since 1991, the 2001 recession showed a delayed and more gradual rise in marginal return; the current recession has not shown any significant response yet.

Perhaps the current recession will have an associated increase in marginal return. If it is delayed and gradual, as in the case of 2001, it could be taken as further evidence of the poor quality of debt.

In the Welsh essay, a linear trend line is drawn that projects to zero marginal GDP return for an increase in debt, occurring in 2015. I have explored other trend lines and find that they all have similar correlation with the data, with R-squared values around 0.75, which is a good correlation, by my definition.

The linear trend line has an R-squared value of 0.75. One could just as well fit a quadratic trend line and obtain the graph below with an R=squared value not significantly different from the linear trend line:

If the quadratic trend line is extended, it does not go to zero, but asymptotically approaches about 12% in future years. This is shown in the next graph:

There has been a clear pattern of decreasing ability of increasing debt to grow the GDP over the past 40+ years. The use of debt has shown productivity improvement coming out of recessions, but the effect was weaker for the 2001 recession. We do not know yet what the result will be for the current recession.

I would speculate that the reason debt has greater productivity coming out of recessions is that the weakest users of capital have been “weeded out” by the recession and only the more efficient remain.

I would argue that if the trends of the last 40+ years continue, we are just as likely to asymptotically approach some low marginal return rate of return for added debt (quadratic functionality) rather than go to a zero productivity (linear functionality).

The question that is obvious is: What policy actions could be undertaken to change the declining trend of productivity of debt? One focus that I have discussed before is increasing the use of debt for developing the means of production of goods and services of utility and decreasing the use of debt to finance consumption and higher leveraged debt instruments.

These relationships involving the marginal productivity of debt are new to me and I hope to return with further analysis as I learn more.

Comments

[Steven Hansen:]

i would argue that when you use debt to fund production (such as building a dam) which returns positive product for the life of the payoff of the debt - your efficiency of debt is high as it is providing income during your payback period.

when you use debt to fund programs (such as military expenditure) which is basically pay tomorrow for what you use today - your efficiency of debt is low as the debt is not funding any income during the payback period.

therefore, my theory is we are tending to use a higher and higher percentage of our income to live beyond our means - which is causing a continuing reduction in the efficiency of the debt to produce gdp.

this in no way is contradictory to what you are saying John as I believe also that as debt grows higher and higher as a percentage of total product - it is obvious that debt's return diminishes.

just one observation John which has befuddled my own work on this topic is the Clinton era with the reduction of debt. you would have expected the efficiency of debt to increase in this period - and it does not. i have no answer to this.

May 07 09:12 AM

[RSAAKS:]

we may still be producing return on debt, a larger portion is being eaten away by increased regulations, leading to lower net

May 07 09:30 AM

[youngolf:]

As someone who 'sold' large group health insurance plans for insurers since the 1980's, I saw the squeeze these constantly rising premiums put on employers. I foresaw them cutting older workers (who raised their risk factors), I foresaw them moving to part-timers, contract workers to avoid having to cover them, etc, etc. I cannot emphasize enough the 'sucking sound' of taking capital out of production and sending it to medical care - across all society.
The insurer did not care, the medical community wanted more and more, and the capitalistic system, although funding all the new tech gadgets to keep us alive, is now unaffordable....hence 50M uninsured.
Worse, the individual frets over starting his own business because he must come up with $$$ just for 'insurance' against potential illness that could bankrupt him.........and so goes to work for the 'corporation'. And we all know how inefficient the corporation is, especially the large ones.
The outlandish, uncontrolled cost of medical care is the behind-the-scenes drag on our economy. But our wonderful legislators ALL have themselves taken care of. And in health plans that we pay for for them, that we cannot access ourselves. This must be changed.

May 07 10:02 AM

[Gregman2:]

Excellent John. It used to be that public debt was primarily used to finance capital projects, like toll bridges or light rail systems. Private offerings were typically used for income generating endeavors, like shopping centers, malls, commercial buildings. But as Steve Hansen notes, we're using debt more to finance low margin operations. You've
opened a great door to some weighty policy discussions. Thank you.

May 07 10:49 AM

[Jeff Nielson:]

Good analysis, John. However, for those without the background to follow your analysis, this can be simplified MUCH further. It is simple arithmetic that when you borrow more and more money, then a steadily larger percentage of each dollar goes to paying INTEREST on that debt.

Increasing debt annually, EVERY YEAR, does not simply translate into "lower marginal utility" on new debt, it dictates the only possible outcome: bankruptcy.

May 07 12:24 PM

[John Lounsbury:]

Steve - - -

You wrote: "just one observation John which has befuddled my own work on this topic is the Clinton era with the reduction of debt. you would have expected the efficiency of debt to increase in this period - and it does not. i have no answer to this."

This is an excellent point. I have thought that we need to find a way to analyze how the debt is utilized, as you discussed earlier in your comment. The implication of the marginal return graph in this article is that debt was not put to as good use since 1980 as in earlier years. So, I would propose that it does not do as much good to control the amount of debt incurred as it does to direct the debt to productive usage.

Productive use of capital. If we could solve that problem systemically, how the world would change. There are those who would argue that government interference (regulation, tax incentives and disincentives) is a big reason why capital is not used efficiently. There are others who argue that concentrated financial power, with the interest of wealth to protect and extend that wealth, even at the expense of systemic risk, is a big drain on productive use of capital. I have argued for both points of view, but am not willing to exclude either to the benefit of the other.

May 07 12:39 PM

[One Eyed Guide:]

The reason for the decreasing margin return to debt over the last 42 years is the increasing use of tax cuts instead of infrastructure building. Kennedy started this and it has just increased until Bush 2 was doing tax cuts combined with decreased infrastructure spending which yielded the negative return.

The Romer's in their paper 'The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks' (www.econ.berkeley.edu/~cromer/draft1108.pdf) did not address the effectiveness of tax cuts when a deficit was already being run but the data strongly suggests that teh net effect woudl be negative.

May 07 12:47 PM

[John Lounsbury:]

Steve - - -

More on the 1990's. It's true that federal deficits were smaller and even a couple of positive years, but there is a graph in Jim Quinn's article today seekingalpha.com/artic... showing a sharp increase in personal debt from 1994 to 1997. It increased from 12% of GDP to 16% of a larger GDP. This was the most rapid increase since 1950.

The only other two rises anywhere close were in 1984-87 and 2000-03, both with increases at (or just under) 3%.

While this huge increase in consumer debt provided an adder to GDP in the quarter it was incurred, it provided litle addition to GDP in subsequent quarters. Most of this debt was incurred to support consumption or luxury, not to fund means of production. So, while the government was more prudent, the consumer was becoming less so.

May 07 01:38 PM

[Jeff Nielson:]

John, regarding the observation that there was no increased "efficiency of debt" during the Clinton era, this is because there WERE NO SURPLUSES.

It was the Clinton era which marked the beginning of the truly outrageous lies on the U.S. "bottom-line" - techniques which were perpetuated with Bush Jr.

During Bush's eight years of fiscal insanity, he REPORTED $2.5 trillion in total deficits, while the U.S. national debt actually increased by DOUBLE that amount.

When you simply omit TRILLIONS of dollars of expenditures from the "bottom line", most governments can report "surpluses".


On May 07 12:39 PM John Lounsbury wrote:

> Steve - - -
>
> You wrote: "just one observation John which has befuddled my own
> work on this topic is the Clinton era with the reduction of debt.
> you would have expected the efficiency of debt to increase in this
> period - and it does not. i have no answer to this."
>
> This is an excellent point. I have thought that we need to find
> a way to analyze how the debt is utilized, as you discussed earlier
> in your comment. The implication of the marginal return graph in
> this article is that debt was not put to as good use since 1980 as
> in earlier years. So, I would propose that it does not do as much
> good to control the amount of debt incurred as it does to direct
> the debt to productive usage.
>
> Productive use of capital. If we could solve that problem systemically,
> how the world would change. There are those who would argue that
> government interference (regulation, tax incentives and disincentives)
> is a big reason why capital is not used efficiently. There are others
> who argue that concentrated financial power, with the interest of
> wealth to protect and extend that wealth, even at the expense of
> systemic risk, is a big drain on productive use of capital. I have
> argued for both points of view, but am not willing to exclude either
> to the benefit of the other.

May 07 03:17 PM

[Alan Young:]

You've made a fine contribution by distinguishing between useful debt and problematical debt on the basis of how the cash is spent, and examples noted in some of the comments have advanced the idea very well.

Ironically, I have not seen this distinction honored in most articles by Austrian School economists. Too many people want a simple ideology to take sides with, rather than a process for finding optimum solutions. More honor to the exceptions.

May 07 03:46 PM

[candooman:]

Here is my two cents worth of observation that may help explain the deminishing return being observed here. I am in the engineering/construction business and I have seen over the last 20+ years how we are forced to do more and more of things that do not contribute to a good end product. We spend so much resources - material as well as manpower - to avoid exposing ourselves to the risk of being sued should something bad happen. Cost benefit analysis are not done nor required for taking those extra measures that "avoids" a lawsuit. [This by the way can be clearly seen in the medical field when unecessary tests are ordered to protect the medical service provider.... at the expense of the consumer.]

This is also done in the name of "better safety". Extra and expensive steps are taken to make an action that has a probability of being 99.95% safe already --- so it will be 99.99995% safer -- based usually in the 'judgement' of an unqualified person who has no idea on the subject of risk analysis. This happens daily in industry and in business.... millions of times. We are spending an ever increasing amount of money in the US on activities that bring negligible or zero returns. Billions are wasted every year on these kinds of activities!

On the other hand, an activity that will increase the usefulness of debt to very large scales is building of nuclear power plants and retirement of coal power plants. Nukes built 30 - 40 years ago are still giving us solid returns. In fact some of them have been upgraded to bring even more returns for the next 20 years. We need more of them to both replace the ones nearing their end-of-life, to provide power to the rising demand of our increasing population and to ---- this is the big one --- replace coal fired power plants.

Coal fired power plants are a very expensive losing proposition. They produce the highest volume of CO2 that causes our climate to change that in turn, causes destruction all over the US. Destruction by wild fires, tornadoes, hurricane, floods, extreme drought --- are all hugely negative returns! We should stop building new coal plants and start building new Nuclear Plants. The Asians and Europeans have realized this and are starting to build nuke plants. Clean coal is a myth. Anyone who has taken basic chemistry understand that when air and carbon in coal are burned, CO2 is produced and -- in very high volumes. To think that these high volumes of CO2 gas emitted by coal fired power plants all over the US can be captured and stored underground is absurd. To capture it, highly compresse it and send it to underground storage takes more than half of the useful energy produced in burning it. And then the big question is, how much compressed gas can be stored and for how long? A few years? At what cost?

The US economy grew larger and faster than most countries in large part, because of cheap energy. Investing in nuclear energy is undoubtedly, one of the best way to bring up the usefulness of debt.

May 07 03:56 PM

[MinAkkar20:]

Alan, I side with the Austrian school and do not disagree with your observation. I feel the reason for your observation might be due to the fact that so-called "good debt" is all but non-existent in our recent history. A large portion of our deficits have gone towards foreign aid to corrupt regimes, maintaining military bases in over 130+ countries around the world, welfare, disability, bloated government bureaucracies, etc. The Austrian school doesn't believe debt is inherently bad, rather it is bad when the government forces debt on its citizens. Ideologically, there are some who would argue that all government debt is bad, but most would be tolerant of government deficits if they were executed without inflation and invested prudently.


On May 07 03:46 PM Alan Young wrote:

> You've made a fine contribution by distinguishing between useful
> debt and problematical debt on the basis of how the cash is spent,
> and examples noted in some of the comments have advanced the idea
> very well.
>
> Ironically, I have not seen this distinction honored in most articles
> by Austrian School economists. Too many people want a simple ideology
> to take sides with, rather than a process for finding optimum solutions.
> More honor to the exceptions.

May 07 04:16 PM

[Living4Divi...:]

"Prof. Antal Fekete argues that the creation of excess new money in the current situation is deflationary"

I don't believe it. He is crazy

May 15 10:03 PM

[John Lounsbury:]

Lining4Dividends - - -

To get a negative return on debt, you must fit the data to a linear trend line. My point is that it fits a quadratic just as well. With a quadratic, continuing the same declining trend will produce an asymptotic approach to some positive return. With the data to date, that is about 12%. Further abuse of the financial system with non-productive debt can lower this asymptotic value, but never to less than zero. The end point is not deflation; to me the end comes if the return is so low that there is no credit available and economic activity grinds to a halt. If there is no economic activity then currency becomes irrelevant and a battered existence becomes likely as people trade items needed for basic sustenance with each other.

May 15 11:52 PM

[John Lounsbury:]

excuse the typo - not a "battered existence" but a bartered existence".

May 15 11:53 PM

[duster:]

Perhaps efficiencies per unit produced have also contributed, i.e. as time passes and profit per unit decreases if debt is comparable for the initial process then result is less for the amount borrowed. Undoubtedly the trend toward easier credit has lent itself to frivolous activities as well.

May 16 07:50 AM

[User 283977:]

Hello John
That is indeed an interesting chart. The finding that leaps off of the page for me is that variability is systematically decreasing with time. Why? I suggest you take the first and second derivatives of that data and plot them on the time axis. That will give you a better picture of changes in variation as a function of time.

Looking at your current chart, it appears something happen between 1991 and 1993 since that seems to be a point where variation changed. Either something happened in the system, or perhaps the way the metric is defined changed.

One possible explanation for the change in variation is inflation. As the value of the dollar decreases, you should get less bang for the buck. However, there may be something else in this signal. GDP refers to the total market value of all final goods and services produced in a country. Is it not possible that a significant portion of the loss of Marginal return per $ of debt is related to the avalanche of imports into the US? Is it a coincidence that that the change in variation in the Marginal return per $ of debt metric occurred in close proximity to the passage of NAFTA? I wonder what a chart of Marginal return per $ of debt by dollar valuation of imports into the US would look like? If they are well related, what would that portend?

May 16 02:22 PM

[tjhorton:]

Good on you John Lounsbury for asking fresh questions, but trendline analysis is truly only skin deep. There is deeper analysis out there!

Please read Horace Brock's essay, "The End Game":
www.investorsinsight.c...

He gets into the endgame in Section D, entitled "The Critical Dynamics of the Debt-to-GDP Ratio". He employs economic history (and game-theory models) to show that the outcome depends on real economic growth versus deficit growth.

Brock worries that "virtually no orientation towards rapid future growth is evident in the policies and 'reforms' proposed by the Obama administration, as we see in Section G".

May 25 10:14 AM

[John Lounsbury:]

TJ - - -

Thanks for the reference to Horace Brock's article via John Mauldin. I had read it and have exchanged e-mails with Dr. Brock on the subject.

Sorry for the delayed response. I tried to reply to your comment on the weekend, but the Add Your Comment window was not available.


On May 25 10:14 AM tjhorton wrote:

> Good on you John Lounsbury for asking fresh questions, but trendline
> analysis is truly only skin deep. There is deeper analysis out there!
>
>
> Please read Horace Brock's essay, "The End Game":
> www.investorsinsight.c...
>
>
> He gets into the endgame in Section D, entitled "The Critical Dynamics
> of the Debt-to-GDP Ratio". He employs economic history (and game-theory
> models) to show that the outcome depends on real economic growth
> versus deficit growth.
>
> Brock worries that "virtually no orientation towards rapid future
> growth is evident in the policies and 'reforms' proposed by the Obama
> administration, as we see in Section G".

May 26 06:48 PM

[joebhed:]

joebhed said -

Did you say debt?
Did you say the debt-money system?
Did you mention that all money comes into existence as a debt?
Did someone mention the Fed's Robert hemphill's famous quote about the need to remedy the flaws of the debt-money system?
Have we all read Steven Lachance's paper on "How Debt Money Goes Broke."?
www.financialsense.com...

It ends like this:
""Thus, when interest charges, now $2 trillion per year and accelerating, overtake annual debt growth, now $3 trillion and decelerating, liquidation will immediately trigger cascading cross-defaults. Without domestic savings to mobilize, the Fed cannot facilitate the expansion of government debt to fill the breach and simultaneously hold down interest rates. It cannot win the battle to keep debt growth greater than interest charges, the precondition for the viability of a debt-based monetary system.
Once started, cascading cross-defaults consume all debt within an economy. The Fed has only two options: institute a new monetary system with a new currency or return monetary authority to the market and shut down.""

So, I'd say we need a new money system.

May 27 06:24 PM