The Diminishing Impact of Debt on U.S. Economic Growth

Between the years 2000-2007, nominal GDP growth in the U.S. was $4.2 Trillion. During the same period, the total credit market debt grew by $21.3 Trillion. This means that for every $1 increase in GDP, debt of $5 was required.

In other words, $1 debt lead to just a 20 cent increase in GDP.

In 1966, $1 of debt used to increase GDP by around 90 cents.

Thus, debt growth in the U.S. economy is having a diminishing impact on the GDP growth as years pass by and the debt burden mounts.

What economists call the 'Zero Hour' might also just be round the corner for the U.S. economy. Zero Hour arrives when $1 of new debt has no incremental effect on GDP growth of the country.

Just to give readers an idea of the pace at which the total credit market debt in the U.S. has increased, I have presented a graph below showing the increase in debt and the debt to GDP ratio in the U.S. In 1980, the debt to GDP ratio for U.S. was around 130%. Currently, it is over 360%.

Total Credit Market Debt

Source: U.S. Global Investors (Marc Faber presentation)

So the debt growth had a sharp upward trend, especially post 1980. At the same time, when we see the chart for the impact of each additional Dollar of debt on economic growth, the following is observed.

Source: Dr. Marc Faber's presentation for CFA Society Vancouver (6th March 2009)

Very clearly, the positive impact of each additional dollar of debt on economic growth has witnessed a sharp decline over the years. According to the chart, Zero Hour, when $1 of new debt has no incremental positive effect on U.S. GDP will be reached in 2015. But, with so much of money already printed and with a huge amount of new debt taken and more in the pipeline, the Zero Hour might come well before 2015.

When additional debt has no positive impact on the GDP then all the incremental debt leads to price increases. In other words, when Zero Hour is reached additional debt will just lead to price increases or inflation. This happens as the economy is too weak to absorb the liquidity and all the excess money is absorbed into price increases.

Thus, we can clearly conclude that if the debt mounting exercise goes on, the U.S. will have inflation far worse then that of the 1970's. This might be asset class supportive, and stocks and commodities might surge up in the near future. This can also bring us to the conclusion that increasing stock markets and commodity prices might not always be a positive signal.

One needs to be cautiously optimistic. At the same time one needs to prepare for the inflation that might be coming in the next few months or years.

Comments

[Dave Wrixon:]

Zero Hour might also logically be called the point of no-return.

That is pretty much the point where the economy becomes unmanageable even if you do all the right things, and that would already include some pretty horribly painful stuff. That is the point where default is de facto, whether it is policy or not.

Jun 14 04:11 PM

[Larry House:]

You're right, Dave. What a horrible possibility! Inflation can carry paper assets some, but there is a point where inflation kills all paper investments. I will be surprised if we see inflation flare short-term, but long-term, how can it be avoided under current policy? Some say the Fed wants to inflate away some of our national debt. I hate to think that the case, but they are doing nothing to negate that view.

Jun 14 04:27 PM

[Jasper M:]

Good article.
Von Mises alluded to the "Zero Hour" (though not by that name), when he pointed out that, once a credit inflation had reversed, there was no stopping the resulting deflation.
I think Larry is correct - ALL recent price increases are due to credit supply (which is now, By Far, the majority of the money supply), and Cannot withstand the destruction of that credit supply. And since credit is a state of mind, ANY perceived setback can destroy it - including inflation.

Jun 14 04:32 PM

[Donald Ingram:]

I have a fear that's exactly what the master plan is - payment of debt by way of inflated currency.
Since the dollar will be replaced on the global financial stage as the reserve currency of choice and debt at impossible levels to pay off, why not just crash the dollar? Pay down all the debt with dollars that are worth pennies. Next step - a major contraction from the world stage while America is still the omnipotent military force it is. No one will argue the financial action using military force. Withdraw behind VERY secure borders with a powerful domestic military force and pursue a philosophy of Wilsonian isolationism.

Jun 14 04:47 PM

[imnotadoofus:]

A LOT HAS BEEN SAID THAT WE ARE EMBRACING KEYNESIAN SOLUTIONS; THAT IS MASSIVE DEBT INCREASES TO FOSTER MORE CONSUMPTION. BUT VON MISES AND ROEPKE ALSO POINTED OUT THAT GOVERNMENT OWNERSHIP AND CONTROL THROUGH HEAVY REGULATION ACTUALLY IS MORE AKIN TO THE FASCIST ECONOMICS OF GERMANY, ITALY and SPAIN DURING THE 30s. THE CONTROL OF CAPITAL, NOT THE OWNERSHIP IN THE MAIN, WAS THE ESSENCE OF THAT STRATEGY. FOLKS TEND TO FORGET THAT HITLER HAD THE BANKS AND MAJOR INDUSTRIES UNDER HIS CONTROL OR IN HIS CAMP DURING HIS CHANCELLORSHIP BEFORE WWII. LITTLE DID THEY REALIZE HOW THEY WOULD BECOME PRISONERS OF HIS MADNESS AS WELL.

Jun 14 05:52 PM

[Danny Newton:]

I would like to hear from a Keynesian a theory why this phenomenon of debt becoming unable to support GDP. Credit rating agencies are always on the lookout for good debt versus bad debt with bad debt being mostly financing of activities tha are mostly consumptive. A government borrowing to mow the grass on a highway right-of-way or borrowing to met payroll. This is a sign of failure due to poor management of either income, spending or both.

Socializing a debt by applying it to more people or households does not make the debt go away. Credit is not income but can eventually becoame income if managed well. Businesses muct be more careful about spreading their debt to the customer base. The results can be disasterous. Customers can find other providers. But for the government, what can the ordinary ctizen do to retaliate against mismanagement?

Indeed, we have developed a society that embraces mismanagement as a kindness and as a way to right wrongs that are decades, centuries and even millinia old. Hatred for Capitalism and profit has morphed into a philosopy that rejects the concepts of economic efficiency.

I see demand expanding well past the ability to pay for it. There is no lack of demand, there is a lack of a feedback mechanism that can incrementally improve government and delivery of government services.

Jun 14 07:55 PM

[japan20000:]

1) there is no reason extrapolating that graph with a straight line - you do it in a math class in a respectful school, and you fail the class
2) the (gross) dept/GDP ratio will grow simply as a result of the ever increasing division of labour.
So, no bomb going off in 2015

Jun 14 10:32 PM

[perceptions...:]

"One needs to be cautiously optimistic."

Why? Debt & Deleveraging is already an anchor, which is dragging on the real economy & the US$.

Together with other major, Global influencing factors, including an Aging population & Peak Oil, ZERO HOUR has already passed.

Jun 15 08:27 PM