By Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC., and with the permission of both.
In the seven years following the global financial crisis, global growth remains lethargic despite outsized fiscal deficits and increasingly aggressive monetary accommodation. This is leading some financial pundits including Bridgewater's Ray Dalio, for example, to postulate that a long-term supercycle of debt-fueled growth is over. Others including former Treasury Secretary Larry Summers postulate that the U.S. and the world have entered a period of secular stagnation. And others are assuming that if not addressed soon, the increasing burden of entitlements will siphon resources from private productive uses, constraining growth and driving interest rates ever lower.
With all the attention that has been directed toward the evils of fiscal deficits and profligate spending, the Great Recession and subsequent recovery did nothing to slow the flow of red ink. The McKinsey Global Institute estimates that in 2000 global debt was about 60% of global GDP as shown on Chart I. By 2007 the ratio had climbed to over 150% and in 2014 it was about 200%. Data for 2015 is not yet available but it was undoubtedly even higher. Over the past seven years of economic recovery debt has grown by more than 5% annually while global GDP expanded by roughly 3% annually.
Chart I shows that both private and public debt expanded over the past seven years absolutely and relative to global GDP with the private sector's debt exposure rising faster than the public sector's exposure. Among selected countries McKinsey notes that Japan's debt to GDP ratio was about 400% in 2014. Ireland's debt ratio was the world's second largest at 390%. For the U.S. total debt to GDP stood at about 233% while China's ratio came in at 217%.
According to McKinsey the growth of total debt was about evenly split between developed and developing countries. Ordinarily this would be a positive to the extent the debt of developing countries fuels infrastructure and industrial capacity expansion. But in this cycle it is proving a mixed blessing since slow global growth and expanding capacity have precipitated a price bust which is hurting export earnings and the accumulation of foreign exchange that is necessary to service debt. Compounding this is the fact that real estate debt exploded in China over this period, leaving lenders with bad loans as the real estate market collapsed.
The U.S. and China are the world's two largest economies. Charts II and III show that total debt and its level relative to their respective GDPs expanded in both countries over the 2007 - 2014 period. But the composition of each country's debt growth has diverged. In the U.S., debt relative to GDP rose by about 5% per year with public sector debt nearly doubling relative to GDP. Private sector debt in the U.S. actually fell by about 4% annually. In China both public and private sector debt exposure increased from 2007 through 2014 with the private sector's exposure increasing at about twice the rate of the public sector. Private sector debt exposure in China was largely fueled by unbridled real estate speculation and a ballooning of mortgage debt. This is now an albatross on the Chinese economy.
The U.S. situation is quite different as private sector deleveraging has progressed swiftly with the corporate sector improving balance sheets, the banking system boosting its capital base, and real estate debt slowing significantly since the housing peak in 2006-2007.
With the private sector in the U.S. having deleveraged and its banking system now in excellent condition, the U.S. has proven to be the strongest economy in the world. But even so, growth has downshifted from its post World War II potential of about 3.5% yearly to what has been described as a new normal rate of about 2% yearly. The inability to escape from this norm has given rise to the secular stagnation thesis and the ending of the debt supercycle hypothesis.
In 2014 Dr. Lacy Hunt of Hoisington Economics posited that the growth of public sector debt was and would be a major constraint on U.S. and global growth. His thesis was that growing public sector deficits to finance exploding spending on entitlements would be self- defeating because entitlement spending does not provide a growth dividend.
The result according to Hunt would be a never-ending debt spiral which would result in higher interest rates relative to the economy's ability to grow. In June 2015 we published "Global Debt and Global Growth" in which we devised a measure of the ability of an economy to service its debt. We examined the difference between nominal GDP growth and the BAA corporate bond rate. For most of the post-World War II period nominal GDP growth exceeded the BAA rate, meaning the U.S. could easily service its debt. In that period up to about 1980 economic growth exceeded 3.5% annually on average.
Beginning in about 1980 or at just about the time that the U.S. and global debt-to-GDP ratios began rising continuously, the bond rate began to exceed nominal GDP growth as shown on Chart IV. In the immediate aftermath of the 2007-2009 recession, nominal GDP growth exceeded the BAA rate. This coincided with two phenomena. First, as shown earlier, private sector deleveraging took hold, offsetting a rise in public sector debt growth. Second, the Federal Reserve introduced quantitative easing, driving down long term interest rates and narrowing credit spreads. So, in this brief interlude nominal GDP growth exceeded the BAA rate because of lower interest rates, not because economic growth was vibrant. Growth averaged only 1.75% in 2010-2013, below its post-war norm and particularly weak for the early stage of a cyclical recovery.
In both 2014 and with updated data for 2015 as well, the BAA rate has climbed above nominal GDP growth. This period was characterized by two phenomena. First, economic growth was stubbornly slow. Fiscal policy was actually contractionary in response to tax increases which took effect in 2013 and spending restraints imposed by the 2011 Budget Control Act. Indeed, the federal deficit fell from $680 billion in 2013 to about $500 billion in 2015.
During this period, though, the Federal Reserve ended its quantitative easing program, the dollar exchange rate began rising significantly, and global excess capacity showed up, combining to weaken commodity prices and igniting worries over a credit squeeze in emerging economies. The result was that while Treasury yields remained low in absolute terms, credit spreads began widening. This drove up the BAA rate both absolutely and relative to nominal GDP growth.
One could argue that while Dr. Hunt's thesis was taking hold, his transmission mechanism of spiraling public sector debt acting as a stranglehold on the economy was not accurate. It was all about the Federal Reserve. Arguably if the Fed had not ended QE the BAA rate may well have remained below the growth rate of nominal GDP. And this may have provided the wherewithal for the private sector to launch a real investment-led recovery.
Of course, Hunt's thesis was meant to describe a long run phenomenon just as is true of Dalio's musing about the ending of the debt supercycle. Indeed, as we described in our recent report on the Congressional Budget Office's 10-year budget outlook, the CBO itself sketches out a horizon of rising deficits and a rising debt-to-GDP ratio. And this is largely fueled by accelerating growth in entitlement spending.
Even in this setting the Hunt/Dalio thesis need not take hold. After all, the Federal Reserve could be enlisted to simply buy all the increased debt that is being forecast, further expanding its balance sheet, keeping long term interest rates very low. Interestingly enough, this is the equivalent of Milton Friedman's analogy of dropping money from helicopters and letting the blades distribute money throughout the economy. The fact that this policy is being openly discussed among policymakers worldwide is illustrative of how frustrating the global growth slowdown (or secular stagnation in Summers' terms) has become.
Of course we all know that central banks are capable of monetizing public debt. And in this context the public sector may be a cause but not the transmission mechanism. The real transmission is in the private sector. Given this it is encouraging that as Chart V shows earlier, private sector deleveraging progressed significantly since 2008. In 2008 U.S. household debt was 98% of GDP and it was down to 78% in 2015. The private sector has and had the capacity to boost spending and investment.
Whether or not the Hunt/Dalio prognosis materializes is going to depend on the animal spirits of the private sector to borrow a phrase from the late Lord Keynes. Dr. Summers would prefer to ignite these spirits through massive public sector investment financed by the Federal Reserve (although he does not explicitly state this part of his policy). Others prefer low tax rates, regulatory reform, and tax reform along with a reordering of spending priorities to ignite animal spirits, with this being financed by the dividend gotten from faster economic growth.
When all is said and done, these alternative courses of action should be what the 2016 presidential election is all about. So far it has been everything but.
Chart I Global Debt as % of GDP
Chart II USA Debt as % of GDP
Chart III China Debt as % of GDP
Chart IV Difference between the nominal GDP growth and Baa rate 1952-2015
Chart V USA Debt as % of GDP by Sector 1947-2015
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.