Let's talk about debt...
Debt is that four letter word that we dare not speak, yet we all rely on it every single day. I can't think of another financial issue that inflames so many negative feelings as debt, and I expect this article will light up many. As the worst sinner in the room, let's talk about the federal government.
Federal Government Debt
The Federal Government has a running tab, both with itself and with the public at large. As of March 31st, 2012, the total federal debt outstanding was $15.6 Trillion and the net debt held by the public was $9.2 Trillion.
First, let's put that in historical perspective. The chart below shows the total and net public debt as a percent of nominal GDP going back to 1940. Total and net public debt were their highest at 122% and 98% of GDP in 1946, which is not surprising given the war spending and post war obligations. Since 2007, the debt has shot up dramatically to counter the effects of the great recession. As of March 31st, 2012, total and net debt, as a percent of GDP, were 100% and 59%, respectively.
What is the difference between total and net public debt? The government owes itself almost $5 Trillion to various government agencies and the federal reserve. Payroll taxes that have been collected over the years have not been put away in a "trust fund". They have been spent, like any other tax is spent. The treasury "borrows" from those funds, instead of from the public market, and will have to redeem the debt to itself when the benefits exceed the taxes. The government alone decides levels of taxation and benefits, and can unilaterally change those levels at any time. The federal reserve holds 11% of the total debt stock as the main tool to manage interest rates.
Debt vs. GDP
How has the federal debt been growing over time? The next chart shows the relationship between net debt and nominal GDP (right side) and the growth rates of both (left side). As would be expected, growth of debt is typically countercyclical to GDP growth. What is striking about this is how the "great recession" of 2009 was truly great and required a massive fiscal response, as nominal GDP had not gone negative once since the depression. What is apparent is how disproportionate the fiscal response was to the magnitude of the decline in nominal GDP.
What do we have today for all that debt? Most people would assume that the vast majority of the funds were squandered on foreign adventure, welfare, subsidies, etc. However, in reality we have quite a lot. The next chart shows the direct investment in R&D and physical capital by the federal government since 1940. The values have been depreciated based on the useful life of each investment category, and are in 2005 chained dollars.
The total depreciated value of these investments by the federal government, in 2012 dollars, is $4.7 Trillion. We can discuss and debate the merits of the investments, however, the net result is that the country has close to $5 Trillion in assets to show for our public debt of $9.2 Trillion. Taking these assets into consideration paints a much different picture of the net federal debt outstanding.
Investment vs. GDP
How has this investment changed over time? This investment in R&D and physical capital has been steadily decreasing as a percentage of GDP. From 1947 to 2011, investment averaged 3.54% of GDP. From 1950 to 1970, investment averaged over 5% of GDP, and fell throughout the 80's and 90's to under 3% of GDP today.
What effect has this reduction in investment had on GDP? Since 1940, every dollar invested has coincided with two dollars on average in incremental GDP growth. The chart below shows the change in nominal GDP (right hand side) and the current and subsequent year increase in nominal GDP dollars (left hand side) for each dollar invested in physical capital.
As can be seen, the effectiveness of federal investment in physical capital has varied over time, and is just as important as the magnitude of the investment. On average, investment in physical capital has produced a multiple of economic activity, while adding to the structural capacity of the economy. Federal spending on physical capital has been a significant driver of economic growth over the last 50 years.
Given the government's ability to borrow long term at excessively low rates, it's easy to make the case for increasing the investment in physical capital and R&D. There is no shortage of labor or investment needs across the country. The American Society of Civil Engineers estimates that the country needs $2.2 Trillion more of infrastructure investment over the next five years than what is currently planned. Such a program would double the investment in physical capital from 2.66% of GDP to over 5% of GDP, and generate economic growth of at least two times that amount.
History shows clearly that investments in physical capital and R&D does generate productive economic growth, and builds on the physical stock of the nation. Whether this investment is achieved through an increase in taxation or an increase in the debt load, or both, it is a necessary and highly effective policy tool. The notion that we are drowning in debt and cannot afford such a program is misguided, and history has proved the opposite. More investment is exactly what we need. Investment in physical capital generates immediate returns, reduces unemployment, grows the tax base, and adds structural capacity to the economy.
No matter who wins the election, rhetoric will give way to reality, and the government will be forced to implement a massive infrastructure spending program. This will be extremely bullish for sentiment and the stock market, especially cyclical industrial stocks. The impact on consumer spending will drive aggregate demand higher and accelerate the repair or household balance sheets. Most importantly, this will renew confidence and build a foundation for years of productive economic growth.