The Relationship Of The Debt/GDP Ratio And Economic Growth

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 |  Includes: DIA, QQQ, SPY
by: Derek Tomczyk, CFA

We hear a lot in the media about debt/GDP ratios and how the rise and fall of them is an indicator of a country's economic health. In particular in Europe, the rise of the debt/GDP ratios has driven the calls for all types of spending and service cuts on the assumption that the number one priority should be the decrease of the debt or at least the deficit. Not much time is spent discussing what this debt/GDP ratio actually is and what its meaning is to the economy. The need for the debt part of the ratio to go down is assumed to be "common sense" and the discussion just focuses on what should be cut to reduce it. Since "common sense" is so often no sense at all, I thought I would take some time to look a bit deeper into the meaning of this ratio.

First of all, the debt part of the ratio refers to the government debt, not the overall debt burden for the country. In turn, the GDP part of the ratio refers to the combined income of the entire country, not just the government. Therefore, the debt/GDP so often reported in the news is actually government debt/(government income + private sector income).

This creates a problem in interpreting the ratio to evaluate the debt burden on the economy simply because a transfer of private debt to government debt will make the ratio go up even if the overall debt burden of the country does not change. This is in fact exactly what has happened since 2008 in the USA and more recently in Europe. When private sector banks got into debt trouble because private citizens were no longer able to pay for their overpriced houses, it was the governments that stepped in and assumed all that debt through bank bailouts. Therefore blaming government programs and spending for the high debt/GDP ratio is incorrect since it was the private sector that racked up the debt leading up to 2008. The governments had to come in and take the debt over to save the economy through various bail outs, so it shouldn't be surprising that the government portion of the total debt burden has increased drastically. Regardless of what you may think of the bail outs themselves, it was not reckless government spending or expensive government programs that led to them, and therefore cutting those programs will not prevent a similar crisis in the future.

The other point worth remembering is that since the debt/GDP ratio was caused by the transfer of debt from the private sector to the public sector, it is unlikely that transferring that debt back to the private sector through the cutting of subsidies and programs would help the economy. This is a major reason why European attempts at austerity have failed so badly to instill any confidence in those economies, and in fact, have driven the debt/GDP ratios even higher. When the citizens of the country are leaving in droves, it should be clear the country is not pursuing a policy that is in any way inspiring confidence, but yet you hear leaders in Europe trying to make the financial markets and bond vigilantes the culprit.

Since the reduction of public debt is being done at the expense of private citizens and economic growth, it's actually a completely rational reaction by citizens and bond holders to run for the hills as a country attempts to cut its deficit through cuts to its programs. It's just as rational as it is for corporate bond holders to raise rates on a company that is shutting down its offices and plants. No one wants to lend to a sinking ship even if that ship is shedding weight.

This effect is made worse because of the special relationship that government spending (deficit) has with its income (GDP). If a company or an individual is in debt, they can easily reduce that debt by reining in their spending because the spending is not directly related to their income. This means that if John Smith spends less, this does not affect how much John Smiths employer pays him. If a company spends less, it may or may not affect its income depending on whether that spending was generating immediate income. However, if a government cuts its spending in an economy where unemployment is high, it is directly and immediately affecting the country GDP and in-turn its own revenues.

If a country cuts the deficit by $10, it is also decreasing the GDP by at least $10. In fact, it is decreasing the GDP by at least $10 x Velocity of Money. In the US right now, that velocity is 1.5 (lowest in decades btw) which means each $10 decrease in spending today will directly reduce the GDP today by at least $15. Why do I say "at least"? Well, if the country cuts $10 in spending, it will not reduce its deficit by $10 because it is also reducing its tax base. If we assume a 25% tax rate, that means that the reduction in deficit, and therefore saving on debt, will be about $7.5 because $2.5 would have been returned to the government in taxes. With the deficit reduction at $7.5 and the drop in the GDP at $15 and the debt being larger than the GDP to begin with, it should really be no surprise that the debt/GDP ratio increases as countries cut spending. It is not even economics, it's just simple mathematics.

Now of course if the economy was strong and employers were having difficulty finding people to take jobs, any reduction in spending by the government would be quickly offset by hiring in the private sector. However, somehow I don't think the argument from the deficit hawks is that the economy is growing too strongly and the unemployment is too low. Companies are not exactly starved for job applicants and the job market is anything but tight. The most likely effect of the cuts to public spending is to simply add those people cut to the already large waiting line in the unemployment offices.

To be fair, a closer look at US employment figures over the past few years reveals that while government spending cuts have been devastating to overall employment figures, they have been offset by a surprisingly strong private sector. This is not to say the private sector is firing on all cylinders, but it is certainly doing far more good for the economy then the currently popular government policies of deficit fighting. This article here shows just how much a drag the government has been during this recovery as compared with other recoveries, though I disagree with the author that more spending is not necessary.

In fact, it's very likely that without the deficit cutting measures enacted in so many countries all at once, and if government spending in the US was maintained at the same level as in previous recoveries, we would have a solid recovery underway already.

From an investment perspective, it is very important to understand this difference since it shows that the great US economic engine is anything but dead. The private sector is doing a great job thus far in the recovery, which is driving the profit and stock market price increases, but it needs the government to at minimum maintain if not outright grow. To the individual investor, this means ignoring all the doomsayers who believe we need years of debt purging before the economy can truly recover and that governments are helpless to speed this up. Any policy shift from the government in favor of growth and away from deficit (debt) fighting will in fact be very successful in creating a strong recovery.

Since the overall debt burden on the economy is falling regardless of what the government is doing, and the private economy is improving despite being actively hampered by government layoffs, there is no reason to believe that the stock market increases we have seen since the trough of the recession are unreasonable. In fact, it might be a very good time to invest in broad market indices using ETFs such as SPY, QQQ, DIA in the US, since whoever wins the election this year is likely to pursue spending or tax cutting policies without much offset, regardless of what they promise. The already strong private sector helped along by pro-growth government policy is very good news for stocks in the US, and perhaps the world.

Disclosure: I am long SPY, QQQ. 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.