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This article is a follow up to "The Relationship Of The Debt/GDP And Economic Growth", in which I argue that it is mathematically impossible to reduce a countries public debt burden by cutting spending when the economy is weak. I also point out the difference between public and private debt and how the private portion is far more important.

The most common criticism of the suggestion that public debt can grow to spur the economy is that this approach is unsustainable. The argument is that there has to be some point, in the future, where you pay of the debt to reduce the public debt burden or otherwise the country will fall into a Greece-like spiral of economic contraction. It implies that whatever is gained today will simply be a government induced bubble and will just cause a larger catastrophe down the road. I thought I would take a look at US historical data and see if there was any period where public debt was used to jump start the economy, but then reduced meaningfully while the economy kept growing. If such a period was found it would be interesting to look into how this was achieved.

Let's first define how we can measure the "public debt burden" of a country effectively. Let's take an example from household finance. If your salary is $50,000 a year, a $500,000 mortgage can be crippling and any rise in interest rates will be a major problem, however if your salary is $1,000,000 a year the same mortgage is immaterial and no rise in interest rates will be much of a problem. Therefore the important metric is not the amount of debt, but rather the ratio of debt-to-income, or in aggregate country terms debt-to-GDP. Since we are trying to measure the public debt burden the debt part of the ratio can replaced with public debt.

The following chart shows the relationship of the debt/GDP ratio with the S&P 500 (acting as a proxy for the US economy) since 1901. The right hand S&P 500 scale is logarithmic to better illustrate relative changes in the index. The reason for using a logarithmic scale is that a move from 10 to 20 in the index has the same magnitude as a move from 1000 to 2000. Since for our purposes both moves are equally important, as they are 100% increases, it is the correct scale to use. To illustrate another way, you wouldn't care whether you invested at 10 and got to 20 or invested at 1000 and got to 2000, it would make you the exact same amount of money.

click to enlarge images

US Debt/GDP and S&P500 since 1901

There have been two times in the last 100 years where the public debt burden of the US increased suddenly and they are marked above at 1919 and 1947. It's clear when looking at the two cases that only one leads to a sustained market recovery that does not eventually fail when the public debt burden is reduced. In other words even when the debt/GDP ratio is reduced after 1919 it just leads to a stock market collapse back down to the same values seen before 1919, however after 1947 the stock market keeps on increasing even as debt/GDP decreases. There are good explanations for both cases but I will concentrate on post-1947 in this article and write a follow up article about post-1919.

It should be clear from the graph that any recovery is always preceded by a sharp increase in the public debt/GDP ratio. The major difference is that the increase in 1947 created a bull market that never retraced it's gains as the debt/GDP ratio fell. So how exactly was this debt burden reduction achieved without sabotaging the recovery?

US Debt/GDP and Debt

The answer might be surprising to those predicting an imminent catastrophe if the debt itself is not reduced. The graph above shows that while the debt/GDP ratio fell sharply from 1947 on, the actual debt amount did not decrease at all and in fact it rose at a very reduced rate. The debt burden (debt/GDP) fell because the bottom part of the ratio, the income or GDP part, increased at a much quicker pace than the debt itself.

US Debt/GDP and GDP

US Public Debt and GDP since 1935

The above graphs show that the debt burden reduction after 1947 was not achieved through debt repayment, as many think, but rather through GDP enhancement. The catalyst for this enhancement was a massive increase in government spending, in this case for a war, probably the worst type of stimulus since it produced nothing in the US itself. It is also interesting to note that this reduction was achieved despite rising interest rates. I would like to say that it was in fact achieved because of the rising interest rates, but that's a longer article for another time. For now it's enough to say that those that believe rising interest rates would be a catastrophe at current public debt levels should take a look at the graph below.

Interest Rate since 1935

The debt/GDP ratio did not stop falling until after 1981, after interest rates had hit their peak, so it doesn't appear as though rising interest rates hurt either the economy (with debt/GDP at 120% in 1947) nor the reduction of the public debt burden (debt/GDP itself). The question that comes to mind then is why the perceived spending spree since 2008 hasn't worked to spur the economy. It turns out the answer is rather simple.

Debt YoY increase and S&P500 since 1901

If you look at the right hand side of this graph you will see that there is something missing compared to 1919 and 1947. The deficit spending has not worked because it hasn't really happened. There was a very minor spike in debt, not any larger than most years in the 1980's, but nothing even close in magnitude to 1947. I am not suggesting an increase such as the one in 1947 would be a good idea, after all the debt/GDP ratio is already far higher than it was in 1945 so there is not as much room, but the fact remains that the fiscal stimulus since 2008 has been a joke. This is why the government, rather than helping, is such a large drag on the recovery.

The interesting thing is that despite all the fighting between democrats and republicans about the debt, it has always gone up under both of the parties (the exception were the years of 1920 to 1930 leading into the great depression, but that is a topic for my next article). Not only has the debt always gone up, but it has always been used as a way to jump start the economy, regardless of political rhetoric. This is why I strongly believe that regardless of what party wins the next election the current stimulus road block will be gone. If Obama wins, spending will increase, and even if republicans hold the house, they will have far less incentive to block bills as Obama cannot run again. If Romney wins he will go ahead with the proposed tax cuts and then drag on the spending reductions which he knows very well would kill the recovery. He would not want to be up for re-election in 4 years with the economy still struggling. The increased government support (or perhaps less of a drag) with the already improving private sector should combine for a good year for US stocks (SPY, QQQ, DIA) in 2013.

Source: The Amazing Disappearing Public Debt Burden