There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved. - Ludwig von Mises
Cullen Roche recently argued that high levels of sovereign debt are beneficial to an economy during a balance sheet recession. With all due respect to my esteemed Seeking Alpha colleague, Mr. Roche is wrong.
Last year Carmen Reinhart and Kenneth Rogoff (of “This Time Is Different” fame) published an eye-opening NBER working paper in which they determined the effects of heavy sovereign debt on GDP. According to Reinhart and Rogoff, government debt inexorably becomes a drag on an economy after passing 90% of GDP.
Three economists from the Bank for International Settlements recently wrote a follow-up to the NBER piece which verified Reinhart and Rogoff’s conclusions. Using 20 years of data from 18 OECD countries, Stephen Cecchetti, M.S. Mohanty, and Fabrizio Zampolli found that, with debt-to-GDP ratios above 85%, GDP falls .1% for every 10% rise in aggregate sovereign debt. This is an important revelation, as the U.S. debt-to-GDP ratio since the financial crisis has blasted past 85% to over 100%.
Highly indebted nations, which hurt their own economies with profligate spending, often spend even more during times of economic duress. That is precisely what the U.S. has done, and that is a primary reason why the “recovery” has been so anemic. Using the formula outlined in the Bank for International Settlements paper, debt levels in the U.S. are currently decreasing quarterly GDP growth by .75%. That means that, if the government had tightened its belt at 85% debt-to-GDP, quarterly GDP growth would currently be hovering around the post-WWII average of 3.28%. In other words, we would be recovering instead of treading water.
But don’t expect any sovereign debt relief from the so-called "Supercommittee". As per the Budget Control Act, the committee must only agree upon ways to reduce annual deficit growth. And only by .7% of GDP. Even if the Supercommittee comes to a compromise, aggregate debt will continue to grow rapidly. In fact, the Peter G. Peterson Foundation's debt projections, which exclude intragovernmental holdings, suggest that U.S. sovereign debt will eventually pull the country into perpetual recession.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.