Debt Vs. Deficits, And Deleveraging Shocks

Includes: AXSL
by: Ryan Ragano

National debt is created through accumulation of the annual deficit. An annual deficit arises when a nation spends more than the total revenue. Typically, multiple years of deficit or net loss compile, thus amounting to debt.

Paul Krugman writes of the significance of debt in an economy.

Debt is the crux of advanced economies current policy debates. Some argue for fiscal expansion to avoid recession and deflation. Others claim that you can't solve a debt created problem with more debt.

Krugman asserts that the central element that can prove a decisive issue amongst a nation's constituents is its debt consumption. Debt consumption can drive an economy to variant levels of devaluation, depending on the size of the debt in relation to the size of the gross domestic product. While no debt is desirable, an economy as gargantuan as the United States can function normally even with an increasingly sizable debt. In comparison with the gross domestic product, the level is debt is not currently a hindrance.

The real concern with continually increasing debt is the finite period in which the United States can borrow money. Quantitative easing is the system in which the United States increased its monetary supply through treasury bonds and other liquid assets. The treasury bonds were mainly purchased by the nation of China, along with other domestic and private investors. The United States Federal Reserve has already undergone two phases of quantitative easing. Many economists are skeptical that China would approve a third or fourth round, in which the United States would have to turn elsewhere for funding. There are few other foreign outlets which could absorb such vast lending, and they may be unwilling to invest. In this scenario, the United States would have maximized its borrowing capacity, and a liquidity trap would result.

A liquidity trap manifests when the government is no longer able to regulate and manipulate monetary policy. Debt is perceived as insurmountable, and the continual accumulation of deficits appears inevitable. In Ireland's current financial crisis, the interest rates were lowered substantially and this move has yet to yield any positive result. Ireland may decrease interest rates to almost zero and borrowing would likely remain low. This is a nation currently in a liquidity trap. A monetary supply increase is implausible because of the universal currency known as the euro. The United States uses its own currency and therefore does not adhere to collective monetary standards, as they do in Europe.

In response to the Great Depression, Franklin Delano Roosevelt created the New Deal to stimulate a nation in debt. The New Deal was ultimately a failure, but not because of the commonly held misconception that big government spending only increases debt. Roosevelt was correct in following Keynesian models of economic recovery, but he did not spend enough. When a nation's economy is in a position where borrowing is necessary, the borrowing is only productive if it is substantial enough. To analogize, it is wiser to buy a brand new $200 refrigerator than a $50 refrigerator that does not work. When the central focus becomes minimizing debt instead of maximizing potential revenue, deleveraging shock ensues.

On both national and private individual levels, deleveraging shock shows how fear of debt leads to greater financial instability. Paul Scalise reflects on Japanese economist Richard Koo's book Balance Sheet Recession. Using the internal logical of a balance sheet recession, "businesses and individuals are saddled with excess liabilities and are forced to pay down debts by curbing consumption and investment. The last thing they are interested in is increasing their borrowings." For inflation targeting to work, theory must ultimately supplant practice.

Scalise agrees with Koo's premise of a balance sheet recession, in which cutting deficits takes precedence over strengthening revenues. When a firm is unable to leverage any further, the inability or unwillingness to increase debt can cause commerce to decrease and the economy to contract. Deleveraging leads to less expansion, profit, and revenue. The reason it has become so difficult for the private sector to regain its prosperous economic standing is because of this deleveraging shock. While one may believe that the government sector's monetary expansion policies allow for private commerce to freely grow once again, a large portion of the funds they receive are used to absorb previous debt. When the level of debt is high enough to discourage future debt increase, quick, and steady re-growth is limited.

When a deleveraging shock arises, many economic principles come attached. One of these principles is the paradox of flexibility. The paradox of flexibility states that when workers accept lower wages due to the dire need for a job, they are actually increasing demand, which generates greater stress for a hurting economy. The salaries of the lower sector of workers are so crucial for they are most likely to spend the largest portion of their earnings, and spending is vital to the health of an economy. The paradox of toil also becomes prevalent, as the surplus of workers drives tougher competition in the workforce, and greater competition may cause for workers to accept lower wages. This downward earnings pattern corresponds with the broadest economic vice on the demand-side, the paradox of thrift. The paradox of thrift is simply the theory that the more money saved by the individual, the less money circulating and thus less revenue.

If one operates off of the premise that debt can only be reduced through long-term economic growth, then increasing revenue should be the top priority. In the situation of the United States, the major economic barrier continues to be the high level of unemployment. With an economy that thrives on consumption, increasing the employment rate is a necessity for economic growth. When enduring cyclical unemployment, in which core inflation is low and the quantity of the work force exceeds the amount of jobs available, the issue lies on the demand side. There are several strong yet complex remedies to fix the unemployment issue.

As stated earlier, those who can best increase demand are those who are most likely to spend. Therefore, those who earn the least should receive the greatest boost through government policies (tax cuts, minimum wage, welfare), as they represent the greatest amount of people and are best equipped to increase demand. The expansion of the amount of the monetary flow will generate a higher rate of inflation, yet that higher rate of inflation may cause weaker, cheaper United States goods to become more valuable overseas. China was against the United States using quantitative easing because they have a foreign trade surplus, whereas the United States has a foreign trade deficit. While not the crux of the United States economy, an increase in foreign trade may cause for positive growth. Wars have been proven to end recessions as they pay off great amounts of debt and require large military orders in brief periods of time.

While government spending may be unpopular with the American public, the 2008 financial crisis was caused by overextension solely in the private sector. Most of the financial meltdowns across Europe were a results of private debt, with exceptions such as Greece. While many view gargantuan spending as dangerous, the problems that may occur are completely dependent on the party that is creating the debt. The United States government understands and is able to fully anticipate the consequences of amassing debt, as compared to a public individual. The idea that debt is self-borrowed is ludicrous, as one's debt is always another's asset. When a financial crisis reaches the level of the current global spending, government spending is imperative as is increasing the gradual tax rate. In the case of the private sector, Deleveraging is cyclical and if decline in debtors spending drops the more deleveraging shock occurs.

Investing will be slow for United States investors for a couple more years, unless the Federal Reserve acts courageously and utilizes the quantitative easing tool. Several rounds of quantitative easing would be necessary to expedite a slow recovery with a U-shaped bottom. Short-term CD's and consumer staples are advisable in the near future. Despite warnings from the "bond vigilantes," Treasuries may still be a good purchase over the next couple of years. Until corporations feel comfortable enough to start expanding operations and infrastructure, growth will be limited.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.