Archive for November 23rd, 2009

Debt Crisis

In 1930, the first year of the Great Depression, most economists and prognosticators thought that while the crisis was deep, it would run its course in a limited amount of time, and growth would come back to the economy.   It didn’t.   The crisis continued throughout the decade as economies were stuck in a stagnant mode while governments rejected the idea of using debt to stimulate their economies.

In some ways, the depression seems easy in comparison to the crisis we now face.   If our policy makers would go back to 1930, they’d see US debt at about $16 billion, or only about 13% of GDP.    As a percentage of GDP that debt would rise to over 40% by the middle of the decade, but in nominal terms would rise only to about $30 billion — the shrinking GDP was causing the debt to GDP ratio to worsen.   Only WWII would bring a significant increase in debt (over $220 billion and 120% of GDP by 1946) as the US had to pay for a two front war.

US policy makers in 1930 would have numerous fiscal and monetary tools at their disposal.  The low debt to GDP ratio would mean they could inject significant stimulus directly into the economy and jump start growth.  They’d have low interest rates, and the capacity to increase connections across borders to fix the economy.    I’m absolutely certain that policy makers now, if transported back to the 1930s, could create policies which would have meant economic growth by the mid-thirties, and perhaps an avoidance of WWII.  So when people ask whether or not we’re facing another “great depression” my response is “if only it were that good.”

Total US debt reached nearly $400 billion by 1970, while Richard Nixon was President.  However, that was only 37% of GDP, and reflected the new willingness to use “Keynesian” policies to maintain economic stability.   John Maynard Keynes was the economist who, besides writing in 1924 that the Versailles treaty made another war with Germany likely, figured out the Great Depression and how to get out of it.  He realized that the market had no magical or “natural” solution to an economic downturn, and fiscal stimulus was necessary to “prime the pump,” so to speak.   Yet he was not in favor of ongoing debt and deficits.   He recommended counter-cyclical budgeting — run surpluses when the economy is strong, be willing to run budget deficits if there is a recession.

Though the last Johnson budget (for 1968) was in surplus, the economies of the West ignored one side of Keynes’ advice and instead became very adept at running deficits during economic slow downs, while refusing to cut that spending when things improved.   Still, since the debt to GDP ratio was improving, this wasn’t seen as a major problem.   The first year of the Reagan Administration, saw debt at 33% of GDP, even though it had reached $1 trillion.  Our economy was growing faster than our debt.   An analogy:  If you have $10,000 credit card debt and an annual income of $35,000, you’re in trouble.  If your annual income is $200,000, it’s not that big of a deal.

The eighties, as noted last week, saw the US undertake a series of economic policies that set up the current crisis.  The biggest was to stop even attempting to limit debt growth during a boom.   In 1983, the last year of a recession, debt was $1.4 trillion, and 40% of GDP.   By 1990 it was nearly $3.3 trillion, and almost 60% of the GDP.  Yet that period from 1983-90 was defined by a serious spurt of economic growth, a time when Keynes would have said we should save money and cut deficits.   Keynes was out, however, as his “demand size” fiscal policies were replaced by “supply side” monetarism.   The deficit doesn’t matter as long as inflation is low, and inflation was low.

Now, low inflation over the past generation is in some ways an illusion.   The quality of goods has declined to the point that things need to be replaced more frequently, hiding inflation.   Anyone who has bought a cheap DVD player probably knows that the cost only seems low until a year or two later it gives out and you have to replace it.  Suddenly the Sony seems a better buy.   For the US, however, it was a double illusion — the role of the US dollar meant we could export inflation to the rest of the world, meaning that we didn’t suffer the usual currency decline caused by increasing budget deficits (or current account deficits).

In the 90s things stabilized as the US, like the rest of industrialized world, found debt at 60% of GDP something we could live with.    By 2000 US government debt was $5.8 trillion, but in a$10 trillion economy that was slightly under 60% of GDP.    Despite a booming economy in the first eight years of the 21st century, US wars and government spending started a debt to GDP increase again.  By 2008 debt was at nearly $10 trillion, or 70% of GDP.   Then the last days of the Bush Administration saw a dramatic increase due to the bailouts, meaning 2009 debt is likely to come in at $12 trillion or 90% of GDP.   Spending early in the Obama administration on economic stimuli mean that by 2014 we should be looking at debt and GDP at about $18 trillion.   Estimates suggest we could remain at such high debt loads for the next decade.

Herein lies the problem:  stimulating the economy by increasing debt becomes counter productive if debt is too high.  Given that the private and corporate sectors of the US are also in debt (total national debt is probably about $60 trillion), there is no reserve of money able to be injected.   Moreover, the US now pays relatively low interest rates on short term loans to finance much of the debt.   This could increase massively in the near future, much like people with subprime mortgages saw their loan payments go up when they couldn’t refinance.  In a weird way, the subprime crisis could symbolize the budget crisis faced by the US.

This debt crisis is the reason why the US economy will not simply grow out of this recession like we did in past recessions.   From 1980 to now we’ve gradually put ourselves in an unsustainable position, making ourselves vulnerable to a new depression, though one where we lack tools we could have used in 1930.  So what our the options?

1.   This is like  a war.   One could look to the massive spending during WWII as a sign that we can go deep into debt and, if it sparks economic growth, slowly work out of it.   This seems to be the approach of the Obama administration, and is the most optimistic scenario.  The problem is that the world was under producing in 1945, and could rely on European growth and increased trade to fuel a major spurt of economic prosperity which would allow the debt to go down as the economy prospered.   For this to happen now the developing world would have to be the engine for growth.   If this scenario plays itself out, the US is headed for a “soft fall,” though the world economy will move away from US dominance and Americans will have to get used to a lower standard of living.   And again, that is the best case scenario.

2.  Dollar devaluation.   In this scenario foreign countries will stop investing in US bonds at low interest rates, distrusting the dollar at such high debt levels.   The collapse of the dollar in an otherwise deflationary economy will have a devastating effect on the US economy.   Previously cheap foreign goods will become expensive, meaning inflation will increase during a time of economic stagnation (stagflation).    This would intensify the recession (things would get far worse), bringing structural change to the US economy.  Slowly production would increase here (to replace cheap foreign goods), meaning jobs would come back.   To deal with the debt, the US would either default or alllow currency devaluations to handle the debt (meaning new debt would not be allowed, as interest rates would be much higher).   This all would mean a long term structural adjustment to the US economy which would likely take the next decade to play itself out.   If this scenario becomes reality, we’re only at the start, only feeling a pinch of the pain that is in store.

My own guess is that reality will be between the “best” case scenario 1 and the “worst” case scenario 2.  Simply: the debt crisis is real, unprecedented (not like past war time debt), and defies any quick solution.   Moreover, any external complications — an energy crisis, terrorism, war — only makes things more difficult.   The bottom line is that the US is in real economic decline, thanks to our lack of fiscal and monetary discipline over the past three decades.