"IS AGGREGATE DEBT EXCESSIVE? The Obama administration is looking at the wrong ratio "

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<<<"IS AGGREGATE DEBT EXCESSIVE?

The Obama administration is looking at the wrong ratio

A paper presented at the Santa Colomba Conference on the International

Monetary System at the Palazzo Mundell, July 2009.

Antal E. Fekete

San Francisco School of Economics

E-mail: aefekete@hotmail.com

The Obama Administration has raised the ante in combatting the recession by

increasing the debt of the government to levels that were previously considered

unthinkable. It is explaining away the weakening financial structure of the

country by saying that aggregate debt has not increased much relative to GDP

and is therefore not excessive.

This argument is false to the core. One cannot take comfort in past

increases of GDP to justify future increases of debt. The fact is that the increase

in debt has been the major motive power behind the increase in GDP and prices.

It cannot, therefore, be tested by its own results. The real test is the burden of

debt. The economic advisers of president Obama forget that the GDP and prices

may well decline, but the debt remains fixed. This means that, given the decline,

even without further increases in aggregate debt the financial structure will

deteriorate. How much more must it then deteriorate when all caution

concerning the threat from excessive debt is thrown to the winds!

The argument about stimulating the economy with the proceeds of selling

more government debt is equally false. It misrepresents the long-run economic

effect of debt on the capacity to produce. If we stimulate the economy beyond

its natural level by increasing debt, then we create a capacity that will not be

required, and we induce a price and wage level that will not be possible to

maintain when the debt spiral ceases. In this way government stimuli create

latent pressures for future price, wage, and output declines, increasing the debt

burden to a much greater extent than was originally envisaged.

Some people say it does not make any difference whether the money

spent has come from debt or equity. This is fallacious because debt creates

rigidities that are hard to adapt to declining prices and output. There will be

some very unsettling effects. When people are scrambling for liquidity in self-

defense, as they do now, debt will make them extra cautious about increasing

their spending. This, in turn, makes conditions worse which will then make the

debt more burdensome still, etc., creating a snowball effect. In adapting to

adverse conditions the greatest enemies are fixed costs, such as interest,

depreciation and, above all, debt which is not only hard to refinance but it also

limits flexibility. If equity was used instead of excessive debt, then the snowball

effect of adjusting to adverse conditions would be far less.

By virtue of pricing power the granting of “cost-of-living adjustments” to

labor is easy and logical, provided that the cycle is in its upswing, so things are

kept in fair balance. By contrast, reverse adjustments are very hard to make on

the downswing. Therefore rigidities and maladjustments accumulate much

faster, and they result in a much more precipitate decline as compared to the

preceding rise in output.

The Obama administration is looking at the wrong ratio. Instead of the

ratio of total GDP to total debt it should watch the ratio of additional GDP to

additional debt, that is, the amount of GDP contributed by the creation of $1 in

new debt. This ratio shows how effective debt is to make the economy grow at

the margin, and for this reason it may be called the marginal productivity of

debt. As long as it is well above 1, the creation of new debt has an economic

justification. It shows that the economy can have a healthy growth. But a falling

marginal productivity is a danger sign. It shows that the quality of debt is

deteriorating. Should the ratio fall below 1, it is “red alert”. The volume of debt

is rising faster than the national income. The country is living beyond its means

and is consuming capital.

In the worst-case scenario the marginal productivity of debt may fall into

negative territory. This means that the economy is on a collision course with the

iceberg of debt. Not only does more debt add nothing to GDP, in fact it causes

contraction and greater unemployment. Debt creation must cease at once as a

matter of utmost urgency. The condition of the economy can be compared to

that of a patient suffering from internal hemorrhaging that must be stopped

immediately.

Several observers calculated the marginal productivity of debt tracing it

back for the past fifty or sixty years. One of them, Barry B. Bannister of

Baltimore published his results on his website bbbannister@stifel.com. While

the calculations of various observers have yielded various results, they all agree

that the marginal productivity of debt has been falling and will reach 0 if it has

not already done so. The discrepancy is due to the difference in defining net

financial debt to avoid double counting. For example, Bannister is netting out all

except the first round debt in the derivatives tower and, as a consequence, his

calculations predict a further decline in the ratio but it will not become negative

before 2015. Others argue that the layers of the derivatives tower are essentially

higher levels of debt re-insurance which cannot be netted out because every

higher level means the introduction of new risks. Accordingly, their calculations

show that zero marginal productivity of debt was reached back in 2007 and

since then the ratio has been negative and falling further.

In spite of disagreements and discrepancies, these studies agree that the

present crisis is a debt crisis, and any further addition to aggregate debt runs the

risk of making the economy contract further. Under these circumstances the

Obama administration’s economic policy is self-defeating. More debt is poison

to the economy. The internal hemorrhage will continue, nay, it will get worse.

The correct policy should allow insolvent firms and banks to be liquidated

without interference from the government. There should be a resolute policy to

strengthen the capital structure of the remaining firms and banks. It is imperative

that the level of aggregate debt be progressively reduced until a marginal

productivity of 1 or higher is restored. It follows that the balance sheet of the

Federal Reserve banks should be contracted rather than expanded.

Why is a negative marginal productivity of debt a sign of an imminent

economic catastrophe? Because it indicates that the economy is literally

devouring itself through the consumption of capital. Production is no longer

supported by the prerequisite quantity and quality of capital goods. The

responsibility for this belongs to the fast-breeder of debt. It may give the

economy a sense of euphoria during the upswing of the cycle, but is devastating

in a downswing.

In March, while he was the president of the European Union, the Czech

prime minister Mirek Topolanek publicly characterized president Obama’s plan

to spend nearly $2 trillion to ease the U.S. economy out of its recessionary hole,

as “a highway to hell”, and he predicted that “it will undermine the stability of

the global financial market”. While undoubtedly it was an undiplomatic gaffe

and a display of extreme impoliteness, the caretaker prime minister did nothing

but blurted out unpleasant truths.

It would have been more polite and diplomatic if Mr. Topolanek had

couched his comments in the following tenor: “the stimulus plan was made in

blissful ignorance of the marginal productivity of debt which is negative and

falling. In this situation more debt will only stimulate deflation, economic

contraction, unemployment, and it will lead to further weakening of the global

financial structure.”

References

by the same author, see www.professorfekete.com

Falsifying bank balance sheets, April 21, 2009

Marginal productivity of debt, March 28, 2009

A critique of the quantity theory of money, April 15, 2009

June 24, 2009. ">>>