Debt-to-GDP and Misdiagnosing a Bubble Economy’s Ills

A few economists seem to be catching on, but not nearly enough…

About a year ago, St. Louis Fed President James Bullard wondered whether too much faith was being placed in what models say economic growth should be but, as detailed in When Models Trump Common Sense, he was rebuffed by nearly the entire establishment (or at least “a small army of bloggers with PhDs in economics”).

Now, in a story at Project Syndicate, Raghuram Rajan, Professor of Finance at the University of Chicago Booth School of Business and the IMF’s youngest-ever chief economist tries to explain Why Stimulus Has Failed and, in doing so, questions whether the root cause of our current economic troubles is simply a lack of demand, casting himself as an Austrian sympathizer in the process:

What if the problem is the assumption that all demand is created equal? We know that pre-crisis demand was boosted by massive amounts of borrowing.

Put differently, the bust that follows years of a debt-fueled boom leaves behind an economy that supplies too much of the wrong kind of good relative to the changed demand.

The only sustainable solution is to allow the supply side to adjust to more normal and sustainable sources of demand … The worst thing that governments can do is to stand in the way by propping up unviable firms or by sustaining demand in unviable industries through easy credit.

Not surprisingly, it didn’t take long for one commenter to call Rajan out:

Raghuram Rajan’s article sounds awfully close to me to a defense of Austrian Economics, a la Ludwig von Mises. Even though Mr. Rajan might not want to portray it that way. [Austrian Econ is not all too popular these days in the venerable halls of the top departments of Economics, where Mr. Rajan circulates.]

For reasons that make no sense to anyone who isn’t an economist, it has long been accepted as conventional wisdom amongst the dismal set that demand is demand - it doesn’t matter where it comes from - and, once it appears, it forms the basis of an economy’s “potential” output or “potential” GDP.

Once an economy’s actual output dips below its “potential” output (as extrapolated from past activity, regardless of what drove that past activity), then you have what’s called an “output gap” as shown below, and this is what leads to the massive amounts of money printing and borrowing seen today.

What Rajan is suggesting above is that policymakers may have misdiagnosed the problem - that the mid-2000′s demand wasn’t really sustainable demand - and, as a result, they are now applying the wrong solution by trying to close this “output gap” via more money printing and more government debt.

In effect - Gasp! - the Austrians could be right about this - there is no easy solution to a debt-driven boom.

You either take your medicine or you take steps that could end up destroying your currency (in our developing global currency war, perhaps all the worlds currencies).

Clearly, the world’s economists are opting for the latter.

How this all relates to debt and deficits is important because a big part of the rationalization for all the borrowing and spending that is going on in the U.S. and in other developed nations around the world these days is that these debt-to-GDP ratios are only high because GDP is low.

Once we restore economic growth back to its early-2000s glory, the debt won’t seem so bad anymore.

The thinking goes that, once a strong recovery takes hold, tax receipts will go up, fewer people will collect jobless benefits, and the government’s books will look much better, but that will only happen when heady rates of growth return, growth rates that have, in recent decades, required a heady expansion in credit.

Coming at a time when consumers and businesses are trying to get out from underneath an already hefty debt load, that doesn’t seem likely, but, that’s not stopping policy makers from taking this approach.

That’s all they know - we have a shortfall of aggregate demand, therefore, we need more demand.

One well known Nobel Prize winning economist and New York Times columnist has gone so far as to recommend no longer looking at the real economy when assessing the nation’s borrow-and-spend ways, but to look at “potential GDP” which, of course, isn’t such a scary picture.

As shown to the right, when viewed this way, government spending as a share of “potential” GDP is just about back to where it was in the days prior to the bursting of the housing bubble that led to the precipitous decline in “actual” GDP.

The conclusion?

All that extra debt the government has been piling on is no big deal.

The basic problem here is that the vast majority of the world’s economists don’t seem to even consider the possibility that a good portion of the demand (and, hence, strong economic growth) seen in the early-2000s and in prior decades has been debt-driven.

Home equity driven consumer spending around the middle of the last decade is probably the best example of this and how anyone can just blindly extrapolate from this point to calculate “potential output” is beyond me.

More importantly, having expanded credit about as far as it could go six or eight years ago before the wheels fell off of the global economy and financial system, we’ve surely come to the end of the road when it comes to strong credit expansions, yet few economists seem to acknowledge this reality.

It’s highly unlikely that the “bubble economy” levels of growth can be restored (and slowing population growth makes this even more difficult), yet governments continue to borrow and spend while central banks continue to print money with abandon, all of these efforts all aimed at doing so.

Of course, the unacknowledged solution here is that all this borrowing and money printing will lead to another asset bubble and, an even briefer period of debt-driven prosperity. That this is, basically, being sanctioned by the world’s economists is probably the most disturbing aspect of all of this.

We are, in effect, trying to create more “artificial” demand to close the “output gap”, all the while fooling everyone into thinking that debt-to-GDP is the only thing that matters when talking about the national debt.

In a bubble economy, perhaps the more important part of debt-to-GDP is the nature of the GDP, not the debt.

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12 Responses to Debt-to-GDP and Misdiagnosing a Bubble Economy’s Ills

  1. Ted S. January 24, 2013 at 8:35 AM #

    It it weren’t so sad (and distressing as to the long-term implications) this “blind spot” of modern day economists would actually be pretty funny.

  2. Frank H January 24, 2013 at 10:04 AM #

    The concept of aggregate demand is the poison eating at the root of economic theory. Keynes basically repeated Malthus positions on demand, which was effectively ridiculed as naive thinking by Ricardo and Mills. In the 19th century, you were considered a good economist if you did not make this mistake about demand. Keynes was able to revive Malthus naive ideas by finding a ready public in 1936. Economics is not like physics or medicine which improve with time. We understood economics much better in the early 1800s than we do today. Economic science has regressed, and after teaching economics for 30 years, I consider that taking a macroeconomics at universities today is negative knowledge. You know less when you leave than when you entered the classroom.

    • Tim January 24, 2013 at 12:53 PM #

      I knew things were bad, but I didn’t know they were that bad.

    • Mitchn January 24, 2013 at 7:40 PM #

      It’s simple. The economic “prosperity” of the last thirty years was fueled by massive borrowing, at all levels. The only solution to too much debt is to pay it down or write it off. With the demographic trends already in place, insisting that it be paid bedown at par will consign the developed world to another twenty, twenty-five years of stagflation and recession — that is, if democratic capitalism is able to survive such a scenario. The only way out of this trap is debt forgiveness, at all levels. The Austrians know nothing.

  3. Digby Green January 24, 2013 at 4:12 PM #

    Yes its very serious.
    So how can we get governments and the bankers to get us back on to a sound money system, where there is steady growth, and no bubbles and no crashes and every currency is priced right?

    • Jones January 24, 2013 at 4:40 PM #

      I think Tim has referenced this Jeremy Grantham quote a couple times before, but it appies here. When asked what the Fed and he government should do, he quipped:

      “I wouldn’t start the journey from here if I were you when you ask the way. You really shouldn’t allow the situation to get into this shape. You should not have allowed the bubbles to form and to break. Digging out from a great bubble that has broken is so much harder than preventing it in the first place.”

  4. Benoit Essiambre January 24, 2013 at 5:00 PM #

    I’m not an economist, but from what I understand, this is not quite right. The Keynesian models already takes into account demand that is “fueled by debt” from stimulus so you don’t have to worry that they are getting things wrong based on that.

    However, monetary and fiscal stimulus does have an Achilles’ heel that most economist (even Keynesians) acknowledge, even though they have been pretty mum about it lately (the fact that there is evidence we haven’t reached the limit yet might explain why they are not saying anything ).

    The Achilles’ heel is natural resource constraints. Keynesian economics teaches that when there is high unemployment, stimulus can increase GDP at no cost by putting people to work. It has no cost, because they show that these people will create more goods, and pay back more taxes than the cost of borrowing (or creating money) for the stimulus. This also won’t cause inflation because the labor is cheap in conditions of high unemployment and the new supply of products created will help lower prices.

    Unfortunately, this only works if there are enough natural resources for the new workers to process into products. If resources are at their limits and growing the GDP pushes commodity prices up too fast, stimulus becomes dangerous and will cause inflation without reducing unemployment. Businesses won’t hire new people if they can’t buy the raw materials they need at a reasonable price for these workers to work.

    Now the reason this doesn’t seem like a worry to economists is that commodity prices have been fairly low since the financial crisis. There seems to be some leeway for more stimulus.

    However, in my opinion, there are hints that we could be approaching some natural resource constraints. Just before the crisis in 2007, commodity prices were creeping up. Prices of oil, wheat, copper were often reaching record highs. Overall, the prices seem to have mostly corrected down but it could be that they are only temporarily depressed because of the unresolved crisis.

    More monetary stimulus is probably a good thing right now, but it might not be as effective as some economist seem to think. We might hit the natural resource limit sooner than they think. In the face of increasing demand from emerging countries and depletion of some natural resources such as cheap oil, fertilizer, water for crops, copper etc… output might be constrained not by a lack of demand but a lack of supply and thus the gap might be smaller than we think.

    • Frank H January 25, 2013 at 12:42 AM #

      Well, I am an economist. The problem with keynesianism is always the same: where does the money come from (the crowding out effect) How do you walk into a supermarket without any money and without a credit card and buy anything. The answer is you don’t!. The entire premise of keynesianism is based on hoarding. (Keynes constantly confused hoarding with savings). The classical economist recognized hoarding but considered it relatively unimportant, say 5%. But even if you consider hoarding important, it is irrelevant if prices adjust.

  5. fresno dan January 25, 2013 at 3:35 AM #

    I agree completely with the article.
    I would also add that the distribution of GDP is never addressed. If most people understood the machinations of the Federal Reserve and the “primary dealers” - there would be a revolution. Money for nothing, and the chicks are free….
    Economists posit a theory of ever more demand and actually assert that every debt is somebody’s asset. Funny how all the “assets of Mortgage backed securities” became the publics “assets” when the bottom fell out of the market, and funny how the government paid nonmarket (higher) prices for these sh*tty assets…
    Of course, crony capitalists buy congressional “services”

  6. Heinz January 26, 2013 at 12:10 AM #

    I keep wondering why debt-to-GDP is such an important number. What about debt compared to income? Even bankers use this measure when they approve loans as it shows the borrowers
    (un-)ability to repay the loan. Do we use the former because the ratio of the latter would look even worse and would be more telling? Granted, GDP determines income somewhat but so do other factors.


  1. 10 Thursday PM Reads | The Big Picture - January 24, 2013

    [...] Holds More Than Meets the Eye (WSJ) • Debt-to-GDP and Misdiagnosing a Bubble Economy’s Ills (Iacono Research) • How Fed Learned to Stop Worrying and Love Zero (Bloomberg) see also Economists Give Abenomics [...]

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