It’s the debt, stupid

Let’s say I run a company. For the sake of argument, we’ll call it a shoe store in New York City. I am making $100,000 net per year now. But, I look around me and see huge opportunity for growth. So I go to my bank and ask for a loan to expand my business.  I invest the money in expanding the store, and over the next five years I increase my earnings to $140,000.  Not bad!

Is this a well-run business?

GDP is not enough

Well, if your first instinct is to say, “you didn’t give me enough information,” I would have to agree. But, this is the way GDP statistics are used to measure the success of an economy.

Clearly then, GDP is an inadequate measure for understanding how healthy an economy is.  Nobel Prize-winning economist Joseph Stiglitz brought this issue into the public domain last week when he spoke in Paris, calling the focus on GDP a ‘fetish’ and favoring a broader measure of economic health.

Stiglitz was responding to reporters after a study on alternative measures of economic growth commissioned by French president Nicolas Sarkozy was released. At the time, Bloomberg reported Stiglitz saying:

GDP has increasingly become used as a measure of societal well-being and changes in the structure of the economy and our society have made it increasingly poor one…

So many things that are important to individuals are not included in GDP. There needs to be an array of numbers but we need to understand the role of each number. We may not be able to aggregate everything together.

Stiglitz is talking about the social costs of growth here.  Think about pollution, infant mortality rate, healthcare, life expectancy, or rates of obesity to name a few.  And his views are echoed in an article which prompted this tirade from me called “Emphasis on Growth Is Called Misguided“ by Peter Goodman in today’s New York Times.  Read it.

However, in this post, I want to focus on one narrow issue: debt.

The income statement vs. the balance sheet

In the shoe store example I gave, I borrowed money to fund growth.  In assessing how successful my growth strategy is, the obvious question is: how much did I borrow? It’s the debt, stupid.

What if I borrowed $1,000,000 at 7% interest? $40,000 is a return of 4% on that money, less than the cost of debt. In that case, the growth strategy is a loser.

We need to see the balance sheet as well as the income statement to know what is happening. GDP gives us no insight into the balance sheet of an economy, and is therefore incomplete as a measure of economic health. (I’ll leave the cash flow statement for another day!)

There is 4% growth sustained only through a rise in debt, growth that would have been 2% without an increase in relative indebtedness. And there is 4% growth fuelled by a positive return on that debt.

I am sure you have seen the graphs I published last October at the height of the panic in my post “Charts of the day: US macro disequilibria.” What should be clear from those charts is that the U.S. has been living in a period fuelled more by increases in debt and a concomitant increase in asset prices than in a world of sustainable growth.

The economics profession focus on the income sheet only

I suspect the GDP fetishism owes a lot to the models currently in use in the economics field, which focus exclusively on an economy’s income statement.

When I studied economics, in our introductory course, we used a book called “Economics – Principles and Policy” by two Princeton-affiliated professors William Baumol and Alan Blinder, a former vice chairman of the Federal Reserve (Yes, I still have the book from over twenty years ago).  The only mention of debt comes in Chapter 15 on “Budget Deficits and the National Debt” and it is basically a discussion of trade-offs between budget deficits and inflation.

Nowhere are aggregate debt levels in the private sector mentioned.  Now, I could be wrong because it is not in the index and I couldn’t find it in the book. I see this is reflective of the absence of debt as a topic in economic theory taught in universities.

In fact, the Chapter just before is called “Money and the National Economy: The Keynesian-Monetarist Debate.” I think the title says it all. Baumol and Blinder are Keynesians and they released a book to teach Economics in the Keynesian tradition.  To the degree they discuss any other economic models, it is only to weave the monetarist view into their own framework.  In the introduction of Chapter 14, the book states:

Then we turn to a very old and very simple macroeconomic model – the quantity theory of money, and its modern reincarnation, monetarism – for an alternative view of the effects of money on the economy. Although the monetarist and Keynesian theories seem to be two contradictory views of how monetary and fiscal policy work, we will see that the conflict is more apparent than real.

Now that crisis has hit, there is no inter-weaving of theories. Those two worlds, the monetarists (freshwater economists as Krugman calls them) and the Keynesians (saltwater economists in Krugman’s parlance), are at war over economic theory’s contribution to the global economic meltdown.  The Economist laments:

Economic writers will continue to try and describe the arguments wracking the field for an audience which wants to know about them, but economists need to figure out how to resolve some of these questions on their terms. If the best the dismal science can do in establishing the merit of one position versus another is make a play for the hearts and minds of lay-people, then economics is in more trouble than we all thought.

More noteworthy for me is how the salt- and freshwater types completely disregard debt, an issue central to the Austrian and Minskyian schools of thought. Paul Krugman wrote 6,000 words focused only on the income statement. There was no mention of the huge rise in debt in the U.S. and other economies like the U.K., Spain, Ireland, Iceland or Latvia. All of these countries have one common feature: asset price booms underpinned by rising debt levels.

Let’s hope we start seeing more discussion about the balance sheet in future.

  1. Anonymous says

    Spot on, as the heavily indebted Brits might say. And thanks for the related link to the Lounsbury writeup on the Depression of the 2000s on a debt-adjusted basis.

  2. Goldilocksisableachblond says

    ” ….that the U.S. has been living in a period fuelled more by increases in debt and a concomitant increase in asset prices than in a world of sustainable growth.”

    If the increase in asset prices were ‘real’ , it would probably be ok to disregard debt in calculating GDP. For an individual , for example , as long as net worth continues to go up , ability to service debt … via home equity extraction , for example … is not constrained , or constraining ( on productive activity ).

    The problem is , asset value increases have NOT been ‘real’ , but rather , bubbles, which deflate eventually to rational values , possibly even overshooting on the downside. The debt , however , remains in all its prior glory , and , without the elevated asset values , debt servicing ability goes “poof”.

    To sort out the effects of debt on GDP calculations , one needs to determine some ‘normalized’ value for assets , to see what true net worth is. Long-term price/rent or price/income ratios are ways to look at housing values , for example.

    I think Steve Keen has a good handle on this . His blog is at :

    I agree that , presently , “It’s the debt , stupid” pretty well sums it up. For the last several decades we’ve been ‘advancing’ GDP growth , in a cash-for-clunkers manner , by borrowing it from the future. In the post-WWII decades , by contrast , we actually ‘lent’ GDP growth to the future , since debt/GDP ratios declined during that time.

    You’d think our leaders would look at the policy differences in those two eras for clues on how to clean up our act . There’ not much evidence that’s happening , however , Obama’s campaign rhetoric notwithstanding.

  3. hbl says

    I can’t remember whether yours was among the blogs that linked to this in the past but I don’t see it now searching your site, and it is very relevant:

    “No One Saw This Coming”: Understanding Financial Crisis Through Accounting Models

  4. Ramanan says

    Hey Ed,

    Yes you are thinking in the right direction. Such an approach is already in place. You can try to find the work of Wynne Godley and Marc Lavoie and many others at the Levy Institute. There is also a book on this by Godley and Lavoie – Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth

    Wynne Godley’s approach is stock-flow consistent as well. Its so surprisingly rediculous that the work of a genius has been neglected by Economists.

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