Not all government deficits are created equal

By Lance Roberts

I recently posted some thoughts on “The Most Dangerous Line Uttered During The Debt Ceiling Debate” in which I discussed the idea of having to increase the government’s debt limit in order to pay its bills. The premise was rather simple. As the government continues to increase its borrowing in order to meet spending requirements; the additional interest service requirement detracts dollars from productive uses. As a consequence, over time, economic growth has slowed. This article, along with my conclusions, elicited some excellent questions that deserved some follow up.

Scott N. stated that:

“Not all government debt is created equal. We have bad deficits and good deficits. Good deficits are used to fund investments that will have a positive rate of return, properly determined. Those contribute to GDP.”

He is absolutely correct. This comment falls within the realm of Austrian economics which is something that I addressed in a previous missive entitled“The Breaking Point:”

“The Austrian business cycle theory attempts to explain business cycles through a set of ideas. The theory views business cycles ‘as the inevitable consequence of excessive growth in bank credit, exacerbated by inherently damaging and ineffective central bank policies, which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings.’

Rising Money Supply and Credit

In other words, the proponents of Austrian economics believe that a sustained period of low interest rates, and excessive credit creation, results in a volatile and unstable imbalance between saving and investment. In other words, low interest rates tend to stimulate borrowing from the banking system which in turn leads, as one would expect, to the expansion of credit. This expansion of credit then, in turn, creates an expansion of the supply of money.

Therefore, the credit-sourced boom becomes unsustainable as artificially stimulated borrowing seeks out diminishing investment opportunities. Finally, the credit-sourced boom results in widespread malinvestments. When the exponential credit creation can no longer be sustained a ‘credit contraction’ occurs which ultimately shrinks the money supply and the markets finally ‘clear’ which then causes resources to be reallocated back towards more efficient uses.”

This point was also addressed by Dr. Woody Brock during his presentation at the 2012 Altegris Investment Conference, wherein he stated (these are my personal notes):

“There is a huge debate over ‘Austerity’ versus ‘Spending’ which leads to increases in debt.

High debt to GDP ratios must ultimately be reduced. There is no question of this.

Rising debt levels erode economic prosperity over time. However, the word, ‘deficit’, has no real meaning – let me explain.

Let’s take two different countries.

Country (A) spends $4 Trillion with receipts of only $3 Trillion. This leaves Country (A) with a $1 Trillion deficit. In order to make up the difference between the spending and the income; the Treasury must issue $1 Trillion in new debt. The new debt that is issued is only used to finance current spending (welfare) but generates no income. Therefore, the gap that is created continues to grow as the cycle is repeated.

Country (B) spends $4 Trillion and receives only $3 Trillion in income. However, the $1 Trillion of excess debt created was invested into projects and infrastructure that produced a positive rate of return. There is no real deficit as the rate of return on the investments ultimately fills the ‘deficit’ by paying for itself.

There is no disagreement about the need for government spending. The disagreement is with the abuse and waste of it.

Keynes’ theory is that when private spending is low it should then be stimulated with public spending. The problem with this theory, while correct, is that it was badly abused. When the economy is strong and growing the public spending should be sharply reduced. This was never the case.

The problem today is that government spending is primarily unproductive in nature (roughly 70%) with only 30% going towards productive investments. This is against the Arrow-Kurtz principles. Today we are borrowing our children’s future with debt. ‘We are witnessing the ‘hosing’ of the young’ he stated.

The U.S. has the labor, resources and capital for a resurgence of a ‘Marshall Plan’. The development of infrastructure has high rates of return on each dollar spent. However, instead, the government spent trillions bailing out banks and supporting Wall Street which has had virtually NO rate of return.

The problem is that we have been running deficits since the beginning of 1980. These deficits have retarded economic growth as the borrowed dollars were used for non-productive purposes. Currently, it requires in excess of $5 of debt to produce $1 of economic growth. This is ultimately unsustainable. The chart below shows the annual change in GDP, the annual net increase in Federal Debt and the surplus or deficit. The red dotted line is the polynomial trend line of the annual rates of economic growth.


This chart goes to address the point made by John L. in relation to economic growth rates versus debt:

“A vast majority will agree with your assertion. But the time lag effects I have pointed out have been bothering me ever since the seemingly perfect Rogoff and Reinhart bubble got deflated. That was another ‘question everything’ wake-up call.”

This is an excellent point. There are MANY factors that go into the reality that economic growth rates are slowing. In fact, as I stated in “A History Of Real GDP & Population Growth” we are now running the lowest rates of economic growth in the history of the U.S. This is not only because of the massive increases in debt but also to ow rates of inflation, population growth, and real employment and wages.

In regards to Reinhart & Rogoff’s work on debt levels versus economic growth, while there was great controversy over the calculation of certain metrics, the end conclusion that rising debt does impede economic growth remains intact. (R&R’s Response To Critics Here) The only question is whether it is 90% or 130% or some other level. The reality is that the “bang moment” has much to do with the underlying metrics of the country in question such as whether they are a sovereign currency issuer, a net exporter or importer, population growth, dependency ratios, wage levels, and, now, the level of central bank interventions.

The questions posed by John, and Scott, were excellent. My hope is that I have made a decent attempt at answering them. There are no simple solutions to the issues that currently plague the U.S. and, unfortunately, the latest debt ceiling debate/government shutdown did nothing to institute any reforms whatsoever. The “kick-the-can” solutions by fiscal policy makers continues to show little understanding about the drivers of real economic growth, the need to reduce governmental dependency or a real “wealth effect” that impacts more than just 1% of the population.

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