An Unsustainable Path of Debt Expansion

Discussion in 'Economics' started by jueco2005, Oct 21, 2009.

  1. An Unsustainable Path of Debt Expansion

    Mises Daily by Thorsten Polleit | Posted on Wednesday, October 21, 2009
    Debt Growth Exceeds Income Growth

    In Q2 2009, total debt outstanding in the United States — financial plus nonfinancial debt — amounted to 373.4% of GDP.[1] At the start of 1952, the debt-to-GDP ratio stood at only 130%. In fact, in the last decades the rise in total debt has increasingly outpaced nominal income — a development which gained momentum after the erosion of the last vestiges of the gold standard in the early 1970s.
    Figure 1

    The current upward dynamic of the debt-to-GDP ratio is economically unsustainable. It cannot go on forever. To see this, let us assume that the total debt-to-GDP ratio does continue to grow at the average rate at which it has expanded from Q1 1971 to Q2 2009 (case 1 in the chart above). The total debt-to-GDP ratio would exceed 600% at the start of 2029 and reach more than 1000% in 2050.

    If one assumes that the total debt-to-GDP ratio will expand at the average growth rate seen from Q1 1995 to Q2 2009 (case 2), a level of 600% would be reached as early as the middle of 2024, and the ratio would go up further towards 1300% by the end of 2050.

    Interest payments on total debt would rise substantially as a percentage of GDP. If one assumes that the average interest rate was 4% in Q2 2009,[2] total interest payments amounted to 15% of GDP. In case 1, interest payments would double by the middle of 2038, while in case 2 this level would be reached in the middle of 2031.
    Figure 2
    Correction Scenarios

    Admittedly, we do not know how much debt relative to GDP an economy can shoulder. And, of course, there might even be good reasons for the ratio to rise over time. For instance, an increase in "financial intermediation" and a decline in the societal time preference(related, for instance, to rising confidence in the protection of property rights) might justify a higher level of loaning and borrowing in the economy.

    One thing is clear, though: the level of debt relative to income cannot rise without limit.[3] This insight is important, given that there is strong reason to believe that the extraordinary rise in the debt-to-GDP ratio is a result of the government-controlled, fiat-money system in which the money supply is increased through bank lending.

    Let us assume, for the sake of argument, that the current debt-to-GDP ratio has exceeded its sustainable level. What are the chances that output could start expanding more strongly than debt, thereby lowering the ratio? This would be a rather favorable scenario, as the debt-to-GDP ratio would decline, while income and employment would increase. Unfortunately, however, it is a rather unlikely correction scenario.

    Austrian Economics teaches that a circulation-credit-fueled boom can only be sustained by ever-greater doses of credit and money expansion, provided at ever-lower interest rates. As soon as the growth rate of credit and the money supply slows down, the illusionary upswing collapses. Malinvestment is revealed, firms cut employment, and the economy goes into recession.

    Lenders can then be expected to demand higher interest rates and/or to stop extending loans — as the outlook for the possibility of borrowers repaying their debt (in real terms) deteriorates. In other words, market forces start pressing for a change in the hitherto-observed path of the total-debt-to-GDP ratio.

    If commercial banks make their debtors repay their loans, the money supply declines. A drop in the money supply, in turn, would represent deflation — and the symptoms would be declining prices for goods and services of current production, and for existing assets (such as, for instance, stocks and real estate).

    Deflation would lead to credit losses as a growing number of borrowers would find their incomes greatly diminished and — most importantly — falling short of expectations. Many borrowers would default on their debt.

    If credit-related losses exceed their equity base, banks go bankrupt. Savers and investors in bank debentures would have to accept losses, as banks could not meet their debt service. It doesn't take much to see that such an outlook could trigger a "flight out of debt."

    Investors would try to dump their bonds, causing interest rates to go up. Borrowers in need of rolling over their debt would have to accept higher refinancing rates, which would leave a growing number of investment projects unprofitable. The mere expectation of rising credit costs would therefore make possible an anticorrection scenario.
    The Anticorrection Scenario

    In the anticorrection scenario, central banks — seeing an unraveling debt pyramid — would decide to prevent banks from defaulting on their debt by pushing short-term interest rates to record lows and providing additional base money for bank refinancing — by monetizing banks' debentures and/or (troubled) assets.

    Keeping a circulation-credit boom going requires — as Austrian economists have explained in great detail — ever-greater amounts of credit and money, provided at ever-lower interest rates. However, credit and money cannot be increased indefinitely by the central bank and commercial banks. In fact, it is money demand that would set a limit.

    If inflation — that is, a rise in the money supply — does not exceed an unacceptable level, people may well continue to use money even if it loses its purchasing power. If, however, inflation exceeds an acceptable level, or if people start expecting inflation to continue to rise further, the money is doomed to fail. As Ludwig von Mises noted in 1923,

    Once the people generally realize that the inflation will be continued on and on and that the value of the monetary unit will decline more and more, then the fate of the money is sealed. Only the belief, that the inflation will come to a stop, maintains the value of the notes.[4]

    The private sector may be able to cope with deflation (and the ensuing redistribution of property rights). The institution of government, in its current size and scope, however, cannot. Inflation — the rise in the money supply — is an indispensable tool for financing government outlays for which the taxpayer would presumably not want to pay out of his current income.

    Mises noted,

    Inflation becomes one of the most important psychological aids to an economic policy which tries to camouflage its effects. In this sense, it may be described as a tool of antidemocratic policy. By deceiving public opinion, it permits a system of government to continue which would have no hope of receiving the approval of the people if conditions were frankly explained to them.[5]

    The effort to prevent government from defaulting on its debt — and this goal would most likely be subscribed to by the ruled class as well as the ruling class, especially under deflation — is therefore the greatest danger for the value of money. And this is why an unsustainable debt-expansion path poses such a great danger to the exchange value of money.

    Print $17

    Audio $25

    Central banking makes it possible for the government to expand the money supply by any amount, at any time deemed necessary. And once (hyper)inflation is publicly seen as being the lesser evil of all options available for the government meeting its debt service, it cannot be dismissed out of hand that (hyper)inflation would be the consequence of an unsustainable debt-to-GDP ratio.

    In 1923, Ludwig von Mises (1881–1973) published his essay, "Stabilization of the Monetary Unit – From the Viewpoint of Theory."[6] In it, he not only outlined the consequences if the government continues to increase the money supply, he also outlined a monetary reform plan. In view of today's challenges regarding worldwide monetary affairs, Mises's essay is as insightful and instructive today as it was back then.
  2. this is the problem though. all of the vital functions of an economy as reliant on debt. generating capital for investment, providing income for pensioners and controlling aggregate demand. they need other ways to control these functions without debt otherwise we will be in this situation continually.
  3. You are right. this is a great opportunity to abolish fractional reserve lending. But if we do there will be no need for a FED. Politics rules supreme again.
  4. This is what no one discusses. Not politicians, not economists, not central bankers.

    We are at the end of a monetary system, and the only logical conclusion is some sort of reset in the near future.

    A fiat monetary system requires a growing economy in order for there to be enough money for debts *and interest* to be paid off. When the economy shrinks for too long - the system risks collapse.

    Derivatives, Bad mortgages, ballooning gov't debts - all these are not problems, but symptoms of a collapsing monetary system.

    Financial engineering and exotic mortgages were inventions that propped up our collapsing monetary system. If you look at total debt to GDP - more and more debt is required to support a dimishing GDP. At one point (and it has been reached) income flattens and debt continues. Then, the gov't is last resort of debt creation.... then either collapse or hyperinflation follows.

    And by the way - there are finite resources on our planet - how can economies continue to grow exponentially when resources get depleted? Our way of life is a meager experiment in a blip of human evolution.

    Resistance is futile!

    The truth is too ugly to face.
  5. Agree with that idea, disagree on timing and the rest of your theses.

    This FIRE economy will not last forever. Something else will be created. Unfortunately, what it is and how to position for it, if you even can, is another thing.
  6. m22au


    I agree with most of what you have said.

    A lot of these concepts are well captured by Chris Martenson in his crash course:

  7. +5.

    Great comment. thank you

  8. Misthos really nails it. The expansion of derivatives that went into overdrive starting at the beginning of this decade is definitely a symptom of a monetary system nearing its end. The lax lending standards, packaging of bad debts, etc, etc were simply heavy handed attempts to continually feed the credit machine to buy the system a few more years.

    So, in reality, it has been "inflate or die" for longer than we think. The difference between then and now is that the tactics are more overt and in your face.
  9. With all due respect I disagree with quite a few of your points, Misthos...

    What do you define as the 'near future'? 10yrs or 100yrs? Where do you see a diminishing GDP? Are you referring to real GDP, maybe, rather than nominal one? Is it world GDP that's diminishing or the US GDP?

    As to your last point, hasn't this Malthusian-type argument been refuted time and time again? Simplistically, couldn't one argue that there's no upper bound on TFP, which means that there's no upper bound on GDP growth, even if resources are finite?
  10. Near future - within twenty years. I wouldn't rule out next week - but that probability is low - as low as twenty years is. So I guess somehwere in the middle? I'm in my late thirties and have just recently concluded that 20 years flies by. That's why I used the term "near."

    Diminishing GDP - I should not have used that word, or at least described the different meanings I meant by it: In a recession, GDP shrinks, so that's what I meant. However, what I also meant to emphasize was the growing divergence between gdp and debt growth on the same timeline during recessions and boom times of the past 40 years. If one dollar of total debt creates 1 dollar of GDP 30 years ago, and say five years ago the stat is 3 dollars of debt creates 1 dollar of gdp - you have a rate of diminishing returns. I hope that helps explain what I meant. I think others understood, so i don't think I wrote it that poorly. hey, it's message board.

    Malthus was delayed, not disproven. Malthus will strike back this century.

    GDP requires that something is produced... something derived from nature, and that something is tangible. There is only so much room for landfills, so much easy metals to mine, etc... If the current world's population of 6.7 (?) billion people lived like the average American, and even if the population growth froze - we'd be SCREWED. We would look back to Malthus and say - wow, we should have saw this comming.

    But guess what? The other billions that live in mud huts want to live like us. We Americans consume 23% of the world's oil. We may have to share that. When that happens, what does that mean for our lifestyle? Oh wait, we'll be scooting around like the Jetsons by then! Sorry, I don't mean to be a rude smart ass. I just want to address the techno fix cornucopians.

    Or, I guess we can create a society based on a ponzi scheme casino, the use of computers, and paper and ink toner. That doesn't use too many resources... oh wait, we tried that.

    Or... we can become a society of artists. You buy my music, I buy your ebook. But A LOT of us have to do it. That's not resource intensive, but my faith in humanity producing that many talented authors and musicians is limited.

    But seriously... I hope I adressed your disagreement(s) with what I wrote.
    #10     Oct 21, 2009