Wednesday, June 15, 2011

Marginal Productivity of Debt---By Shan Saeed

It is as simple as ABC if you analyze the balance sheet of any country and make a forecast. Its simple statistic that continues to warn of huge economic problems ahead for the US economy. Some economists call it the ‘marginal productivity of debt [MPD].’ It relates the change in the level of all debt (consumer, corporate, government etc.) in a country to the change in its gross domestic product (GDP). However, due to the message it is delivering, most US economists employed in financial institutions, governments and private industry, as well as financiers and politicians, want to simplify it or ignore it for some reasons.

And for the US economy and government finances, the MPD (and related variants of it) is continuing to indicate extremely difficult economic times ahead. Default cant be ruled out at this point of time. With QE2 finishing on June 30th and Debt ceiling $14.3 trillion yet to raised and deadline of August 2, is approaching fast, things are looking ominous...

I have vague recollections of the MPD concept from my economics classes two years ago. But I was re-introduced to it around 2010 by a renowned economist Nobel Laureate Prof Gary Becker at Uni. of Chicago, USA during my deliberation with him. I follow him and President Reagan economic adviser Milton Friedman. Another Nobel Laureate from Uni. of Chicago, Booth School of Business, USA

I wrote an article on my blog titled, Is the US heading for lost decades? and how debt productivity decline coming to a bad end? I found that, “for decades, each dollar of new debt has created increasingly less and less national income and economic activity. With this ‘debt productivity decline,’ new evidence suggests we could be near the end-game… ”

Another way of viewing the debt productivity problem is to look at it in terms of how many dollars of debt it took to help create total national income, which is the wages, salaries, profits, rents and interest income of everyone. Again, from my above mentioned article, i shared my analysis.

In 1957 there was $1.86 in debt for each dollar of net national income, but [by] 2006 there was $4.60 of debt for each dollar of national income – up 147 per cent. It also means this extra $2.74 of debt per dollar of national income produced zilch extra national income. In 2006 alone it took $6.32 of new debt to produce one dollar of national income.”

Such data helps explain why US exponential debt growth—after reaching certain limits—collapsed in 2008 and contributed massively to the global financial crash.

However, whereas the US private sector debt has marginally ‘de-leveraged’ (retrenched) since that crash (which might now be reversing), the US government, as everyone knows, has run up mammoth deficits to purportedly keep the country’s economy from imploding. Thus, the US’s MPD is marching to another, perhaps even more frightening tune, suggesting government financial insolvency and/or debt default.

One fascinating way of looking at the declining MPD of US government debt has just been presented by Rob Arnott on May 9, 2011, in his post, Does Unreal GDP Drive Our Policy Choices? What Mr. Arnott does is to subtract out the change in debt growth from GDP, and refers to this statistic as ‘Structural GDP.’ He finds that, “the real per capita Structural GDP, after subtracting the growth in public debt, remains 10 per cent below the 2007 peak, and is down 5 per cent in the past decade. Net of deficit spending, our prosperity is nearly unchanged from 1998, 13 years ago.”

In its effort to counter the significant economic difficulties since 2008, the US government has added, or will have added, around $4 trillion in deficits (financed by new debt) in its three fiscal years 2009, 2010 and 2011. Yet, all this massive government deficit spending has failed to really ignite economic growth. Most likely this is because of the enormous dead weight loss of unproductive and onerous private sector debt, particularly that of consumer debt. Hence, real US GDP will have increased probably less than $1.5trn during these years. Including some further economic benefit in the years thereafter, a total GDP benefit of only about $2trn is probable.

So, $4trn borrowed for $2trn in GDP gains. Thus, in very rough round numbers, each new one dollar of US government debt might only produce $0.50 in new economic activity and probably only about $0.08 in new federal tax revenue. (Federal tax revenue as a percentage of GDP is around 15 per cent.) Therefore, the economic marginal return for each new dollar of US government debt is possibly around -50 per cent! If you loaned someone $10 million and they gave you back $5m, you would not be happy!

Hence, it might not be long before those holding or buying US government bonds perceive the reality that the US government, and US economy, are losing massively on government borrowings. This will result in much, much higher US government bond yields and interest costs. Most importantly, it may make the rollover of US debt and new debt issuance incredibly difficult unless either US taxes rise stratospherically to cover the deficits, and/or the US Federal Reserve money printing goes into hyper-drive to purchase the debt the markets will not buy. (Of course US banks, pension funds etc., could also be forced to buy them.) Thus, the idea that US government debt continues to be ‘risk-free’ is absurd. PIGS is a live case study in Europe to change that perception now. For this, and for many other reasons cited above, is why the US financial and political elites want to keep hush-hush about what the MPD and its variants reveal!

Disclaimer: This is just a research piece and not an investment advice. Investors are encouraged to execute their own due diligence before making any investment decision or entering into financial contract. All financial transactions carry a RISK

1 comment:

  1. Ha! This guy has definitely never worked in a central bank. Let you in on a secret, dude. In a fiat/credit money economy... all money IS DEBT.

    Or, as Fed president Marriner Eccles told the Senate in the late 1930s:

    “If there were no debt in our money system there would be no money.”

    The rabbit hole runs deep!