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One Chart Explains Why Government Debt Is Dragging on the Economy’

Contributed by Dan Steinhart, Casey Research.

The US has too much debt. This is no longer a controversial statement. Some may believe other problems are more urgent, or that we need to grow our way out rather than slash spending. But even the most spendthrift pundits acknowledge that the debt-to-GDP ratio of the US must decrease if we are to have a stable, prosperous economy.

The private sector has reacted to this over-indebted reality as you would expect: by deleveraging. Since 2008, households and businesses have extinguished of 67% of their debt when measured against GDP. Some paid debt down purposefully, and others defaulted. For our purposes, it doesn't matter how the debt went away. Only that it did.

Meanwhile, the government has done the exact opposite. It has upped its own borrowing by 52% of GDP since 2008.

As a result of these countervailing forces, the aggregate debt-to-GDP ratio has declined only slightly since 2008. Had the government not stepped in, the US economy would we well on its way to a sustainable debt path. Instead, it has shed a paltry 15% of GDP. In other words, government borrowing largely offset private deleveraging.

Why, in a country in that so desperately needs deleveraging, would the government do such a thing?

The typical response is that such a quick and drastic drop in debt would have flung the US into a depression. That's probably true, as far as it goes. There's no denying that debt growth correlates strongly with GDP.

But it's only half the story. And the other half is more important.

Filling the debt gap with just any borrowing doesn't cut it. In order for debt to aid in economic growth, it needs to be productive. Borrowing for the sake of borrowing is worse than ineffective – it's destructive. Debt itself is neither good nor bad. It depends on what the borrower uses the money for.

Consider a businessman who borrows money to invest in a new project. If his endeavor is successful, it generates enough income to service the debt and return a profit. His income rises more than his debt. Viewed from a macro perspective, GDP rises faster than debt, and so the debt-to-GDP ratio declines. Paradoxically, he actually reduced the debt-to-GDP ratio by taking on debt. This is good debt.

Then there's unproductive debt, which is bad. And in times of over-indebtedness, it's really bad. Think your neighbor buying a TV on credit. He now has more debt with no additional income. He has added to debt, but not productivity. This is bad debt.

The government is the undisputed champion of creating bad debt. Borrowing to spend on weapons, relics (the post office), and losers (Solyndra) does not produce wealth. Even if you argue that some of these expenditures are necessary, they are certainly not productive, in the sense that they add only to the debt side of the ledger without even the prospect of producing income.

That's the fatal flaw of the government stepping in to fill the borrowing gap. Government debt is dead weight. It is a detriment without a corresponding benefit. And even worse, it crowds out private investment, accomplishing the exact opposite of its alleged goal of spurring growth.

The borrowing gap should be filled either with productive debt or not at all. Private businesses are indeed beginning to grow credit, albeit very slowly. That's a good sign, especially for equities – a factor that is shifting the balance between stocks and bonds that investors should have in their portfolios, and just one of the factors covered in our recent free investor bulletin on striking the right balance in your portfolio. But glance up at the chart one more time. Government borrowing has metastasized to the point that it consumes a third of all debt in the US, leaving private borrowing precious little room to grow.

All debt is not created equal. If the debt doesn't produce growth, it's a waste at best, and a destruction of wealth at worst.

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Reader Comments (6)

Almost all money is debt. Therefore, if there is no debt, there is no money. Not only that, there must be enough money in the system to *service* all existing debt (interest and principal).

The government knows this and it knows that if someone doesn't keep borrowing money, the money supply will contract, meaning more people will default, which will make the money supply contract further leading to more defaults... Until eventually, the entire thing collapses which means no more hookers and blow for the politicians.

So while they may *talk* about deleveraging, and reducing the debt - they're not even in the same neighborhood as serious.
October 29, 2012 | Unregistered CommenterCol Sanders
I see the current situation as a colossal mismatch between debt and collateral - too much of the former and not enough of the latter.

I agree about money being debt and I believe that in the present system debt actually has to grow for the economy to grow.

However, I also agree that there is a difference between "self-liquidating" debt (what the article calls "productive" debt) and borrowing money just to piss it away on things that don't create new wealth.
October 29, 2012 | Unregistered CommenterJB McMunn
The problem is worse than you think.

Most money is created using mortgages. And while the principal of a mortgage is created money, the interest is not. However, both must be repaid. This typically works well however, because it occurs over twenty or thirty years and there are many loans made a staggered intervals creating plenty of money that’s also paid back in staggered intervals.

The problem is that once the "original money" enters the system, it is re-loaned out by others in the secondary, tertiary, and quaternary markets. And in each case, interest is tacked on – typically in larger and larger amounts.

Bear in mind that no interest is created at any level and none of the money in the non-primary loans is created. It simply doesn’t exist. At any given time, there is only enough money in the system to pay back the principals on the *primary* loans – AND – whenever a dollar of principal is paid on a primary loan, that dollar is removed from “circulation” – it ceases to exist and cannot be used to pay back *anything* else.

Make a flowchart. Do the math. You’ll find the outcome is baked-in.

And it can’t be stopped.
October 29, 2012 | Unregistered CommenterCol Sanders
That is what I meant about how for the economy to expand debt has to expand.
October 30, 2012 | Unregistered CommenterJB McMunn
Col Sanders. You say that most money is created using mortgages, this is correct. But money is also created when you take out a loan from a bank or spend money on your credit card. From the banks point of view the interest is profit, they do not lend it out. Also, what about quantitative easing, where money is created out of thin air.
January 7, 2013 | Unregistered CommenterMichael Haymar
All FIAT money is currently debt. REAL money has intrinsic value that does not depend upon any other party. Only indestructible commodities are free of counterparty risk, and of those gold and silver have maintained their value for thousands of years. Insisting otherwise is like maintaining the shackles on your wrists don't exist and you are therefore free.
January 13, 2013 | Unregistered CommenterLouis Nardozi

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