John Taylor Explains Why Credit Growth Equals GDP Growth

Credit Growth Equals GDP Growth

August 19, 2010

By John R. Taylor, Jr. , FX Concepts

Way back in the 1960’s analysts were worried about the multi-decade increase of debt. Some focused on personal debt burdens, some looked at corporate gearing, and others feared government deficits, but for years and years these worrywarts were proven wrong, as the economy powered higher and higher making the critics look like idiots. Statistics on almost all types of debt showed a high correlation between their increases and increases in measures of economic health like the GDP, average personal net worth, and the country’s standard of living. Underneath this positive economic view, seemingly out of sight to everyone, a slow weakening was taking place. As the years went on, the dollar increase in debt necessary to generate a dollar increase in GDP kept growing. Back in the late 1940’s and 1950’s, it took about a one dollar increase in debt to generate a one dollar increase in growth, but in each succeeding decade the amount of debt necessary to generate a dollar increase in GDP kept growing. Through the most recent decade, it seems to have taken more than five dollars of debt to produce one dollar of growth, and over the last few years the numbers might have gone into reverse, or perhaps only toward infinity, as all the increase in debt does not seem to create any growth.

Debt does not seem to be the answer, but there is absolutely no sign that the opposite is the answer either. The world has not seen a global reduction in debt levels since the Great Depression and that process was not understood at the time. No one really knew what the level of total credit was until after the fact and no country went about purposefully cutting the national debt level. It is true that there were many disjointed efforts to reduce government borrowing, but these efforts were not international in scope and did not involve squeezing corporate or individual borrowing. Looking at recessions through the last half-century, it is clear that credit levels decline in recessions and it should be obvious that any coordinated efforts to reduce credit outstanding will lead to a decline in final demand. As an expansion of credit has lost its power to stimulate growth (because of the extremely high levels of current debt outstanding) and as a reduction in debt levels is not a good thing, the world seems to have reached a dead end – at least in a growth sense.

As a result of this logic, we have reached the conclusion that a new depression has begun (as we argued back in late 2008). Any increase in debt only delays the process. But with no growth generated by increasing debt, this strategy can only fail quickly, as unfortunately the US administration has illustrated. Eventually, there is no choice but to go through a reduction in the global debt level, most likely by defaulting on much of it and less likely by paying it all off over many, many years. Only after the debt is purged from the global balance sheet can the growth-augmenting reflation successfully begin again. The sharp, aggressive recession in 2008 was created by the collapse in the global banking system set off by the collapse in the US real estate market. Although the moves by Paulson and Bernanke to re-float the system were courageous and temporarily successful, because they increased US and global debt levels without generating growth, they were doomed to fail. Any further efforts by Obama and Bernanke will be an echo of the first effort, but a fainter one. With the Eurozone entering into an ‘austerity’ regime which will impact on six countries, three of which (Spain, Italy and
France) rank among the top economies of the world, we are seeing the deflationary debt process move into a more aggressive phase at this time.