Andy Lees Kills The Argument Of Endless Debt-Funded Stimulus

There are those who watch quietly from the sidelines as month after month, year after year, decade after decade, the Keynesians among us (especially those who only focus on the upswing in the business cycle and always ignore the downswing) announce that the only thing the economy needs to grow is a just a little more debt... more debt.... much more debt....  And for the most part it worked: for years every dollar in additional debt generated a little less than a dollar of economic growth, or GDP. Alas, slowly but surely, we have been pushed to the point where incremental debt generates no incremental growth: an event that if it were to be recognized for the debt-stimulus dead end it is, would put an end to years of flawed economic thought taught in the world's most prestigious universities. Yet there is more to it, and as always it goes to the age-old question of capital allocation efficiency, and specifically how with time, any centrally-planned attempt to allocate capital effectively always fails, usually accompanied by incurring insurmountable leverage. Probably one of the best and most succinct summary of this core quandary facing the entire developed world and the voodoo economics profession in general, was done by UBS's Andy Lees today, who in one note, deconstructed the primary flaws, and outright lies, at the base of the last ditch economic rescue effort planned by Obama, by the world's army of "fiscal stimulants" and by the western world in general.

On the fallacy of "GDP":

Economists and politicians tell us that if we try to cut the level of debt the economy will slow and it will become self-defeating; debt will rise relative to GDP. Whilst this is sounds fair enough, how does this fit in with the truism that if debt is rising relative to GDP then by definition we are allocating capital unproductively and therefore unsustainably?


The answer is simple definitions. Clearly over the last few years vast amounts of capital have been written off and yet we have not revised previous estimates of GDP. We have effectively ignored that some element of the economic activity was unproductive and unsustainable. If debt rises by 10% relative to GDP, then only 90% of the stated GDP is actually sustainable. The 10% balance is made up of non-jobs that are dependent on debt accumulation. They are either consuming down our productive balance sheet, and thereby borrowing from our future level of economic activity, or alternatively borrowing from another country’s either present consumption level or their productive balance sheet. Either way, unless we are going to default, we are again borrowing from our future level of economic activity. We are putting the balance sheet through the P&L account and accounting for that as profit or GDP but without an offsetting liability. 


Realistically therefore we should not look at debt-to-stated GDP, but rather debt-to-“sustainable” GDP. Taking the example where debt-to-stated GDP has risen over the course the last year from 190% to 200%, then we know that 10% of the factors of production are misallocated and unsustainable, and therefore sustainable GDP is just 90% of the stated level. This means that debt-to-sustainable GDP is not 200% but rather 222.2% (ie. 200/90). Imposing austerity simply recognises that fact, slowing the economy to the sustainable level of output and thereby recognising the level of debt against this truer measure of GDP. Take Greece for example; clearly the country has been living way beyond its means, and its sustainable level of GDP is significantly lower than the stated level. Recognising and accepting this reality is extremely difficult, but we cannot clear Greece’s debt without at the same time “clearing” the level of economic output to a true level.


If we allocate resources correctly, then debt-to-sustainable GDP will start to fall immediately. The confusion and the pain comes from having to recognise what that sustainable level is, ie to own up to what is our true economic worth. Taking the above example, we know that debt-to-sustainable GDP is not 200% as recorded but actually 222.2%, so if we allocate resources efficiently, all other things being equal, GDP will fall back to the sustainable 90% level and debt-to-sustainable GDP will remain at 222.2%. Given the painful acceptance that is necessary, if we make the adjustment over time, then the total debt will continue to rise in both absolute and relative terms, but by incrementally less each year relative to sustainable GDP.

On the toxic feedback loop of why ever more central planning (such as what is happening in the US and the entire developed world) means fiscal stimulus becomes self-defeating. The irony is that as those "planners" locked up in a room "plan" and issue more and more debt, all that debt goes for failed projects, until all of it ultimately serves non-productive purposes.

Whilst differentiating economic output as either productive or unproductive may sound sterile and ignore hidden values from work that are not obviously measured in conventional GDP calculations, the reality is that these “externalities” are included in GDP as they feedback into the calculations indirectly in just the same way that loss-leaders do with corporates. There will be both productive and unproductive externalities, and the best measure of whether we are misallocating capital or not will be whether debt is rising relative to GDP or not. Pursuing a Keynesian stimulus can only make sense if the capital reallocation results in a reduced debt-to- sustainable GDP ratio. This does not factor in inter-temporal investments where the pay-off may not be immediate, but easy adjustments can be made for this.

And the interlinking continues: the biggest culprit for the failure of fiscal stimulus? Why the monetary stimulus authority itself, the Federal Reserve.

The only meaningful reduction in debt throughout this crisis has been the forced deleveraging of households in the US through foreclosure, and in Europe through job losses. Total debt has increased throughout the crisis as the public sector initially socialised the private sector debt, whilst running large fiscal deficits. The zero interest rate policy also continues to misallocate capital, supporting unsustainable consumption levels at the expense of productive investment. QE2 and the hotly anticipated QE3 will drive a speculative bubble in risk assets and give cheer to the financial markets but will not support or drive sustainable investment. As you can see below, the continued misallocation of capital in Japan from similar policies has not only lifted the debt to frightening levels, but has also raised the cost of servicing that debt as it strangles the productive assets, despite the zero rate policy. Far from lowering the cost of business, the printing of money by central banks sustains this misallocation of capital and thereby adds to the costs of business. Governments are simply crowding out the only part of the economy that can get us out of this mess, and thereby killing the overall economy with their supposed kindness

The toxic spiral then moves away from the sovereign state and its debt printing apparatus and migrates to every state that has a monetary authority: read a central bank.

The paper The real effects of debt –( – by Cecchetti, Mohanty and Zampolli highlights that debt is supposed to improve the efficiency of capital allocation across its various possible uses in the economy by shifting the risk to those most able to bear it, but of course that very statement reinforces what I am saying; if debt is causing a better allocation of capital, then debt will fall, not rise, relative to GDP. Modelling the stock of non-financial sector debt against GDP per capita for 18 OECD countries over the period 1980 – 2006, the authors found that every 10% increase in corporate debt resulted in a 20bpt reduction in growth per capita, and every 10% increase in household debt resulted in a 25bpt reduction in growth per capita. The authors found this somewhat surprising as they did not believe that debt was uniformly bad for growth, but of course during that period debt was rising relative to GDP. A second regression found that a 10% increase in the ratio of public debt to GDP is associated with a 17 – 18bpt reduction in subsequent average annual growth.


The paper concludes by saying that the clear implication of these results is that the debt problems facing advanced economies are even worse than we thought as the benefits that governments have promised to their ageing populations will not only sharply raise debt but will thereby  sharply lower GDP growth. As growth falls, debt rises even more, reinforcing the downward impact on already low growth. “The only possible conclusion is that the advanced countries with high debt must act quickly and decisively to address their looming fiscal problems. The longer they wait, the bigger the negative impact will be on growth, and the harder it will be to adjust”.

Andy's conclusion: the current approach to fixing problems is dead wrong. At this point issuing more debt merely compound the problems in an exponential fashion.

What return per unit of additional debt will we get today? The idea that we should slow austerity and grow our way out of this with further debt, or increase our ability to service our debt by taking on more, seems disingenuous at best. Why should the same cheap money policies used by central banks to avoid the occasional cleansing of debt via a recession, now succeed in allocating capital productively and sustainably when they have clearly failed in the past? Perhaps politicians and the press can be excused for taking a different view as their individual priorities are not necessarily aligned with the good of the economy as a whole, but what I don’t understand is why the wider economics profession also seems unable to come to a comprehensive conclusion; to establish data that presents the facts accurately and thereby establishes policy agreement. 

Alas, the world will be engulfed in mushroom clouds before economic Nobel peace prize winners finally admit their lunacy and that the false cause they have spent their lives defending, has been a lie. In the meantime, everyone else will continue to suffer. That is the only thing that is guaranteed: after all, it is the definition of insanity. And those in the status quo doing all they can to preserve their, well, status, are now all insane.