Guest Post: “Nobody understands Debt (But Me)”

From Alexander Gloy of Lighthouse Investment Management

"Nobody understands Debt (But Me)"

Luckily they are easy to spot: the demagogues, the manipulators and the hired claqueurs. Unfortunately, there is no lack of media willing to provide a platform to perform their insidious game.

Take Nobel-prize wielding economist Paul Krugman. In an article for the New York Times (“Nobody understands debt”) from January 1, 2012, he writes:

“Through most of 2011, as in 2012, almost all of the conversation in Washington was about the allegedly urgent issue of reducing the budget deficit.”

His opening gambit: a reduction of the budget deficit is not an urgent issue. Really? The US has reached 100% debt-to-GDP, and each year another 10%-points get added to the pile. Those $15 trillion exclude a vast array of debt from quasi-governmental organizations (FannieMae, FreddieMac, etc) and unfunded liabilities (Medicare, Social Security, Veterans’ benefits) resulting in a total debt of $61.6 trillion, as per the Heritage Foundation. This explains Krugman’s disdain for the institution, as we will see below. He continues:

“This misplaced focus said a lot about our political culture, in particular about how disconnected Congress is from the suffering of ordinary Americans.”

Krugman tries to portray those who are trying to save the country by reducing spending as heartless and mean-spirited people, when those attributes should apply to those who applauded spending future generations’ taxes to the point of collapsing the financial system. To add insult to injury:

“When people in [Washington] D.C. talk about deficits and debt, by and large they have no idea what they’re talking about.”

He brings out the “I know better – I have a Nobel prize” argument. And the reasoning:

“Perhaps most obviously, the economic ‘experts’ on whom much of Congress relies have been repeatedly, utterly wrong about the short-run effects of budget deficits. People who get their economic analysis from the likes of the Heritage Foundation have been waiting ever since President Obama took office for budget deficits to send interest rates soaring. Any day now! And while they’ve been waiting, those rates have dropped to historical lows.”

This is right in line with those people who, back at the height of the housing boom, ridiculed anyone warning about dangers of a possible fall in housing prices. Only because riding your bike with your hands up in the air went smoothly for 10 seconds doesn’t mean you will make it in one piece over the pothole. Krugman’s rhetoric matches that of a mayfly rejecting the possibility she might die at the end of the day because so far the sun has never set during its life.

Could the international financial crisis have led to a flight to safety into US Treasury bonds? Could the trillions of Fed buying have helped? Could the largest non-official buyer of Treasuries (Cayman Islands) be hedge funds looking for a cheap way to “hedge” stock market risk, because, in a twisted way, they rely on negative correlation between stocks and bonds (if one goes up, the other one goes down) to continue ad infinitum? Where else are the Chinese going to put their trillions of foreign exchange assets accumulated by holding the Yuan down? In the crumbling Euro? Back to mayfly Krugman:

“For while debt can be a problem, the way our politicians and pundits think about debt is all wrong, and exaggerates the problem’s size.”

If anything, the size of the debt problem is underestimated. It is amazing to see how the problem (too much spending leading to too much debt) is being turned around 180 degrees into “the problem is too little spending”.

“Deficit-worriers portray a future in which we’re impoverished by the need to pay back money we’ve been borrowing.”

Paying back debt doesn’t impoverish; spending money you don’t have does. But Mayfly doesn’t relent and tries to spell it out in simple terms for the average American:

“They see America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments. This is, however, a really bad analogy in at least two ways. First, families have to pay back their debt. Governments don’t – all they need to do is ensure that debt grows more slowly than their tax base.”

Exactly. Let’s look at how US GDP and debt have developed over the last 46 years:

Debt caught up with GDP, reaching 100% in Q4 2011. Debt (taking only the “on-the-books” part) is growing faster than GDP.

Over the last three years, US debt has grown by roughly $4 trillion , while GDP has grown only by $1 trillion. One additional dollar of debt has led only to 25 cents additional GDP. This is the “marginal utility of debt” (how much you get out of an additional dollar of government spending). At elevated debt levels, debt service (interest and redemptions) carves out an increasingly high share of tax revenue, leaving less for productive uses.

The lower chart shows rolling 3-year periods for growth in GDP and debt as well as the resulting ratio (marginal debt utility). It has almost reached zero. Granted, the increase in government debt has partially been “diluted” by a deleveraging of the private sector. Still, 2012 will be the fourth year in a row with a budget deficit exceeding $1 trillion. Continuing this pace, combined with a marginal debt utility of 0.25 would get the US to a Greece-like 143% debt-to-GDP ratio within 9 years. But Mayfly tells us we don’t understand.

“We need more, not less, government spending to get us out of our unemployment trap. And the wrong-headed, ill-informed obsession with debt is standing in its way.”

How can a Nobel-prize carrying economist, who is presumably smart, write such nonsense? “He knows better”, says Jim Rickards (author of “Currency Wars”). And that makes Krugman so dangerous. Decision makers will reference his “debt does not matter” mantra over and over again – until it’s over. Thank you, Mayfly. You really understand debt – and how to make others believe it doesn’t matter.