By
CFA
Institute
:
By Ron Rimkus, CFA
We are three years into a "recovery," but labor participation is
still low, gasoline prices - albeit off their highs - remain at
high levels, and economic growth is clearly substandard. In support
of the case for growth, significant bad loan volumes have been
written off, huge unprecedented amounts of capital have been
committed to support the banking system, many government loans have
already been repaid, and the government has removed any ambiguity
about their resolve to support the economy. So, why can't the
economy turn the corner? I'll bet you $1 trillion that I can tell
you why.
As I thought about the grossly over-indebted situation the world
finds itself in, I began to wonder how debt flows through GDP. Does
additional debt automatically mean additional GDP? Is it somehow
quarantined on balance sheets, unable to impact the real economy?
Has it been used to prop up GDP, or has it harmed GDP? Or has it
been successful in manufacturing real growth? Governments and
central banks have steadily increased public debt levels, lowered
interest rates and encouraged ever greater debt consumption by the
private sector. Has this been good or bad? Let's find out!
GDP, of course, is the sum of consumption, investment,
government spending, and net exports. Consequently, any and all
debt that people take on, ultimately flows through GDP in one (or
more) of these four categories. Naturally, I became intrigued with
the notion that debt must flow through and contribute to GDP in
some way. The first place I started is to look at the total debt in
the United States over time. This includes both public- and
private-sector debt. Everything. As we've discovered in the global
debt crisis, private-sector debt can quickly shift onto
public-sector balance sheets during a crisis. Moreover, when it
comes to GDP growth, it's the total economy that grows, and it's
the total debt that impacts the economy in some way. So, total debt
is what matters, not just private or public debt. Consider the
graph of total debt by quarter in the United States (through 2011),
below.
U.S. Total Credit Outstanding ($ in Billions)
(click to enlarge)
Sources:
St. Louis Fed, U.S. Federal Reserve, CFA Institute.
Go ahead. Marvel at it in all its splendor: $38.3 trillion (as
of 4q 2011). That's trillion with a "T." Done marveling? No
problem, I'll wait a moment while you try to wrap your mind around
it. I know you are still a little light-headed now, but we must
move on. Now let's think about what that debt means? By itself?
Insufficient. So, here's debt relative to the size of the
economy.
U.S. Total Debt as a Percent of GDP
(click to enlarge)
Sources:
St. Louis Fed, BEA, CFA Institute.
As you can see, over the past 40 years, total debt in the United
States has gone from 130% in 1970 to 250% of GDP in 2011. Yeah, but
how much did the increase in debt itself boost GDP?
Let's start with "who." Who borrows all this money? Borrowers
come in three categories: businesses, consumers, and government.
Businesses borrow money for lots of reasons. Chief among them are
to build or expand infrastructure, to grow (either organically or
by acquisition), or to meet operational cash flow needs. Naturally,
they also borrow to replace depleted or worn out capital to simply
maintain the status quo. Likewise, consumers borrow to purchase
longer-term assets like homes and cars. Like businesses, consumers
borrow to repair or replace worn out capital (e.g., furnaces, water
heaters, etc.). Unlike many businesses, consumers also have a nasty
little habit of borrowing just to consume (i.e., credit cards).
Businesses and consumers together are known as the private sector.
The private sector will be the basis of our analysis. Lastly, the
government borrows. Governments borrow to finance fiscal deficits
and - in Keynesian theory - grow the economy. So what is the net
benefit of all this borrowing? How much does leverage amplify
historical growth? And what is in store for the future?
In economics, all the interesting stuff happens on the margin.
So, let's look at the absolute change in total debt over time and
compare that with the absolute change in GDP for the United States
on a rolling five-year basis.
U.S. Trailing Five-Year Change in Total Debt and GDP ($
in Billions)
(click to enlarge)
Sources:
St. Louis Fed, BEA, CFA Institute.
As illustrated in the graph above, the five-year change in total
debt peaked in the fourth quarter of 2008 at $12.02 trillion, while
the five-year change in GDP was only $2.67 trillion for the same
five-year period. However, the change in debt captures the net
change over that time period, while the change in GDP captures only
the increase in GDP (segment E in the following exhibit), so it is
an apples-to-oranges comparison. Because the incremental debt is
used, at least in part, to make investments and because it can flow
through GDP in any of the years (segments A, B, C, D), not just the
last year (segment E), I computed a variable called incremental GDP
Flow which is the summation of all the incremental changes in GDP
during each five-year period. Conceptually, it is computed as
illustrated by adding segments A+B+C+D+E as seen in the graphic
below.
Incremental GDP Flow
(click to enlarge)
For example, if GDP increases by $500 mm in year one and by
another $500 mm in year two, the incremental flow is not $1
billion, but rather $1.5 billion as the increase in GDP in year one
also flows through in the following year as well. Then comparing
incremental GDP flow to the absolute change in debt, we can examine
how efficiently the debt flows through the economy. This
"efficiency ratio" shows the proportion of total debt that flowed
through the economy (not to be confused with the efficiency ratio
commonly used by banks in examining their fixed costs).
If the ratio is above 100%, then the debt usage was efficient as
it helped the economy expand by more than a like amount of debt. If
the ratio is below 100%, the debt curtailed economic growth as the
debt was more than offset by inefficiencies and capital
destruction. Of course, it is possible that debt accumulated in a
particular period - across the entire economy - went solely into
replacing worn out capital or was simply held on balance sheets
thereby offering no long-run contribution to GDP growth. But
wouldn't we have been reading endless headlines about the Great
Capital Replacement Cycle? Wouldn't we have seen a dearth of
investment activity?
In fact, we haven't. So, such potential criticisms seem
implausible. Moreover, the fact that debt has interest costs,
albeit at low rates right now, sees to it that debt doesn't sit
idle on balance sheets for very long. Actually, that's the point of
the analysis: We want to capture the net effect of adding debt over
long periods, which also captures the capital replacement cycle as
well.
U.S. Total Debt Efficiency
(click to enlarge)
Sources:
St. Louis Fed, BEA, CFA Institute.
What's interesting about this graph is that debt efficiency
started turning downward in 2003 - well before the mortgage/housing
bubble peaked in 2006 - and has remained below 100% ever since.
Alarmingly, it continues to worsen.
Next, let's look at the role, if any, the Federal Reserve has
played in stimulating debt and the GDP by setting interest
rates.
U.S. Fed Funds vs. Change in Total Debt, Three-Year ($ in
Billions)
(click to enlarge)
Sources:
St. Louis Fed, U.S. Treasury Department, CFA Institute.
The red shaded area at the top shows high rate environments (Fed
Funds > 8%), while the green shaded area at the bottom shows low
rate environments (Fed Funds < 5%). The reason to highlight
these two rate environments is that one might expect growth in debt
to be more sensitive to interest rate changes in more extreme rate
environments. To confirm this, I then performed an event study on
rates and debt growth over the past 40 years. I expected growth in
debt to move in the opposite direction of interest rates in general
and to be more pronounced in the extreme rate environments. Here is
what I found.
(click to enlarge)
Sources:
St. Louis Fed, BEA, CFA Institute.
The study turned out as expected. At the extremes, movements in
Fed Funds rates do have a big impact on total debt growth. But, as
noted earlier, debt efficiency is declining markedly. And we are
currently in an extreme (low) rate environment. Consequently, one
might expect debt consumption to accelerate. However, what we
observe is that government debt consumption is accelerating, while
private-sector debt consumption is essentially flat. So, given
today's extraordinarily low rate environment, why isn't private
debt growing like gangbusters? Why is there now a break from the
past?
To help answer this question, let's look at the composition of
total debt.
United States: Total Debt - Public and Private ($ in
Billions)
(click to enlarge)
Sources:
St. Louis Fed, U.S. Treasury Dept, CFA Institute.
We can see that government debt has grown substantially, much
like private debt, but it's difficult to make out the nuance from
this graph. What is the real story with government debt? To answer
this question, I performed some statistical analysis. This analysis
clearly shows a strong correlation between private sector debt and
GDP, while exhibiting essentially no correlation between government
debt and gdp. *** If you have an aversion to statistics, feel free
to skip the following paragraph:
We performed a regression analysis of total debt growth on
GDP growth. In this case, the regression line (the single line
that best represents the data when plotted on a graph) has a good
fit (based on an r-squared value of 43%). Then we performed a
multiple regression analysis, in which we broke out
private-sector debt and government debt separately. In that case,
the regression line has a significantly better fit. More
importantly, private-sector debt growth showed a strong positive
correlation with GDP, while the government debt growth showed
essentially no statistical correlation to GDP growth. The
r-squared value of the model increased to 50%, and the
correlation of private-sector debt registered a robust 54%,
compared to an absolutely meaningless correlation of just 2% for
government debt.
So, now that we've identified the source of the problem, let's
isolate it. Consider the following chart showing the absolute
change in U.S. government debt relative to the absolute change in
GDP over a trailing five-years basis.
United States: Dollar Change in Federal Debt and GDP
(Trailing Five-Years)
(click to enlarge)
Sources:
St. Louis Fed, U.S. Treasury Department, CFA Institute.
As illustrated, for the first time in at least the past 40
years, the absolute change in federal government debt has exceeded
the change in GDP by a substantial margin. As of the fourth quarter
of 2011, the absolute change in federal government debt was $6.5
trillion, while the corresponding change in GDP was only $1.7
trillion. However, unlike the prior analysis, we are now assuming
that government debt is the only thing that helps the economy grow
- getting the full benefit of any increases in debt from the
private sector (to be fair, private sector debt peaked in the first
quarter of 2008 and has been flattish ever since - not truly
delveraging). In any event, on a trailing five-year basis,
private-sector debt exhibits positive growth, so there's no need to
worry about the impact of declines. However, like the analysis with
total debt, we are comparing a stock and a flow. So, using the
incremental GDP flow, we not only find that the efficiency of
government debt is going down but that there is a sharp inverse
correlation - meaning that more government debt harms GDP. Even
adjusting for the cash out the door to support the banking system
through TARP and related programs (excluding the Fed), there is
still $3.7 trillion figure that is unexplained.
United States: Dollar Change in Federal Government Debt
vs. Debt Efficiency
(click to enlarge)
Sources:
St. Louis Fed, BEA, CFA Institute.
What I didn't appreciate in the heat of the debt crisis of 2008
is the extent to which the U.S. government would increase its
balance sheet. When looking at the Fed's massive financial support,
low rates, and money printing, I had feared inflation would ramp up
relatively quickly. What I hadn't appreciated then, but do now, is
the extent to which the inflationary forces of money printing and
Fed liquidity actions would be offset by the deflationary forces of
the additional debt and inefficient government spending. The
ongoing ramp up in debt, debt service, and poor allocation of
capital stymies the economy and prevents equilibrium from being
achieved.
Because the policies the United States is following today
resemble so closely the policies followed by Japan in the aftermath
of their bubble bursting in 1990, Japan offers us a window into our
future, albeit with caveats. Consider first Japan's ramp up in
total debt over time.
Japan: Total Debt as a Percent of GDP
(click to enlarge)
Sources:
World Bank, CFA Institute.
Now, let's look at Japan's absolute change in total debt and GDP
on a rolling five-year basis.
Japan: Five-Year Absolute Change in Total Debt and GDP
(Yen in Millions)
(click to enlarge)
Sources:
World Bank, CFA Institute.
As you can see, the changes in total debt are vastly greater
than the change in GDP, even today. Total debt was first spurred by
the private sector (
due to low rates by the Bank of Japan in the late
1980s
) and then elevated by government debt as the private sector
attempts to deleverage post 1990.
Japan: Five-Year Absolute Change in Government Debt and
Private Debt (Yen in Millions)
(click to enlarge)
Sources:
World Bank, CFA Institute.
So, what happened to Japan's debt efficiency as the government
stepped up its debt growth?
Japan: Five-Year Absolute Change Total Debt and Percent
Efficiency (Yen in Millions)
(click to enlarge)
Sources:
World Bank, Ministry of Finance, CFA Institute.
When isolating just
Japan's government debt
, we see an even more startling correlation characterized by three
pretty distinct periods. As Japan was ramping up government debt
usage, efficiency decline from 1965-1979. Then, from 1979-1990,
growth in government debt leveled off and so did efficiency. Then
debt levels ramped up dramatically after the bubble burst in 1990
and efficiency once again plummeted.
Japan: Five-Year Absolute Change Government Debt and
Efficiency (Yen in Millions)
(click to enlarge)
Sources:
World Bank, CFA Institute.
I will examine this phenomenon in a number of other countries
and expect to find the same story intact. So, you want know where
GDP is headed? Look no further than growth in private-sector credit
and federal government debt. Until the strategic reasons for public
and private debt change, GDP "ain't going nowhere." As investors,
we must invest with what we expect to happen, not with what we
think policymakers should do. And as for the wager, fellow Content
Director
Jason Voss, CFA
, has kindly offered to pay the $1 trillion reward should I lose
the wager. What a gentleman!
See also
Apple: Our Fair And Balanced Analysis Of Apple's
Performance
on seekingalpha.com