THE BASIS POINT

Does Deficit Spending Reduce GDP Growth?

Most people who have taken economic courses have, to a significant extent, been indoctrinated with the Keynesian notion that sometimes (in recessions especially) private sector demand leads to inefficient macroeconomic outcomes. and that at such times the public sector must step in, take up the slack through deficit spending, and get the economy healthy again.

 
While that is a reasonable approach during recessions, deficit spending has come to be regarded as a necessity. This assumes that deficit spending produces economic growth (increase in GDP) and, along with GDP growth, jobs, and hopefully an increase in revenue to Treasury to service the deficit and perhaps even reduce it.

 
One of the best economists in the United States is, in my opinion, Lacy Hunt. Hunt works for Hoisington Investment Management Company of Austin, TX. Hunt’s most recent newsletter makes the case that every dollar of deficit spending currently reduces private GDP by $1.01.

 
Hunt’s case is that as long as government debt is low compared to GDP, deficit spending will have a positive multiplier but once it rose above 90% and stayed there it has a negative multiplier. The next paragraph is his analysis in his words.

 
(1) the government expenditure multiplier is negative; (2) the composition of spending suggests the multiplier is likely to trend even more negative; (3) the federal debt-to-GDP ratio moved above the deleterious 90% level in 2010 and has stayed above it for more than five years, a time span in which research shows the constriction of economic growth to be particularly severe. It will continue to move substantially further above the 90% threshold as debt suppresses the growth rate; (4) debt is likely to restrain economic growth in an increasingly nonlinear fashion; (5) the first four problems produce negative feedback loops from federal finance to the economy through the allocation of saving, real investment, productivity growth and eventually to demographics; and (6) the policy makers force the economy into a downward spiral when they rely on more debt in order to address poor economic performance.

 

Once growth is impacted by deficits, bad things happen. Savings are misallocated. Business stops making capital investments in plants and equipment and in a fit of derangement borrows money to buy back its shares and creates inflated share prices because each share represents a larger piece of the same pie.

 

Hunt’s message is that while the present negative multiplier is small it will become more negative as debt/GDP increases. The ability of the government to come up with beneficial spending is severely limited by the fact that social programs have made mandatory spending 68.3% of the Federal budget. These include Social Security, Medicare, VA benefits and now Affordable Care. Worse yet, the government blames others for this. Discussion about the increase in government expense on healthcare gets displaced from government having created more demand without creating more supply and is blamed on insurance companies and pharma.

Looking at Social Security and Medicare alone which are about 48% of total government spending the problem is obvious. If the payroll-based taxes are insufficient to fund the programs creating the necessity to borrow and add to debt increasing the debt/GDP ratio and, worse yet, the existing assets of the funds consists almost entirely (98.5%) of Treasury debt because these funds were loaned to Treasury and spent then that money will have to be repaid from the general fund not from future SS or Medicare taxes unless those are raised. While raising those taxes may be a solution it is a solution which will lower net income and reduce real GDP.

 
Paul Krugman calls for more deficit spending on infrastructure. As long as increased debt produces a cash flow which as least services it then that deficit spending is good. This is true of governments, corporations, and individuals. Debt is the residue of money spent in the past which cannot be spent at present or in the near future.

 

In 1989 the debt/GDP ratio broke through 50% and is now 105.4%. Household debt has declined but that is deceptive because, while the largest component of household debt was mortgage debt, the Homeownership rate has declined from 69.2% in 4thQ2004 to 62.9% in 2ndQ2016. That 6.3% of the population no longer has a mortgage component of Household Debt and instead lives with relatives or rents. Whereas rent is not debt it most certainly is an expense and a decrease in discretionary spending.

 

The big question about the U.S. economy is this: Why after increasing National Debt by $8.8 trillion in the present administration and having accommodative monetary policy (low interest rates and a massive increase in money supply) do we have average GDP growth of only 1.94% for the past 18 quarters? The answer, according to Hunt is “too much debt.”

 

Japan

 

This discussion would be academic but for one thing – Japan. In the 1980’s Japan was the country whose economy was going to own the world, They seemed to be doing everything right. In 1989 Japan’s debt/GDP was 59.9%. It is now 249.1%., As its debt/GDP has increased productivity fell from an average of +3.2% in the 1980’s to +0.5% in the past 10 years and GDP growth – well there is no GDP growth.

 
Hunt’s point and the point of the pieces linked to below is simple. There is a level of debt/GDP which, once crossed, is like Wile E. Coyote stepping off a cliff and that level is the 90% debt/GDP ratio.

 

As if this weren’t bad enough there is an even larger set of disguised Federal obligation. This is not debt per se but rather the present value of the unfunded liabilities of Social Security and Medicare. How large is this? $60 trillion or 10 x what the Trust Funds hold noting that what’s in the Trust Funds is merely promises to repay the money what has already been spent.

I want to be clear that I have not presented here the entire case about debt. If one wants to understand better why public debt is such a problem please read some of the papers below. The problem is debt in general. Debt consists of public debt, corporate debt and household debt. Public debt is a matter for discussion because it impacts all of us. The 4th item – the paper from NBER enumerates the cases when public debt rose above 90% and contrasts GDP growth above that level with GDP growth below that level.

 

Following are some published works on which Hunt bases his views.

 

The Real Effects of Debt. Bank of International Settlements http://www.bis.org/publ/othp16.pdf

Too Much Finance IMF working paper https://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf
When Credit Bites back Federal Reserve Bank of San Francisco http://www.frbsf.org/economic-research/files/wp11-27bk.pdf

Public Debt Overhangs NBER http://www.nber.org/papers/w18015.pdf

The Great Leveraging NBER http://www.nber.org/papers/w18290.pdf