Source: The Macro Tourist blog, by Kevin Muir
We all know the terrifying debt statistics. We are bombarded every day with bearish reports about the gargantuan Federal debt, and when combined with the growing private sector indebtedness, the monolithic entitlements problem, and the looming pension fund shortage, it is easy to wonder how we will ever get out of this colossal mess.
I do not dispute the numbers one bit. We have too much debt. It’s simple math. We are screwed. Full stop. All of this debt will never be paid back in real terms. Truth be told, I am probably one of the most bearish people out there when it comes to our debt problem.
But I differ greatly from the vast majority of my peers about what that means for the economy and financial markets.
There are three solutions to the problem of over-indebtedness.
The first is to grow your way out. Maybe you cut some spending, hunker down, trim up the sails, and right the ship through good old fashioned economic growth. This solution is a pipe dream left for little children and romantics. In a balance sheet challenged economy, the moment you cut spending, the paradox of thrift kicks in, and the economy rolls over. This is a lesson Japan has learned all too well over the past couple of decades. Not believing Japan’s example, the U.S. repeated the error after the credit crisis of 2008. Thinking overspending was the cause of the problem, the U.S. government (led by the Tea Party) cut discretionary spending to the bone. Remember the 2013 budget sequestration? All of that hullabaloo caused the government to shrink from 2011 to 2015.
Whoa! That doesn’t follow the typical narrative of Obama as a spendthrift fiscally irresponsible President. Didn’t Federal debt balloon under his watch? How does that work? Well, the reality is much of the spending that caused the increase in overall debt was the result of automatic stabilizers – unemployment insurance, etc… Although Obama probably wanted to spend much more, he didn’t. And this is one of the reasons the U.S. economy experienced its weakest post recession recovery. Just look at that chart above. Over the past three decades there has never been a government spending decline of that magnitude.
Now I realize many of you will probably be saying “good – that’s what’s needed. The idea of increasing spending to solve a problem of too much debt is ridiculous. The reason for the anemic recovery is that we didn’t cut enough.” Which brings me to solution number two.
In an environment of over-indebtedness, the economy will naturally try to correct through the private sector paying down debt. But over the past half dozen decades, we have been muting regular business cycle declines through overly easy monetary policies. This has encouraged too much borrowing. We have piled more and more debt on the problem. The trouble is that we have done this for so long, the consequences of allowing the cycle to play out has become catastrophic.
Have a look at the total U.S. credit outstanding (minus financial firms) over the past few decades.
See the slight leveling off in 2007? That is the horrific debt de-leveraging that caused the greatest financial crisis since the Great Depression.
So far all those economists of the Austrian ilk, I acknowledge that if the government and the Federal Reserve would allow the natural business cycle to operate, we would have debt destruction that would cause the financial system to reset. After this event, the economy would be all set to grow again. Yet this reset would make the 2008 credit crisis look like a warm up. We would have 1930’s style breadlines.
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