Practical analysis for investment professionals
05 December 2012

Latest Debt and GDP Figures Indicate US Economy Is Still Unwell

Posted In: Economics

Are we there yet? Is this what the new normal feels like? The US economy — the most important driver of economic activity in the world — remains sluggish. The latest GDP print came in at 2% during what is supposedly a recovery, in which GDP would normally print in the 6–8% range. While politicians and pundits may debate the merits of 1.5–2.0% growth, what remains absent from this discussion is the escalation of debt that has driven this growth. Why? I have yet to find an adequate explanation. Yet the situation is crystal clear: the growth in GDP we have seen since hitting bottom in 2009 has been a function of debt.

Just as when a person increases his use of credit cards, he can spend other people’s money and create the appearance of growth up to a point, but eventually he will hit a limit. It pretty much works the same way with countries, but there is at least one major difference between a country and an individual: Most countries have a central bank that can reduce interest rates, print new money, and influence asset prices through market operations.

What are the trade-offs? What are the limits? Printing money (and other central banking activities) typically allays the immediate fears of an outright debt default, but such easy money comes at price. Newly printed money often leads to rising prices in primary demand areas (e.g., commodities, food, fuel, and farmland). And in a weak economy, assets that people typically want to be strong in price appreciation are weak, like housing for example.

While this phenomenon mollifies the reported inflation figures, it also squashes the average consumer who is wedged in the middle — the price of buying necessities goes up and the value of personal assets goes down. But easy money also leads to more debt across the whole economy. By setting interest rates artificially low, central banks stimulate the economy to grow aggregate credit — from household debt to business debt to state and local government debt to Federal government debt, albeit for slightly different reasons.

This phenomenon is relatively well known. However, what is less well-known is its limit. How much is too much? What is the tipping point? That’s the trillion-dollar question. Carmen M. Reinhardt and Kenneth S. Rogoff’s work suggests that on average countries get into trouble when government debt-to-GDP ratios exceed 80%. What is clear to me is that the US is moving forward as if we will never hit a limit. Let me save you the suspense — there most definitely is a limit — even if no one knows precisely what that limit is.

As total debt-to-GDP grows, the needle moves ever closer to the limit — whatever that is. The US Federal Reserve’s zero interes-rate policy (ZIRP) is indeed stimulating credit growth, which in turn drives — or at least is driving — GDP growth. According to the latest data from the Fed, aggregate credit outstanding was $55.031 trillion on 30 June 2012 (as noted in the following graph).

United States: Total Credit Market Debt Owed ($ in Billions)

United States: Total Credit Market Debt Owed ($ in Billions)

Sources: St. Louis Federal Reserve, CFA Institute.

That’s up 2.3% from a year earlier, placing the total debt-to-GDP ratio at 3.6. What is absent from this discussion is how a dollar actually flows through an economy. Every incremental dollar in debt the US takes out (which was $1.3 trillion for the year ending in 2Q 2012) flows through GDP as either consumption, investment, government spending, or net imports/exports. But this only accounts for debt-driven investment, and investment can be financed with equity too. So, if debt is growing faster than the economy, what does that say about equity-fueled investment? What does it say about the return on total investment?

It means that some GDP is being destroyed each year and offset with fresh investment activity. Creative destruction is normal in any economy, and during healthy times the gains of the winners will more than offset the losses of the losers. That is not happening now. A healthy economy should produce economic growth that is faster than credit growth, if for no other reason than at least some of the total investment came from equity. That is not happening now either. Instead it’s as if the Fed is intent on escalating debt across the whole economy specifically to grow GDP.

Put another way, central banks are acting as if there is one giant demand curve for GDP. But the economy is comprised of many discrete markets in which people buying goods and services make trade-offs based on their scarce resources. Moreover, today’s central bank policy presumes that all credit growth is good so long as it increases GDP. And ZIRP — which means interest rates are below where the supply and demand for money would set them — is in place for a considerable horizon. As such, credit growth is likely to continue outpacing economic growth. As long as debt grows faster than the economy, the US incurs ever greater misallocation of resources. Where does this end? The longer this game slides from the short term to the long term, the more people will adapt their behavior to fit the new norm. This is where we are. The world’s largest and most important economy is drowning in debt and sowing the seeds of yet another bubble.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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About the Author(s)
Ron Rimkus, CFA

Ron Rimkus, CFA, was Director of Economics & Alternative Assets at CFA Institute, where he wrote about economics, monetary policy, currencies, global macro, behavioral finance, fixed income and alternative investments, such as gold and bitcoin (among other things). Previously, he served as SVP and Director of Large-cap Equity Products for BB&T Asset Management, where he led a team of research analysts, 300 regional portfolio managers, client service specialists, and marketing staff. He also served as a Senior Vice President and Lead Portfolio Manager of large-cap equity products at Mesirow Financial. Rimkus earned a BA degree in economics from Brown University and his MBA from the Anderson School of Management at UCLA. Topical Expertise: Alternative Investments · Economics

3 thoughts on “Latest Debt and GDP Figures Indicate US Economy Is Still Unwell”

  1. Ron,

    It’s a good article. However, this is a problem beyond the realm of economic literature. The problem with mainstream economics is that it doesn’t address the physical limitation of resources. With this failure, we think putting a morsel in each mouth is the same as putting a dime in each hand. The governments fall back on the textbook policies to address real-world problems but there lies a major disconnect between the literature and economic dynamics. By equating economic growth to prosperity, we have created a system laden with debt and excess money supply. I think we will create a bigger problem by relying on the same literature to address the current situation. I think writing off the debt would create mayhem in the short term but it should be beneficial in the long run. In any case, the value of the debt not written off is a psychological one.


    Jimmy Dotiwala, CFA

  2. Tahir Adeel says:

    Well, what I can say is that Government has to do what it has to do, to push the economy, and they got the necessary tools to do that. This article is describing the limitations of those tools, no solutions given. The only practical solution is to “stimulate economy” as much as you can and as carefully as you can.

  3. Michael J. Clark says:

    This all shows that GDP is a false indicator. Spending does not show economic growth. Spending borrowed money is, in fact, a negative future-growth statistic, since MORE money will have to be repaid in the future, making spending of borrowed money a liability in terms of economic growth — unless the borrowed money generates more income. GDP should be measured by growth of income, not by spent money.

    One must also take in to account borrowed money’s impact on the local currency: devaluation of the local currency impoverishes everyone using that currency except exporters. A less valuable currency, caused by an increase in government death (and an increase in money creation) needs to also be valued into GDP calculatons.

    More debt is the last thing we need. We are not insolvent because GDP is not growing. We are insolvent because of debt. We are spending billions or even trillions to suppress interest rates or we will have to default on government obligations — and we are spending billions or even trillions to suppress interest rates to keep consumers and corporations from going bankrupt by the millions.

    More debt is not what we need. We need less debt — and therre is only one way to make this happen: higher interest rates. We are bankrupt. We are trying to hide the fact that we are bankrupt.

    The last time we were bankrup this way, we needed a Great depression and a World War to destroy all the bad matter the world had stored up. Today the world has much more debt than it did in 1933. This suggests that the destruction of matter will and must be even greater.

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