Oh, Ho, Ho, It’s Magic

It seems that a bit of remedial math may be a good thing, even for Nobel Prize winners.  In this Sunday’s New York Times, luminary Paul Krugman has, once again, nakedly exposed the simple-minded idiocy of the Keynesian Perpetual Motion Bubble Machine. 

While aptly diagnosed in Gonzalo Lira’s guest post on Zero Hedge (“Why Paul Krugman is an Imbecile, or a Fraud” – and, yes, it would seem that he is one or the other…), I’d like to take a moment here to demonstrate some basic mathematical truths underpinning our discussions of Debt and GDP.  

It should be obvious, but most commentators tend to gloss over the simple fact that GDP includes all public sector spending, even deficit spending…you know, the kind of spending made possible by the accumulation of public sector debt.  So, as our very own math wizard Harry White immediately grasped, we can instantly reduce our worrisome debt-to-GDP ratio by half by simply borrowing and spending an amount equal to our current GDP.  Oh, Ho, Ho, It’s Magic!

Lest we forget, the Debt-to-GDP ratio  is a rather critical economic and public policy metric, more recently studied by Carmen Reinhart and Kenneth Rogoff in their widely acclaimed study, “This Time Is Different:  Eight Centuries of Financial Folly”  (See also their paper “Growth in a Time of Debt“).  As painstakingly demonstrated in this excellent work, a debt-to-GDP ratio above 90% has generally proven to be a fatal “point of no return” on the path of public sector self-destruction…the sort that has led to famous meltdowns such as in Weimar Germany and Zimbabwe. 

The basic problem, you see, is that the accumulation of excess public sector debt will tend, eventually, to limit growth in the economy, mostly since the funds needed to service that debt must be extracted from the productive capacity of the private sector.  Seems simple enough, don’t you think?  Unfortunately, as – again – should be obvious, many among us are inclined to confuse public sector growth with actual, sustainable, economic achievement. 

As Obama likes to say, “let me be clear“:  Even when operating within the limits of a balanced budget, the cost of government is extracted from the productive capacity of the economy.  Too much extraction – whether it is done directly through taxes or indirectly through debt and/or inflation – and you “shrink the pie”.  This principal was the basis of Laffer’s work, as you may recall, at least on the issue of counter-productive taxation.  Too often ignored, however, is the issue of counter-productive debt, on which Reinhart and Rogoff shed considerable light.

In order to facilitate the ruse that debt funded spending =growth, our political leaders, with the help from the likes of Krugman, go to extremes to “hide the pea” under the shells of contrived GDP figures and, ultimately, fudged measures of inflation.   This is amply demonstrated by the most common sleight of hand of all:  “we grew out of our debt after WWII“.  This happy proclamation, we should note, is used almost as often as (or in conjunction with) “the massive deficit spending needed for WWII got us out of the depression“. 

Naturally, these Keynesian apostles are reluctant to add the caveat, “well, the US was the effectively the only industrial economy left standing after it’s competitors were bombed nearly to extinction, along with something like 80 million of their workers“.  Of course, if I could be afforded that sort of competitive advantage, I might just be willing to borrow a couple hundred million to fund a small coffee-and-software start-up in Seattle.  (By the way, we might note that Germany and Japan’s deficit spending during the war added very little to their post-war recovery.) 

Of course, we can guess where Krugman stands on the 90% debt-to-GDP issue, can’t we?  As observed by James Picerno at Seeking Alpha back in May, “Krugman argues that high debt doesn’t cause slow growth; rather, it’s the other way around.”  And, while it’s true, as Picerno notes, that correlation is not the same thing as causation, the data presented by the likes of Reinhard and Rogoff should give us all reason for concern, especially for the outcome of over zealous Krugmania. 

Besides which, there really is – at the root of the whole debate – a simple truth here.  Unless debt is applied directly to the capitalization of increased productivity, you’re not likely to get much in the way of sustainably increased productivity.  Debt accrued in the course of consumption, whether it’s in the private or public sector, will boost production only temporarily and only until the debt is exhausted.  Should I say that again with an Austrian accent?

So, where in this process are we now?  Well, you can read one detailed analysis of the March 2010 CBO report presented in the Washington Times.  But, even this reasonably well intended article misses the central point – as does the CBO itself, it would seem.  That is to say that as deficit spending continues unabated, GDP is inflated by the same degree, which understates the real level of debt-to-GDP.   Just like magic.


We might note, for instance, in the oft-referred-to WWII episode clearly visible in the above chart, that GDP had risen from $101 Billion in 1940, before the war, to $225 Billion in 1945, at the end of the war.  The debt accumulated during that period was $250 Billion, which was roughly 120% of the so-inflated GDP in 1945.  That debt represented closer to 250% of the un-inflated pre-war GDP.  Which number is meaningful do you think?

Well, for starters, we might understand that we’re now accumulating public debt at the rate of 9+% of GDP per year and only adding to GDP at a rate of 2.4%, according to the latest from the BEA.  (By the way, you might note that I’ve avoided digressing into the subject of agency debt and other factors which tend to further distort the picture. )  The central point, really, is “everybody knows this is unsustainable” and that these numbers really imply net losses in GDP of nearly 7%.  Do you get that?  The GDP is not really growing if all we’re really doing is simply borrowing from future savings, future investment, future consumption, future growth.  And, that, my friends, is what it really amounts to. 

And, lest you become similarly tempted by the fact that we have survived this level of debt in the past, perhaps you might also expect that a more complete bombing into oblivion of our competitors might once again be necessary.  And, for the record, only the pathologically stupid continue to drink and drive based on the fact that they made it home safely the last time, especially if they ran everyone else off the road in the process.

Harry Tuttle


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