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#MacroView: Debt, Deficits & The Path To MMT.

In September 2017, when the Trump Administration began promoting the idea of tax cut legislation, I wrote a series of articles discussing the fallacy that tax cuts would lead to higher tax collections, and a reduction in the deficit. To wit:

“Given today’s record-high levels of debt, the country cannot afford a deficit-financed tax cut. Tax reform that adds to the debt is likely to slow, rather than improve, long-term economic growth.

The problem with the claims that tax cuts reduce the deficit is that there is NO evidence to support the claim. The increases in deficit spending to supplant weaker economic growth has been apparent with larger deficits leading to further weakness in economic growth. In fact, ever since Reagan first lowered taxes in the ’80’s both GDP growth and the deficit have only headed in one direction – higher.”

That was the deficit in September 2017.

Here it is today.

As opposed to all the promises made, economic growth failed to get stronger. Furthermore, federal revenues as a percentage of GDP declined to levels that have historically coincided with recessions.

Why Does This Matter?

President Trump just proposed his latest $4.8 Trillion budget, and not surprisingly, suggests the deficit will decrease over the next 10-years.

Such is a complete fantasy and was derived from mathematical gimmickry to delude voters to the contrary. As Jim Tankersley recently noted:

The White House makes the case that this is affordable and that the deficit will start to fall, dropping below $1 trillion in the 2021 fiscal year, and that the budget will be balanced by 2035. That projection relies on rosy assumptions about growth and the accumulation of new federal debt — both areas where the administration’s past predictions have proved to be overconfident.

The new budget forecasts a growth rate for the United States economy of 2.8 percent this year — or, by the metric the administration prefers to cite, a 3.1 percent rate. That is more than a half percentage point higher than forecasters at the Federal Reserve and the Congressional Budget Office predict.

It then predicts growth above 3 percent annually for the next several years if the administration’s economic policies are enacted. The Fed, the budget office and others all see growth falling below 2 percent annually in that time. By 2030, the administration predicts the economy will be more than 15 percent larger than forecasters at the budget office do.

Past administrations have also dressed up their budget forecasts with economic projections that proved far too good to be true. In its fiscal year 2011 budget, for example, the Obama administration predicted several years of growth topping 4 percent in the aftermath of the 2008 financial crisis — a number it never came close to reaching even once.

Trump’s budget expectations also contradict the Congressional Budget Office’s latest deficit warning:

“CBO estimates a 2020 deficit of $1.0 trillion, or 4.6 percent of GDP. The projected gap between spending and revenues increases to 5.4 percent of GDP in 2030. Federal debt held by the public is projected to rise over the ­coming decade, from 81 percent of GDP in 2020 to 98 percent of GDP in 2030. It continues to grow ­thereafter in CBO’s projections, reaching 180 percent of GDP in 2050, well above the highest level ever recorded in the United States.”

“With unprecedented trillion-dollar deficits projected as far as the eye can see, this country needs a serious budget. Unfortunately, that cannot be said of the one the President just submitted to Congress, which is filled with non-starters and make-believe economics.” – Maya Macguineas

Debt Slows Economic Growth

There is a long-standing addiction in Washington to debt. Every year, we continue to pile on more debt with the expectation that economic growth will soon follow.

However, excessive borrowing by companies, households or governments lies at the root of almost every economic crisis of the past four decades, from Mexico to Japan, and from East Asia to Russia, Venezuela, and Argentina. But it’s not just countries, but companies as well. You don’t have to look too far back to see companies like Enron, GM, Bear Stearns, Lehman, and a litany of others brought down by surging debt levels and simple “greed.” Households, too, have seen their fair share of debt burden related disaster from mortgages to credit cards to massive losses of personal wealth.

It would seem that after nearly 40-years, some lessons would have been learned.

Such reckless abandon by politicians is simply due to a lack of “experience” with the consequences of debt.

In 2008, Margaret Atwood discussed this point in a Wall Street Journal article:

“Without memory, there is no debt. Put another way: Without story, there is no debt.

A story is a string of actions occurring over time — one damn thing after another, as we glibly say in creative writing classes — and debt happens as a result of actions occurring over time. Therefore, any debt involves a plot line: how you got into debt, what you did, said and thought while you were in there, and then — depending on whether the ending is to be happy or sad — how you got out of debt, or else how you got further and further into it until you became overwhelmed by it, and sank from view.”

The problem today is there is no “story” about the consequences of debt in the U.S. While there is a litany of other countries which have had their own “debt disaster” story, those issues have been dismissed under the excuse of “yes, but they aren’t the U.S.”

But this lack of a “story,” is what has led us to the very doorstep of “Modern Monetary Theory,” or “MMT.” As Michael Lebowitz previously explained:

“MMT theory essentially believes the government spending can be funded by printing money. Currently, government spending is funded by debt, and not the Fed’s printing press. MMT disciples tell us that when the shackles of debt and deficits are removed, government spending can promote economic growth, full employment and public handouts galore.

Free healthcare and higher education, jobs for everyone, living wages and all sorts of other promises are just a few of the benefits that MMT can provide. At least, that is how the theory is being sold.”

What’s not to love?

Oh yes, it’s that deficit thing.

Deficits Are Not Self-Financing

The premise of MMT is that government “deficit” spending is not a problem because the spending into “productive investments” pay for themselves over time.

But therein lies the problem – what exactly constitutes “productive investments?”

For government “deficit” spending to be effective, the “payback” from investments made must yield a higher rate of return than the interest rate on the debt used to fund it. 

Examples of such investments range from the Hoover Dam to the Tennessee River Valley Authority. Importantly, “infrastructure spending projects,” must have a long-term revenue stream tied to time. Building roads and bridges to “nowhere,” may create short-term jobs, but once the construction is complete, the economic benefit turns negative.

The problem for MMT is its focus on spending is NOT productive investments but rather social welfare which has a negative rate of return. 

Of course, the Government has been running a “Quasi-MMT” program since 1980.

According to the Center On Budget & Policy Priorities, roughly 75% of every current tax dollar goes to non-productive spending. (The same programs the Democrats are proposing.)

To make this clearer, in 2019, the Federal Government spent $4.8 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.6 Trillion was financed by Federal revenues, and $1.1 trillion was financed through debt.

In other words, if 75% of all expenditures go to social welfare and interest on the debt, those payments required $3.6 Trillion, or roughly 99% of the total revenue coming in. 

There is also clear evidence that increasing debts and deficits DO NOT lead to either stronger economic growth or increasing productivity. As Michael Lebowitz previously showed:

“Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found here.

The graph below plots a simple index we created based on total factor productivity (TFP) versus the ten-year average growth rate of TFP. The TFP index line is separated into green and red segments to highlight the change in the trend of productivity growth rate that occurred in the early 1970’s. The green dotted line extrapolates the trend of the pre-1972 era forward.”

“The plot of the 10-year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line) is telling.”

“This reinforces the message from the other debt-related graphs – over the last 30-years the economy has relied more upon debt growth and less on productivity to generate economic activity.

The larger the balance of debt has become, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.

Since 2008, the economy has been growing well below its long-term exponential trend. Such has been a consistent source of frustration for both Obama, Trump, and the Fed, who keep expecting higher rates of economic only to be disappointed.

The relevance of debt growth versus economic growth is all too evident. When debt issuance exploded under the Obama administration, and accelerated under President Trump, it has taken an ever-increasing amount of debt to generate $1 of economic growth.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has been no organic economic growth.

For the 30-years, from 1952 to 1982, the economic surplus fostered a rising economic growth rate, which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been higher. If you subtract the debt, there has not been any organic economic growth since 1990. 

What is indisputable is that running ongoing budget deficits that fund unproductive growth is not economically sustainable long-term.

The End Game Cometh

Over the last 40-years, the U.S. economy has engaged in increasing levels of deficit spending without the results promised by MMT.

There is also a cost to MMT we have yet to hear about from its proponents.

The value of the dollar, like any commodity, rises and falls as the supply of dollars change. If the government suddenly doubled the money supply, one dollar would still be worth one dollar but it would only buy half of what it would have bought prior to their action.

This is the flaw MMT supporters do not address.

MMT is not a free lunch.

MMT is paid for by reducing the value of the dollar and ergo your purchasing power. MMT is a hidden tax paid by everyone holding dollars. The problem, as Michael Lebowitz outlined in Two Percent for the One Percent, inflation tends to harm the poor and middle class while benefiting the wealthy.

This is why the wealth gap is more pervasive than ever. Currently, the Top 10% of income earners own nearly 87% of the stock market. The rest are just struggling to make ends meet.

As I stated above, the U.S. has been running MMT for the last three decades, and has resulted in social inequality, disappointment, frustration, and a rise in calls for increasing levels of socialism.

It is all just as you would expect from such a theory put into practice, and history is replete with countries that have attempted the same. Currently, the limits of profligate spending in Washington has not been reached, and the end of this particular debt story is yet to be written.

But, it eventually will be.

The Most Important & Overlooked Economic Number

Every month, and quarter, economists, analysts, the media, and investors pour over a variety of mainstream economic indicators from GDP, to employment, to inflation to determine what the markets are likely to do next.

While economic numbers like GDP, or the monthly non-farm payroll report, typically garner the headlines, the most useful statistic, in my opinion, is the Chicago Fed National Activity Index (CFNAI). It often goes ignored by investors and the press, but the CFNAI is a composite index made up of 85 sub-components, which gives a broad overview of overall economic activity in the U.S.

The markets have run up sharply over the last couple of months due to the Federal Reserve once again intervening into the markets. However, the hopes are that U.S. economic growth is going to accelerate going into 2020, which should translate into a resurgence of corporate earnings. However,  if recent CFNAI readings are any indication, investors may want to alter their growth assumptions heading into next year.

While most economic data points are backward-looking statistics, like GDP, the CFNAI is a forward-looking metric that gives some indication of how the economy is likely to look in the coming months.

Importantly, understanding the message that the index is designed to deliver is critical. From the Chicago Fed website:

“The Chicago Fed National Activity Index (CFNAI) is a monthly index designed to gauge overall economic activity and related inflationary pressure. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth.

The overall index is broken down into four major sub-categories which cover:

  • Production & Income
  • Employment, Unemployment & Hours
  • Personal Consumption & Housing
  • Sales, Orders & Inventories

To get a better grasp of these four major sub-components, and their predictive capability, I have constructed a 4-panel chart showing each of the four CFNAI sub-components compared to the four most common economic reports of Industrial Production, Employment, Housing Starts and Personal Consumption Expenditures. To provide a more comparative base to the construction of the CFNAI, I have used an annual percentage change for these four components.

The correlation between the CFNAI sub-components and the underlying major economic reports do show some very high correlations. This is why, even though this indicator gets very little attention, it is very representative of the broader economy. Currently, the CFNAI is not confirming the mainstream view of an “economic soft patch” that will give way to a stronger recovery by next year.

The CFNAI is also a component of our RIA Economic Output Composite Index (EOCI). The EOCI is even a broader composition of data points including Federal Reserve regional activity indices, the Chicago PMI, ISM, National Federation of Independent Business Surveys, and the Leading Economic Index. Currently, the EOCI further confirms that “hopes” of an immediate rebound in economic activity is unlikely. To wit:

“The problem is there is not a ‘major shift’ coming for the economy, at least not yet, as shown by the readings from our Economic Output Composite Index (EOCI).”

“There are a couple of important points to note in this very long-term chart.

  1. Economic contractions tend to reverse fairly frequently from high peaks and those contractions tend to revert towards the 30-reading on the chart. Recessions are always present with sustained readings below the 30-level.
  2. The financial markets generally correct in price as weaker economic data weighs on market outlooks. 

Currently, the EOCI index suggests there is more contraction to come in the coming months, which will likely weigh on asset prices as earnings estimates and outlooks are ratcheted down heading into 2020.”

It’s In The Diffusion

The Chicago Fed also provides a breakdown of the change in the underlying 85-components in a “diffusion” index. As opposed to just the index itself, the “diffusion” of the components give us a better understanding of the broader changes inside the index itself.

There two important points of consideration:

  1. When the diffusion index dips below zero have coincided with weak economic growth and outright recessions. 
  2. The S&P 500 has a history of corrections, and outright bear markets, which correspond with negative reading in the diffusion index.

The second point should not be surprising since the stock market is ultimately a reflection of economic growth. The chart below simply compares the annual rate of change in the S&P 500 and the CFNAI index. Again, the correlation should not be surprising.

Investors should also be concerned about the high level of consumer confidence readings. There have been numerous headlines touting the “strength of consumer” as support for the ongoing “bull market.”

Overly Confident In Confidence

As we discussed just recently. 

“The chart below shows our composite confidence index, which combines both the University of Michigan and Conference Board measures. The chart compares the composite index to the S&P 500 index with the shaded areas representing when the composite index was above a reading of 100.

On the surface, this is bullish for investors. High levels of consumer confidence (above 100) have correlated with positive returns from the S&P 500.”

The issue is the divergence between “consumer” confidence and that of “CEO’s.” 

“Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company who is watching sales, prices, managing inventory, dealing with collections, paying bills, and managing changes to the economic landscape on a daily basis?”

Notice that CEO confidence leads consumer confidence by a wide margin. This lures bullish investors, and the media, into believing that CEO’s really don’t know what they are doing. Unfortunately, consumer confidence tends to crash as it catches up with what CEO’s were already telling them.

What were CEO’s telling consumers that crushed their confidence?

“I’m sorry, we think you are really great, but I have to let you go.” 

The CFNAI also tells the same story with large divergences in consumer confidence eventually “catching down” to the underlying index.

This chart suggests that we will begin seeing weaker employment numbers and rising layoffs in the months ahead, if history is any guide to the future.

This last statement is key to our ongoing premise of weaker than anticipated economic growth despite the Federal Reserve’s ongoing liquidity operations. The current trend of the various economic data points on a broad scale are not showing indications of stronger economic growth but rather a continuation of a sub-par “muddle through” scenario of the last decade.

While this is not the end of the world, economically speaking, such weak levels of economic growth do not support stronger employment, higher wages, or justify the markets rapidly rising valuations. The weaker level of economic growth will continue to weigh on corporate earnings, which like the economic data, appears to have reached their peak for this current cycle.

The CFNAI, if it is indeed predicting weaker economic growth over the next couple of quarters, also doesn’t support the recent rotation out of defensive positions into cyclical stocks that are more closely tied to the economic cycle. The current rotation is based on the premise that economic recovery is here, however, the data hasn’t confirmed it as of yet.

Either the economic data is about to take a sharp turn higher, or the market is set up for a rather large disappointment when the expected earnings growth in the coming quarters doesn’t appear. From all of the research we have done lately, the latter point seems most likely as a driver for the former seems lacking.

Maybe the real question is why we aren’t paying closer attention to what this indicator has to tell us?

Need A Break From The Inlaws? Your “Turkey Day” Reading List

It’s “Thanksgiving Day,” and after the annual indulging into too much Turkey and dressing, cranberry sauce, and pecan pie, you might just need a break from the family to “do some research.”

We are happy to oblige with a few of our most important articles over the last few months as they relate to where we are in the current economic and market cycle.


Consumers Are Keeping The U.S. Out Of Recession? Don’t Count On It.

“[Who is a better measure of economic strength?] Is it the consumer cranking out work hours, raising a family, and trying to make ends meet? Or the CEO of a company who is watching sales, prices, managing inventory, dealing with collections, paying bills, and managing changes to the economic landscape on a daily basis? A quick look at history shows this level of disparity (between consumer and CEO confidence) is not unusual. It happens every time prior to the onset of a recession.

The Corporate Maginot Line

“We believe investors are being presented with a window to sidestep risk while giving up little to do so. If a great number of BBB-rated corporate bonds are downgraded, it is highly likely the prices of junk debt will plummet as supply will initially dwarf demand. It is in these types of events, as we saw in the sub-prime mortgage market ten years ago, that investors who wisely step aside can both protect themselves against losses and set themselves up to invest in generational value opportunities.”

Corporate Profits Are Worse Than You Think

“If the economy is slowing down, revenue and corporate profit growth will decline also. However, it is this point which the ‘bulls’ should be paying attention to. Many are dismissing currently high valuations under the guise of ‘low interest rates,’ however, the one thing you should not dismiss, and cannot make an excuse for, is the massive deviation between the market and corporate profits after tax. The only other time in history the difference was this great was in 1999.”

Who Is Funding Uncle Sam

“Unfortunately, two of the largest buyers/holders of U.S. Treasury debt (China and the Federal Reserve) are no longer pulling their weight. More concerning, this is occurring as the amount of Treasury debt required to fund government spending is growing rapidly. The consequences of this drastic change in the supply and demand picture for U.S. Treasury debt are largely being ignored.”

The Disconnect Between The Markets & Economy Has Grown

“The stock market has returned almost 103.6% since the 2007 peak, which is more than 4-times the growth in GDP and nearly 3-times the increase in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not AS subject to manipulation.)

The all-time highs in the stock market have been driven by the $4 trillion increase in the Fed’s balance sheet, hundreds of billions in stock buybacks, and valuation (PE) expansion. With Price-To-Sales ratios and median stock valuations near the highest in history, one should question the ability to continue borrowing from the future?”

Investors Are Grossly Underestimating The Fed – RIA PRO UNLOCKED

“The market has a long history of grossly underestimating, in both directions, what the Fed will do. The implications to stocks and bonds can be meaningful. To the extent one is inclined and so moved to exercise prudence, now seems to be a unique opportunity to have a plan and take action when necessary.”

Happy Thanksgiving!

Your Appreciative & Thankful Team At RIA Advisors

Powell’s Fantasy: The Economy Should Grow Faster Than Debt

In recent testimony to Congress’s Joint Economic Committee, Jerome Powell stated:

“The debt is growing faster than the economy — that’s unsustainable. It’s not the Fed’s job to say how the government should cut the deficit, but we need to get the economy to grow faster than the debt. Otherwise, future generations will be paying more of their taxes to cover the government’s debt costs than for other things like health care, etc.

I think the new normal now is low interest rates, low inflation and probably lower growth. Even with the lower interest on its debt, the government still needs to reduce its budget deficit.” 

Interestingly, these were not the first time we heard these words. In 2012, then-Fed Chair Ben Bernanke told Congress:

“Rising federal budget deficits are posing a significant threat to the U.S. economy and are likely to cause a crisis if not brought under control. Having a large and increasing level of government debt relative to national income runs the risk of serious economic consequences. Over the longer term, the current trajectory of federal debt threatens to crowd out private capital formation and thus reduce productivity growth.”

Looking back now, it was clear that Bernanke was correct. Over the last 30-years, the rising level of Federal Debt relative to National Income has retarded Productivity in the U.S.

Of course, just as is the case today, Congress didn’t listen then either. Just a couple of months later in July, 2012, as Congress was feuding over a “debt ceiling limit funding deal,” Ben Bernanke testified before the Senate Banking committee stating that “fiscal policy” needed to take over for “monetary policy.”

The response from Congress?

“Given the political realities of this year’s election, I believe the Fed is the only game in town. I would urge you, now more than ever, to take whatever actions are warranted. So, get to work, Mr. Chairman.” – Sen. Charles Schumer, D-N.Y.

Almost 8-years later, with the deficit once again approaching $1 Trillion, the Federal Reserve remains the “only game in town.” Such was the case following Jerome Powell’s plea to Congress to enact some responsibility, but all Wall Street heard was: “More QE is coming.”

Such should not be surprising. Regardless of political affiliation, the idea of “fiscal responsibility” in Washington has been replaced by all-out “socialist” leanings. However, you are mistaken if you believe this to be a new mentality in Washington.

It isn’t.

Like a “frog being boiled in water,” the temperature has been slowly rising for the last 20+ years as deficits grew to support unbridled largesse in Washington.

What is most important to understand is that this surging deficit is occurring during the longest economic expansion on record. Naturally, given the lack of immediate negative consequences, many have come to believe that debts, and deficits, don’t matter.

However, the evidence, should those in Washington D.C. care to examine, is using debt to “pull forward consumption” has had long-term negative effects on economic prosperity.

The current expansion is the weakest in U.S. history.

Here is a little different way to look at it. The chart below shows the deficit, 10-year average GDP growth, and the annual change in Federal Debt.

The problem should be obvious. Since the Federal government began ramping up debt, and running an annual deficit, economic growth has continued to deteriorate. This is not just a coincidence.

With the government already running a massive deficit, and expected to issue another $1.5-2 Trillion in debt during the next fiscal year, the efficacy of “deficit spending” in terms of its impact to economic growth has been greatly marginalized.

John Maynard Keynes’ was correct in his economic theory. In order for deficit spending to be effective, the “payback” from investments being made must yield a higher rate of return than the debt used to fund it.

The problem has been two-fold.

  • “Deficit spending” was only supposed to be used during a recessionary period, and reversed to a surplus during the ensuing expansion. However, beginning in the early ’80s, those in power only adhered to “deficit spending part” after all “if a little deficit spending is good, a lot should be better,” right?
  • Secondly, deficit spending shifted away from productive investments, which create jobs (infrastructure and development,) to primarily social welfare and debt service. Money used in this manner has a negative rate of return.

According to the Center On Budget & Policy Priorities, roughly 75% of every tax dollar goes to non-productive spending. 

Here is the real kicker. In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in. 

Do you see the problem here? (In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.”)

Debt Is The Cause, Not The Cure

I am not saying that all debt is bad.

Debt, if used for productive investments, can be a solution to stimulating economic growth in the short-term and provide a long-term benefit.

The current surge in unbridled deficit spending only succeeds in providing a temporary illusion of economic growth by “pulling forward” future consumption, leaving a void that must be filled.

Since the bulk of the debt issued by the U.S. has been squandered on increases in social welfare programs and debt service, there is a negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.

In other words, Powell is hoping for a “fantasy” the economy can grow faster than the debt.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

However, simply looking at Federal debt levels is misleading.

It is the total debt that weighs on the economy.

It now requires nearly $3.00 of debt to create $1 of economic growth.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has actually been no organic economic growth.

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been greater.

This is why Jerome Powell is “wishing for a Unicorn.”

Interest rates MUST remain low, and debt MUST grow faster than the economy, just to keep the economy from stalling out.

This is the very essence of a “liquidity trap.”

Debt Doesn’t Create Real Growth

The massive indulgence in debt has simply created a “credit-induced boom” which has now reached its inevitable conclusion. While the Federal Reserve believed that creating a “wealth effect” by suppressing interest rates to allow cheaper debt creation would repair the economic ills of the “Great Recession,” it only succeeded in creating an even bigger “debt bubble” a decade later.

This unsustainable credit-sourced boom led to artificially stimulated borrowing which pushed money into diminishing investment opportunities and widespread mal-investments. In 2007, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk. Today, we see it again in accelerated stock buybacks, low-quality debt issuance, debt-funded dividends, and speculative investments.

When credit creation can no longer be sustained, the markets must clear the excesses before the next cycle can begin. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE, to tax cuts, only delay the clearing process. Ultimately, that delay only deepens the process when it begins.

The biggest risk in the coming recession is the potential depth of that clearing process.

Despite Powell’s wishes that Congress will become adults and begin to reduce the Federal debt burden, the reality is the economy can not sustain itself without the debt.

While we do have the ability to choose our future path, taking action today would require more economic pain and sacrifice than elected politicians are willing to inflict upon their constituents. This is why throughout the entirety of history, every empire collapsed eventually collapsed under the weight of its own debt.

Eventually, the opportunity to make tough choices for future prosperity will result in those choices being forced upon us.

Capitalism Is The Worst, Except For All The Rest – Part 3

Part 1 – How Wall Street Destroyed Capitalism

Part 2 – The Myths Of “Broken Capitalism”


In Part 1, we discussed how “Capitalism” was distorted by Wall Street. In Part 2, we reviewed some of the “myths” of capitalism, which are used to garner “votes” by politicians but are not really true. Most importantly, we discussed the fallacy that “more Government” is the answer in creating equality as it impairs economic opportunity.

I want to conclude this series with a discussion on the fallacy of socialism and equality, and provide a some thoughts on how you can capitalize on capitalism.

Socialism Requires Money

The “entire premise” of the socialist agendas assumes money is unlimited. Since there is only a finite amount of money created through taxation of citizens each year the remainder must come from the issuance of debt.

Therefore, to promote an agenda which requires unlimited capital commitments to fulfill, the basic premise has to be “debt doesn’t matter.” 

Enter “Modern Monetary Theory” or MMT.

Kevin Muir penned “Everything You Wanted To Know About MMT” which delves into what MMT proposes to be. To wit:

“Modern Monetary Theory is a macroeconomic theory that contends that a country that operates with a sovereign currency has a degree of freedom in their fiscal and monetary policy which means government spending is never revenue constrained, but rather only limited by inflation.”

In other words, debts and deficits do not matter as long as the Government can print the money it needs, to pay for what it wants to pay for.

Deficits are self-financing, deficits push rates down, deficits raise private savings.” – Stephanie Kelton

It is the proverbial “you can have your cake and eat it too” theory. It just hasn’t exactly worked out that way.

Deficits Are Not Self-Financing

The premise of MMT is that government “deficit” spending is not a problem because the spending into “productive investments” pay for themselves over time.

But therein lies the problem – what exactly constitutes “productive investments?”

For that answer, we can turn to Dr. Woody Brock, an economist who holds 5-degrees in math and economics and is the author of “American Gridlock” for the answer.

“The word ‘deficit’ has no real meaning. 

‘Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures, but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the ‘deficit’ over time.’

There is no disagreement about the need for government spending. The disagreement is with the abuse, and waste, of it.

For government “deficit” spending to be effective, the “payback” from investments made through debt must yield a higher rate of return than the interest rate on the debt used to fund it.

The problem, for MMT and as noted by Dr. Brock, is that government spending has shifted away from productive investments, like the Hoover Dam, which creates jobs (infrastructure and development) to primarily social welfare, defense, and debt service which has negative rates of return.

In other words, the U.S. is “Country A.” 

However, there is clear evidence that increasing debts and deficits DO NOT lead to either stronger economic growth or increasing productivity. As Michael Lebowitz recently showed:

“Since 1980, the long term average growth rate of productivity has stagnated in a range of 0 to 2% annually, a sharp decline from the 30 years following WWII when productivity growth averaged 4 to 6%. While there is no exact measure of productivity, total factor productivity (TFP) is considered one of the best measures. Data for TFP can found here.

“The graph below plots 10-year average productivity growth (black line) against the ratio of total U.S. credit outstanding to GDP (green line).”

“This reinforces the message from the other debt related graphs – over the last 30 years the economy has relied more upon debt growth and less on productivity to generate economic activity.”

As noted above, since the bulk of the debt issued by the U.S. has been unproductively squandered on increases in social welfare programs and debt service, there is a negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever-growing amount of dollars away from productive investments to service payments.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has been no organic economic growth.

For the 30-years from 1952 to 1982, the economic surplus fostered a rising economic growth rate, which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been greater, and continues to grow.

MMT is not a free lunch. MMT is paid for by reducing the value of the dollar, and is a hidden tax by reducing the purchasing power of everyone holding dollars. The problem is that inflation tends to harm the poor and middle class, but benefits the wealthy.

While MMT promises “free college,” “healthcare for all,” “free childcare,” and “jobs for all” with no consequences, it will deliver inflation, generate further wealth/income inequality, and greater levels of social instability and populism.

How do we know this? Because it is the same outcome seen in every other country that endeavored in programs of unbridled debts and deficits.

MMT sounds great at the conversational level, but so does “communism” and “socialism.”

In practice, the outcomes have been vastly different than the theory.

Why Wealth Inequality Is A Good Thing

Just recently, Aaron Back accidentally made the case for why we should foster “capitalism” over “socialism.” 

What Aaron exposed in his rush to jump on the “inequality bandwagon” was what capitalism provided. Let’s break down his statement:

  1. Introduction of capitalism lifts millions out of poverty. (This is a good thing)
  2. Yes, inequality was created as those that took advantage of capitalism prospered versus those that didn’t. (How capitalism works)
  3. If capitalism lifted millions out of poverty, which suggests everyone was poor under communism. 

Point 3 is the most important.

Capitalism gets its power—and has created the greatest increase in social welfare in history—from embracing human ingenuity and the positive forces of innovation, open markets and competition. Perhaps the greatest strength of free markets is their ability to nimbly adjust to new ideas and situations and find the most efficient system. Markets are always looking to do things better. We can apply that same logic to capitalism itself to improve capitalism further so that it can provide even greater social welfare.”Daniel LaCalle

Let me clarify something for you.

The ‘American Dream’ isn’t going into debt to buy a home. The ‘American Dream’ is the ability for ANY person, regardless of race, religion, or means, to achieve success, and in many cases great success, through hard work, dedication, determination, and sacrifice.

Capitalism Is The Worst, Except For All The Rest

One thing is for certain. Life isn’t fair.

“The rich have everything, and all I have is a mountain of student debt and a crappy job.”

Capitalism isn’t perfect as Howard Marks recently noted:

Capitalism is an imperfect economic system, because differential performance in the pursuit of economic success – as well as luck – results in there being (a) some people who are less successful as well as some who are more and (b) a few who are glaringly successful.

I’m 100% convinced that the capitalist system has produced the most aggregate gains for our society, exceptional overall progress, and a better life for most. 

In the same way, I’m convinced that capitalism is the worst economic system . . . except for all the rest.”

Capitalism is the only system that will provide you the ability to achieve unbridled success.

Yes, the Government can pay for anything you want. The problem is that it requires those who are succeeding to pay for it.

Think about it.

Do you want to work hard, sacrifice, and take on an exceeding amount of risk to achieve success only to pay for those who don’t?

This is why socialism always fails.

The greater good can only be achieved by making the good greater.” Daniel LaCalle

The Myths Of “Broken Capitalism” – Part 2

Read Part 1 – The Distortion Of Capitalism By Wall Street

Read Part 3 – Capitalism Is The Worst, Except For The Rest


In the introduction to this series, we discussed the bit of the history leading us to the outcry against capitalism. As I concluded:

“The important point is that ‘capitalism’ isn’t broken, but there is one aspect of the system which has morphed into something no one intended. As you hear candidates promising to ‘eat the rich,’ remember ‘political narratives’ designed to win votes is not always representative of what is best for you in the long run.”

In every economy, throughout history, there have always been those individuals who aspire to wealth and privilege and those that beg on street corners for scraps. The battle between “haves” and “have nots” has been going on since men lived in caves.

“Did you see Ugg’s new cave? He’s got a T-Rex floor covering by the fire pit.”

Likewise, throughout history, there have also been the subsequent revolts where the oppressed have stormed the castle walls with “pitchforks and torches” to change the balance of inequity. Unfortunately, those changes only lasted for a little while. Eventually, the system imbalances always return due to our basic human nature:

  • Aspiration (the will to take risks, determination, and drive),
  • Education, and socio-economic factors (access to capital, connections, etc.), and;
  • Greed

However, it is our human nature of greed and competition, which lifts individuals out of poverty. Inequality should not be viewed as a negative, but rather as a driver of prosperity and innovation. As Daniel LaCalle recently wrote in his new book “Freedom, Equality, & Prosperity Through Capitalism:”

“By contrast, the U.S. has historically been a clear example of positive inequality. ‘Mimic inequality’—where you want to do your best and make it seem to others that ‘you’ve made it’–is a positive force. That’s what we all call The American Dream. The reason why millions emigrate to the U.S. is the promise of equal opportunity, not equality. Very few ever emigrate to socialist countries. In fact, governments in those regimes spend large sums of money trying to prevent their citizens from escaping”

This is a vastly important statement. We should be seeking to foster is equal opportunity, not wealth equality.

Fortunately, the United States is rich with opportunity. All you have to do is take advantage of it.

Myth: The System Is Unfair, You Have To Be Rich To Start With

Jeff Bezos, the creator of the world’s largest online retailer and one of the richest men in the world, took advantage of capitalism. Now he has become villainized for it.

What did he have that allowed him to generate billions in personal wealth that others didn’t?

Nothing.

  1. He had an idea. (We all have ideas.)
  2. He took on the “risk of failure.” (Would you quit your job to start a business that could fail?)
  3. He had an educational background. (Princeton University. But education isn’t everything. Bill Gates dropped out of college. Education can provide access to potential contacts and resources.)
  4. He had access to capital. (His dad loaned him $250,000 to seed the company. However, this is why private equity and venture capital firms exist which can fund startup projects.)
  5. He dedicated himself to the project to see it to completion. (Determination and drive in the face of potential failure.)

There is nothing extraordinary about Jeff Bezos. Any person in the U.S. could achieve the same outcome. We see it occur every day with products and services that we use from Grubhub to Uber. FedEx is another great example of capitalism at work.

“Fred Smith developed the idea of a global logistics company when he was a student at Yale University with other notable students such as future President George W. Bush and Democratic presidential candidate John Kerry.” – Education and Contacts

“Smith submitted a paper that proposed a new concept where one logistics company is responsible for a piece of cargo from local pickup to ultimate delivery, while operating its own aircraft, depots, posting stations, and ubiquitous delivery vans.” – Innovative Idea

“Smith began Federal Express in 1971 with a $4 million inheritance from his father and $91 million of venture capital.” – Access to capital

“The first three years of operation saw the company lose money despite being the most highly financed new company in U.S. history in terms of venture capital. It was not until 1976 that the company saw its first profit of $3.6 million based on handling 19,000 packages a day.” – Dedicated to an idea in the face of adversity, risk of loss of his inheritance.

Here are a few others who started with nothing, took risks, and built substantial wealth:

  • Jan Koum, CEO and Founder Of WhatsApp, who once lived on food stamps.
  • Kenny Troutt, founder of Excel Communications, paid his way through college selling life insurance.
  • Howard Schultz grew up in a housing complex for the poor.
  • Investor Ken Langone’s parents worked as a plumber and cafeteria worker.
  • Oprah Winfrey was born into poverty.
  • Billionaire Shahid Kahn washed dishes for $1.20 an hour.
  • Kirk Kerkorian dropped out of school in the 8th grade to be a boxer.
  • John Paul DeJoria, founder of Paul Mitchell, once lived in a foster home and out of his car.
  • Do Won Chang, founder of Forever 21, worked as a janitor and a gas station attendant when he first moved to America.
  • Ralph Lauren was a clerk at Brooks Brothers.
  • Francois Pinault quit high school in 1974 after being bullied because he was so poor. 

So, what exactly is your excuse? It is easy to make excuses for “why you CAN’T do something.”

The only difference between you, and Jeff Bezos, is that Jeff didn’t make excuses.

Myth: The Rich Don’t Pay Their “Fair Share”

Bernie Sanders suggests “billionaires” shouldn’t exist; such implies we should confiscate all their wealth to support the public good. This seems fair, considering the ongoing “claims” the rich don’t pay their “fair share of taxes.” The data below clearly shows the issue.

“By contrast, the lower 60% of households, who have income up to about $86,000, receive about 27% of income. As a group, this tier will pay NO net federal income tax in 2018 vs. 2% of it last year. Roughly one million households in the top 1% will pay for 43% of income tax,up from 38% in 2017. These filers earn above about $730,000.”

Since we are currently running a trillion-dollar annual deficit, we should probably think twice about keeping the rich in a position to continue feeding the public coffers.

As Daniel Lacalle noted:

“In effect, the message of taxing the rich to solve multibillion-dollar spending problems is simply a way of advancing total control, creating clients in low-income voters and creating a group of industries that benefit from being close to the government—in other words, cronyism. This is why governments always use the fallacy of taxing the rich to obtain total control and destroy freedom.

This doesn’t mean that high earners shouldn’t pay their fair share. It means that the magic trick played on us all is to make us look at one hand (the rich) when the trick is in the other (excess spending and increased intervention and government control)

If taxing the rich were the solution to high debt, inequality, and excess spending, the world would have no such problems by now.”

Myth: The Rich Don’t Share

According to Giving USA, in 2017, total donations to charity clocked in at $410 billion, a figure (in current dollars) that has increased almost every year for four decades. The 50 largest families gave $7.8 billion in disclosed donations in 2018 alone, and $14.7 billion to nonprofits the year prior. (2017 was skewed due to Gates donation of $4.8 billion to their charity.) 

Those donations support everything from United Way to the St. Jude’s Hospital, which provides free healthcare to children and housing for their parents. Without those billions in donations, charities which support everything from art, to music, education, research, healthcare, etc. would all cease to exist.

Unintended consequences are very important to consider.

Myth: More Government Is The Answer

“Who cares? No one deserves to have that much wealth. The Government would do a better job.”

The following are the two most high profile proposals of Democratic candidates.

So, we need $4.5 trillion to pay for those two proposals in Year 1, and $3 trillion more annually to pay for “Medicare-For-All” going forward – forever. (This doesn’t include the current $70 trillion unfunded liability of the social welfare system currently.)

According to the Center On Budget & Policy Priorities, roughly 75% of every tax dollar currently goes to non-productive spending. 

In 2018, the Federal Government spent $4.48 trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of the total spending, ONLY $3.5 trillion was financed by Federal revenues. The shortfall of $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of the total revenue coming in. 

Do you see the problem here? (In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.”)

In 2018, Forbes identified the 585 U.S. billionaires which had $3.1 trillion in net worth combined.

So, if we confiscated 100% of the wealth from those 585 billionaires we could:

  1. We pay off all the student debt, and;
  2. We can pay for 1/2 of “Medicare-For-All” in year one

This leaves a shortfall of $1.5 trillion in the first year, plus the existing $1 trillion deficit, or $2.5 trillion further in debt in year one. In year 2, and beyond, assuming no increase in the current deficit, the shortfall would grow to $4 trillion annually.

But therein lies the problem.

Who pays the most in taxes?

Since we confiscated all the wealth of the billionaires, tax revenue is going to fall markedly, further increasing the annual deficit.

Moreover, since those billionaires made their wealth by building Fortune 500 companies, they will reconsider exactly what they are doing operating within the confines of a country that has now taken all their wealth.

So, which companies created the most jobs in the U.S.?

Importantly, each of those companies have:

  1. Created thousands of other companies,
  2. Which employee millions of people,
  3. Who sell to, support, or sell the products and services of those companies.

The economy is a living organism that creates hosts and parasites, which feed upon each other for survival.

“The inequality debate is often an excuse to intervene. Politicians don’t want the poor to be less poor, so long as the middle and upper classes are less wealthy. That’s because interventionism assumes that inequality is a perverse effect that can be solved by state intervention.

But the truth is interventionism perpetuates bad inequality–inequality in opportunity, in job availability and in access to a better life. In fact, it deepens it. What matters to us is equality of opportunity, and that is what the state has to focus on, not on penalizing success.” – Daniel LaCalle

So, you may want to consider the consequences of “killing the ‘Golden Goose.'”


Part 3, How To Take Advantage Of “Capitalism” To Realize The American Dream

How Wall Street Destroyed Capitalism – Part 1

Read Part 2: Exploring The “Myths Of Broken Capitalism”

Read Part 3: Capitalism Is The Worst, Except For The Rest


Over the last decade, wealth inequality in America has become a political battleground. It started with #OccupyWallStreet early in President Obama’s term and has morphed into direct calls for socialistic reforms.

Is there a problem with capitalism? Does it need reform? Or, is Bernie Sanders correct when he says:

In this three-part series, we will explore:

  1. How Capitalism Got Distorted By Wall Street
  2. The Myths Of Capitalism.
  3. Why Government Isn’t The Answer.
  4. The Cost Of Socialism
  5. Why Inequality Is A Good Thing.

Introduction

Is “capitalism,” as an economic system, wrong? Ray Dalio, the head of the largest hedge fund in the world, thinks so. He recently stated that wealth and income disparity was a failure of capitalism. He argues that capitalism is not achieving its goal of more equitably distributing the fruits of capitalism.

Ray is wrong.

Capitalism is an economic system based on the premise of property rights, the rule of law, and free markets, which allows ANY individual the opportunity to create wealth. In other words, as John Mauldin, once penned:

“Properly understood, it provides a level playing field for entrepreneurs to offer goods and services that produce incomes and profits. I don’t think equitably distributing those profits is capitalism’s role.

Ensuring that all participants are treated fairly and, to some extent, regulating these personal and corporate endeavors is the role of society in general and government in particular.

So when you say that capitalists are not very good at sharing profits, I would say that capitalism is not designed to do so.”

So, what type of economic system do you have when profits, goods, and services are shared on an equal basis? “Socialism.”

Importantly, what Ray Dalio is referring to is not a problem of “capitalism,” it is a problem of Wall Street.

How Capitalism Got Distorted By Wall Street

Despite all of the angst surrounding the idea of capitalism, it has benefited all Americans very well. Currently, the median income for the U.S. is $59,039. If you are trying to raise a family of four on that income, it certainly doesn’t make you feel very rich.

However, when compared to the rest of the world, the byproduct of capitalism is a wealth standard far above that of any other country.

According to the Global Rich List, a $32,400 annual income will easily place American school teachers, registered nurses, and other modestly-salaried individuals, among the global top 1% of earners.

Nonetheless, there is little arguing that when 1% of the country controls more wealth than the bottom 80%, something certainly doesn’t seem right.

“Wealth is distributed in a highly unequal fashion, with the wealthiest 1 percent of families in the United States holding about 40 percent of all wealth and the bottom 90 percent of families holding less than one-quarter of all wealth.”  – Washington Center For Equitable Growth

This division between the “rich” and “poor” has become a “political football” perfectly suited for the 2019 primaries as the “wealth gap” in America has become a visible chasm.

Here is what you need to be aware of. The debates over capitalism aren’t about Mike Jones, who started an auto mechanic repair shop. Nor, are they about Annie Smith, who opened a personal training studio down the street from her home. Mike and Annie are participating, and taking advantage of, a capitalist economy where the freedom to compete allows them to earn more wealth than simply “working for the man.” 

Should Mike and Annie, who have taken risks as entrepreneurs, be forced to share the fruits of their 50-70 work weeks, with everyone else who did not take those risks? It’s pretty obvious the answer is “no.” 

So, if “capitalism” at its most basic core is NOT broken, then what are we discussing?

The debate should be focused on the “distortion of capitalism” by Wall Street, and the ongoing share repurchases, which invoke images of corporate greed, inequality, and populism.

However, we should “hate the game,” not the “player.”

The buyback boom began with Bill Clinton’s 1993 attempt to reign in CEO pay. Clinton thought, incorrectly, that by restricting corporations to expensing only the first $1 million in CEO compensation for corporate tax purposes, corporate boards would limit the amount of money they doled out to CEO’s.

To Bill’s chagrin, corporations quickly shifted compensation schemes for their executives to stock-based compensation. Subsequently, CEO pay rose even higher, and the gap between profits and wages has become vastly distorted. Rising profitability, fewer employees, and increased productivity per employee has all contributed to the surging “wealth gap” between the rich and the poor.

In 1982, according to the Economic Policy Institute, the average CEO earned 50 times the average production worker. Today, the CEO Pay Ratio is 144 times the average worker with most of the gains a result of stock options and awards.

You can understand why it is a political “hot topic” for 2020.

The debate over share repurchases came to the fore following the tax cuts in December of 2017. The bill was targeted at corporations and lowered the tax rate from 35% to 21%. The tax cut plan was “sold” the the American public as a “trickle down” plan, and by giving money back to corporations; they would hire more workers, increase wages, and invest in America.

Unsurprisingly, it didn’t happen as the money primarily went to share repurchases.

The reality is that stock buybacks only create an illusion of profitability. Such activities do not spur economic growth or generate real wealth for shareholders, but it does provide the basis for with which to keep Wall Street satisfied and stock option compensated executives happy.

A recent study by the Securities & Exchange Commission supports this claim.

  • SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.

Jesse Fried also wrote for the WSJ:

“The real problem is that buybacks, unlike dividends, can be used to systematically transfer value from shareholders to executives. Researchers have shown that executives opportunistically use repurchases to shrink the share count and thereby trigger earnings-per-share-based bonuses.

Executives also use buybacks to create temporary additional demand for shares, nudging up the short-term stock price as executives unload equity.”

What is clear is that the misuse and abuse of share buybacks to manipulate earnings, and reward insiders has become problematic.

However, rather than hating capitalism, fix the legislation.

Most people have forgotten that share repurchases used to be illegal. Via Vox:

“Buybacks were illegal throughout most of the 20th century because they were considered a form of stock market manipulation. But in 1982, the Securities and Exchange Commission passed rule 10b-18, which created a legal process for buybacks and opened the floodgates for companies to start repurchasing their stock en masse.”

As William Lazonick via The Harvard Business Review noted, the problem is easily fixed:

If Americans want an economy in which corporate profits result in a shared prosperity, the buyback and executive compensation binges will have to end. As with any addiction, there will be withdrawal pains.” 

Unfortunately, given the incestuous relationship between Washington and Wall Street, there are no easy fixes, and banning share repurchases is probably a “horse that has left the barn.”

As Michael Lebowitz wrote in Short Term Pain, Long Term Gain.

Executives should be incentivized to promote the long-term health of their company, the prosperity of the employees who work for it, and the communities in which the employees live and work. These objectives contrast sharply with current decision-making behavior and demands balanced investment decisions, discipline, and quite often a measure of sacrifice in the short-run.”

The important point is that “capitalism” isn’t broken, but there is one aspect of the system which has morphed into something no one intended. 

As you hear candidates promising to “eat the rich,” remember “political narratives” designed to win votes is not always representative of what is best for you in the long run.

Debt & The Failure Of Monetary Policy To Stimulate Growth

A fascinating graphic was recently produced by Oxford Economics showing compounded economic growth rates over time.

What should immediately jump out at you is that the compounded rate of growth of the U.S. economy was fairly stable between 1950 and the mid-1980s. However, since then, there has been a rather marked decline in economic growth.

The question is, why?

This question has been a point of a contentious debate over the last several years as debt and deficit levels in the U.S. have soared higher.

Causation? Or Correlation?

As I will explain, the case can be made the surge in debt is the culprit of slowing rates of economic growth. However, we must start our discussion with the Keynesian theory, which has been the main driver both of fiscal and monetary policies over the last 30-years.

Keynes contended that ‘a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.’

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.”

Keynes’ was correct in his theory. In order for deficit spending to be effective, the “payback” from investments being made must yield a higher rate of return than the debt used to fund it.

The problem has been two-fold.

First, “deficit spending” was only supposed to be used during a recessionary period, and reversed to a surplus during the ensuing expansion. However, beginning in the early ’80s, those in power only adhered to “deficit spending part” after all “if a little deficit spending is good, a lot should be better,” right?

Secondly, deficit spending shifted away from productive investments, which create jobs (infrastructure and development,) to primarily social welfare and debt service. Money used in this manner has a negative rate of return.

According to the Center On Budget & Policy Priorities, roughly 75% of every tax dollar goes to non-productive spending. 

Here is the real kicker. In 2018, the Federal Government spent $4.48 Trillion, which was equivalent to 22% of the nation’s entire nominal GDP. Of that total spending, ONLY $3.5 Trillion was financed by Federal revenues and $986 billion was financed through debt.

In other words, if 75% of all expenditures is social welfare and interest on the debt, those payments required $3.36 Trillion of the $3.5 Trillion (or 96%) of revenue coming in

Do you see the problem here? (In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.”)

Debt Is The Cause, Not The Cure

This is one of the issues with MMT (Modern Monetary Theory) in which it is assumed that “debts and deficits don’t matter” as long as there is no inflation. However, the premise fails to hold up when one begins to pay attention to the trends in debt and economic growth.

I won’t argue that “debt, and specifically deficit spending, can be productive.” As I discussed in American Gridlock:

“The word “deficit” has no real meaning. Dr. Brock used the following example of two different countries.

Country A spends $4 Trillion with receipts of $3 Trillion. This leaves Country A with a $1 Trillion deficit. In order to make up the difference between the spending and the income, the Treasury must issue $1 Trillion in new debt. That new debt is used to cover the excess expenditures, but generates no income leaving a future hole that must be filled.

Country B spends $4 Trillion and receives $3 Trillion income. However, the $1 Trillion of excess, which was financed by debt, was invested into projects, infrastructure, that produced a positive rate of return. There is no deficit as the rate of return on the investment funds the “deficit” over time.

There is no disagreement about the need for government spending. The disagreement is with the abuse, and waste, of it.”

The U.S. is Country A.

Increases in the national debt have long been squandered on increases in social welfare programs, and ultimately higher debt service, which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt versus economic growth is all too evident, as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

The irony is that debt driven economic growth, consistently requires more debt to fund a diminishing rate of return of future growth. It now requires $3.02 of debt to create $1 of real economic growth.

However, it isn’t just Federal debt that is the problem. It is all debt.

When it comes to households, which are responsible for roughly 2/3rds of economic growth through personal consumption expenditures, debt was used to sustain a standard of living well beyond what income and wage growth could support. This worked out as long as the ability to leverage indebtedness was an option. Eventually, debt reaches levels where the ability to consume at levels great enough to foster stronger economic growth is eroded.

For the 30-year period from 1952 to 1982, debt-free economic growth was running a surplus. However, since the early 80’s, total credit market debt growth has sharply eclipsed economic growth. Without the debt to support economic growth, there is currently an accumulated deficit of more than $50 Trillion.

What was the difference between pre-1980 and post-1980?

From 1950-1980, the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%.

There were a couple of reasons for this.

  1. Lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy.
  2. The economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy.  

The obvious problem is the ongoing decline in economic growth. Over the past 35 years, slower rates of growth has kept the average American struggling to maintain their standard of living. As wage growth stagnates, or declines, consumers are forced to turn to credit to fill the gap in maintaining their current standard of living. (The chart below is the inflation-adjusted standard of living for a family of four as compared to disposable personal incomes and savings rate. The difference comes from debt which now exceeds $3400 per year.)

It isn’t just personal and corporate debt either. Corporations have also gorged on cheap debt over the last decade as the Fed’s “Zero Interest Rate Policy” fostered a scramble for cash for diminishing investment opportunities, such as share buybacks. These malinvestments ultimately have a steep payback.

We saw this movie play out “real-time” previously in everything from sub-prime mortgages to derivative instruments. Banks and institutions milked the system for profit without regard for the risk. Today, we see it again in non-financial corporate debt. To wit:

“And while the developed world has some more to go before regaining the prior all time leverage high, with borrowing led by the U.S. federal government and by global non-financial business, total debt in emerging markets hit a new all time high, thanks almost entirely to China.”

“Chinese corporations owed the equivalent of more than 155% of Global GDP in March, or nearly $21 trillion, up from about 100% of GDP, or $5 trillion, two decades ago.”

The Debt End Game

Unsurprisingly, Keynesian policies have failed to stimulate broad based economic growth. Those fiscal and monetary policies, from TARP, to QE, to tax cuts, only delayed the eventual clearing process. Unfortunately, the delay only created a bigger problem for the future. As noted by Zerohedge:

“The IIF pointed out the obvious, namely that lower borrowing costs thanks to central banks’ monetary easing had encouraged countries to take on new debt. Amusingly, by doing so, this makes rising rates even more impossible as the world’s can barely support 100% debt of GDP, let alone 3x that.”

Ultimately, the clearing process will be very substantial. As noted above, with the economy currently requiring roughly $3 of debt to create $1 of economic growth, a reversion to a structurally manageable level of debt would involve a nearly $40 Trillion reduction of total credit market debt from current levels. 

This is the “great reset” that is coming.

The economic drag from such a reduction in debt would be a devastating process. In fact, the last time such a reversion occurred, the period was known as the “Great Depression.”

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns, and a stagflationary environment as wages remain suppressed while cost of living rise.

The problem of debt will continue to be magnified by the changes in structural employment, demographics, and deflationary pressures derived from changes in productivity. As I showed previously, this trend has already been in place for the last decade and will only continue to confound economists in the future.

“The U.S. is currently running at lower levels of GDP, productivity, and wage growth than before the last recession. While this certainly doesn’t confirm Shelton’s analysis, it also doesn’t confirm the conventional wisdom that $33 Trillion in bailouts and liquidity, zero interest rates, and surging stock markets, are conducive to stronger economic growth for all.”

Correlation or causation? You decide.

The Economic Consequences Of Debt

Not surprisingly, my recent article on “The Important Role Of Recessions” led to more than just a bit of debate on why “this time is different.” The running theme in the debate was that debt really isn’t an issue as long as our neighbors are willing to support continued fiscal largesse.

As I have pointed out previously, the U.S. is currently running a nearly $1 Trillion dollar deficit during an economic expansion. This is completely contrary to the Keynesian economic theory.

Keynes contended that ‘a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.’  In other words, when there is a lack of demand from consumers due to high unemployment, the contraction in demand would force producers to take defensive actions to reduce output.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity, and reducing unemployment and deflation.  

Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.”

Of course, with the government already running a massive deficit, and expected to issue another $1.5 Trillion in debt during the next fiscal year, the efficacy of “deficit spending” in terms of its impact to economic growth has been greatly marginalized.

The main issue is that government spending has shifted away from productive investments which create jobs (infrastructure and development) to primarily social welfare and debt service which has a negative rate of return. As I showed on Friday, according to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

Here is the real kicker,

Through the second quarter of this year, the Federal Government has spent $4.45 Trillion which was equivalent to 24% of the nation’s entire GDP. Of that total spending, only $3.47 Trillion was financed by Federal revenues leaving $983 billion to be financed with debt. In other words, it took all of the revenue received by the Government just to cover social welfare and service interest on the debt.

In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.” 

Debt Is The Cause, Not The Cure

I am not saying that all debt is bad.

Debt, if used for productive investments, can be a solution to stimulating economic growth in the short-term. This past couple of quarters was a good example of this as the spending on defense and rebuilding from 3-major hurricanes last year pushed economic activity up in 2018. (Read: Tax Cuts Saved The Economy?)

“As we discussed recently with Danielle Dimartino-Booth, it came from a “sugar-high” created by 3-massive Hurricanes in 2017 which have required billions in monetary stimulus, created jobs in manufacturing and construction, and led to an economic lift. We saw the same following the Hurricanes in 2012 as well.”

However, these “sugar highs” are temporary in nature. The problem is the massive surge in unbridled deficit spending which provides the temporary illusion of economic growth simply “pulls forward” future consumption leaving a void that must be filled.

Since the bulk of the debt issued by the U.S. has been squandered on increases in social welfare programs and debt service, there is a negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

It now requires nearly $3.00 of debt to create $1 of economic growth.

Another way to view the impact of debt on the economy is to look at what “debt-free” economic growth would be. In other words, without debt, there has actually been no organic economic growth.

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy expected to grow at just 2% over the long-term, the economic deficit has never been greater.

But it isn’t just Federal debt that is the problem. It is all debt.

When it comes to households, which are responsible for roughly 2/3rds of economic growth through personal consumption expenditures, debt was used to sustain a standard of living well beyond what income and wage growth could support. This worked out as long as the ability to leverage indebtedness was an option. The problem is that when rising interest rates hit a point where additional leverage becomes problematic, further economic cannot be achieved.

Given the massive increase in deficit spending by households to support consumption, the “bang point” between rates and the economy is likely closer than most believe.

What was the difference between pre-1980 and post-1980?

From 1950-1980, the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 160%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy. This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980.

The obvious problem is the ongoing decline in economic growth over the past 35 years has kept the average American struggling to maintain their standard of living. As real wage growth remains primarily stagnate, consumers are forced to turn to credit to fill the gap in maintaining their current standard of living. However, as more leverage is taken on, the more dollars are diverted from consumption to debt service thereby weighing on stronger rates of economic growth. I have shown this gap previously.

Debt Doesn’t Create Real Growth

The massive indulgence in debt has simply created a “credit-induced boom” which has now reached its inevitable conclusion. While the Federal Reserve believed that creating a “wealth effect” by suppressing interest rates to allow cheaper debt creation would repair the economic ills of the “Great Recession,” it only succeeded in creating an even bigger “debt bubble” a decade later.

This unsustainable credit-sourced boom led to artificially stimulated borrowing which pushed money into diminishing investment opportunities and widespread mal-investments. In 2007, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk. Today, we see it again in accelerated stock buybacks, low-quality debt issuance, debt-funded dividends, and speculative investments.

When credit creation can no longer be sustained, the markets must clear the excesses before the next cycle can begin. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE, to tax cuts, only delay the clearing process. Ultimately, that delay only deepens the process when it begins.

The biggest risk in the coming recession is the potential depth of that clearing process. With the economy currently requiring roughly $3 of debt to create $1 of economic growth. A reversion to a structurally manageable level of debt would involve a nearly $40 Trillion reduction of total credit market debt from current levels. 

The economic drag from such a reduction would be a devastating process which is why Central Banks worldwide are terrified of such a reversion. In fact, the last time such a reversion occurred the period was known as the “Great Depression.”

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns, and a stagflationary environment as wages remain suppressed while costs of living rise.

Debt – Is it just “correlation,” or is it “causation?”

You decide.

But one thing we know for sure is that “debt matters.” 

Is The Ballooning Debt Really Inflationary?

Last week, Kevin Muir wrote a very interesting piece on debt and whether it is inflationary or deflationary. To wit:

“One of the greatest debates within the financial community centers around debt and its effect on inflation and economic prosperity. The common narrative is that government deficits (and the ensuing debt) are bad. It steals from future generations and merely brings forward future consumption. In the long run, it creates distortions, and the quicker we return to balancing our books, the better off we will all be.”

As he states, he is no fan of the Paul Krugman’s “all stimulus is good stimulus” philosophy.

Neither am I.

While I agree with the majority of Kevin’s views regarding the impact of debt on the inflation/deflation debate, I do disagree on the following point:

Creating debt is inflationary, while paying down debt is deflationary. That’s pretty basic.

The easiest way for me to demonstrate this fact is to look at an area where debt has been created for spending in a specific area. No better example than student loans.

Over the past fifteen years, inflation in college tuition has exploded. It’s been absolutely bonkers. Here is the chart of regular CPI versus tuition CPI.”

He is correct, debt used to directly make a purchase of a service or product is inflationary.

I agree 100% with Kevin in his prognosis of how debt effects prices in the short term.  However as I will explain, it is the servicing of debt (paying interest and principal) over the long run that applies deflationary pressures to the economy.

As he states this is basic.

If I have $100 then I can buy $100 worth of goods. That’s it. However, if I am able to borrow an additional $200, then I can buy $300 worth of goods. When there is more demand, due to leverage, the price of the product or service will rise.

This is what happened with student loans. When the government took over student loan debt and assured everyone that money was readily available, Universities cheered as they could raise tuition beyond what students could previously afford. The more debt that was given out, the higher tuition went.

As I have explained before there is good and bad inflation.

Inflationary pressures can be representative of expanding economic strength if it is reflected in the stronger pricing of both imports and exports as well as wages. Increases in prices would suggest stronger consumptive demand, which is 2/3rds of economic growth, and increases in wages allows for absorption of higher prices.

That would be the good.

As shown below, there has been a modest uptick in import and export prices due to the demand generated by the slate of natural disasters last year BUT import and export prices are currently only back to levels last seen in 2008. This isn’t surprising given the weakness in wage growth which combined suggests there is little “good” inflationary pressure presently.

The “bad”: would be inflationary pressures in areas which are direct expenses to the household. Such increases curtail consumptive demand, which negatively impacts pricing pressure, by diverting consumer cash flows into non-productive goods or services.

Take a look at where consumers are being impacted the most.

The largest areas of the CPI inflation calculation, are specifically the areas where consumers have the least amount of control. Escalating rent, utilities, food, and health care are the biggest constituents of the “non-discretionary family budget.” While consumers are spending more on these areas, the economic impact is negligible as paying more for food, rent, utilities and health care does not increase the demand for these products and services which would create stronger rates of economic growth.

Those rising costs combined with the lack of wages leaves a family little choice to fund their “standard of living.” As I discussed in “Sex, Money & Happiness:”

“The ‘gap’ between the ‘standard of living’ and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the ‘gap.’

However, following the ‘financial crisis,’ even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $7000 annual deficit that cannot be filled.”

In the past, when Americans wanted to expand their consumption beyond the constraint of incomes they turned to credit in order to leverage their consumptive purchasing power. Steadily declining interest rates and lax lending standards put excess credit in the hands of every American. Such is why, during the 80’s and 90’s, as the ease of credit permeated its way through the system, the standard of living seemingly rose in America even while economic growth slowed along with incomes.

Despite seemingly increasing levels of consumption, actual inflation pressures have continued to erode as shown below.

Now, let me back up for a minute.

Kevin is correct that debt, when consumers borrow money to buy stuff (cars, houses, washers, dryers, computers) leads to a demand push of inflation in the short-term. However, the use of debt is deflationary over the long-term as debt service redirects consumptive spending into debt service. Said differently, if you buy on credit today, you must make payments tomorrow that inhibit your ability to purchase stuff.

There is simply a limit to what consumers can generate for income and to the amount of debt they can absorb.

Same Goes For Government Debt

The same goes for Government debt as well. As discussed in “The Debtors Prism:”

“In order for government deficit spending to be effective, the ‘payback’ from investments being made through debt must yield a higher rate of return than the debt used to fund it.

The problem is that government spending has shifted away from productive investments that create jobs (infrastructure and development) to primarily social welfare and debt service which has a negative rate of return. According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar now goes to non-productive spending.” 

“In 2017, the Federal Government spent an estimated $4.3 Trillion which was equivalent to roughly 21% of the nation’s entire GDP. Of that total spending, an estimated $3.68 Trillion was financed by Federal revenues leaving $657 billion to be financed through debt. In other words, it took almost all of the revenue received by the Government just to cover social welfare programs and service the interest on the debt.”

For the average person, these social benefits are critical to their survival as they make up more than 22% of real disposable personal incomes. With 1/5 of incomes dependent on government transfers, it is not surprising that the economy continues to struggle as recycled tax dollars used for consumption purposes have virtually no impact on the overall economy.

If debt was truly inflationary in the long-term, then we should actually see two things occurring.

The first would be a DECREASING level of debt to create economic growth as debt would be leveraging accelerating rates of growth. Unfortunately, it is quite the opposite as it is requiring an ever increasing level of “economic debt” to only modestly increase economic growth. Currently, it requires $3.11 of debt to create $1 of economic growth. (Note: for this exercise, “economic debt” is the combined amount of household, corporate and publicly held government debt. All data is in nominal terms)

Secondly, we should also see rising rates of inflation as debt increases. Again, we see the opposite.

The difference between the Government and households is there is no real limit on how much debt the Government can issue. But that is also why economic growth remains constrained at sub-par levels despite “hopes” of a resurgence.

Debt actually is deflationary on a longer-term basis as it acts as a “cancer” siphoning potential savings from income to service the debt. Rising levels of debt, means rising levels of debt service that reduces actual “disposable” incomes, both personal and governmental, that could be saved or reinvested back into the economy.

The mirage of economic growth has been a function of surging debt levels. “Wealth” is not borrowed, but “saved,” and this is a lesson has yet to be learned.

About the only thing that is “inflationary” about debt over the long-term is simply the amount of debt itself.

Until the deleveraging cycle is allowed to occur, and household balance sheets return to more sustainable levels, the attainment of stronger, and more importantly, self-sustaining economic growth could be far more elusive than currently imagined.

However, Kevin is absolutely correct that we will do nothing to correct the problem before “the collision” eventually occurs: To wit:

“Governments were faced with a choice during the 2008 Great Financial Crisis. Credit was naturally contracting, and the economy wanted to go through a cleansing economic rebalancing where debt would be destroyed through a severe recession. Yet, governments had practically zero appetite to allow this sort of cathartic cleansing to happen. Instead, they stepped up and stopped the credit contraction through government spending and quantitative easing.”

We had the opportunity to restore economic balance and we blew it. Of course, since fiscal conservatism left the country decades ago, there is little to stop the debt driven economy until, as Kevin put it, “the bond market takes away the keys.”

The Debtor’s Prism

As noted by Robert Schroeder:

“Last week, the debt hit $21 trillion for the first time, rising from the $20 trillion mark it notched on Sept. 8. The debt is guaranteed to go higher, with President Donald Trump having signed a debt-limit suspension in February, allowing unlimited borrowing through March 1, 2019. Economists expect wider deficits to result from the tax cut Trump signed in December.

While a trillion-dollar increase over roughly six months isn’t unprecedented — there was one in 2009, during the Great Recession, and another in 2010 — it’s certainly fast.”

Excessive borrowing by companies, households or governments lies at the root of almost every economic crisis of the past four decades, from Mexico to Japan, and from East Asia to Russia, Venezuela, and Argentina. But it’s not just countries, but companies as well. You don’t have to look too far back to see companies like Enron, GM, Bear Stearns, Lehman and a litany of others brought down by surging debt levels and simple “greed.” Households too have seen their fair share of debt burden related disaster from mortgages to credit cards to massive losses of personal wealth.

It would seem that after nearly 40-years, some lessons would have been learned.

Apparently not, as Congressional lawmakers once again are squabbling on not how to “save money” and “reduce the federal debt,” but rather “damn the debt, full speed ahead with spending.”

Such reckless abandon by politicians is simply due to a lack of “experience” with the consequences of debt.

In 2008, Margaret Atwood discussed this point in a Wall Street Journal article:

“Without memory, there is no debt. Put another way: Without story, there is no debt.

A story is a string of actions occurring over time — one damn thing after another, as we glibly say in creative writing classes — and debt happens as a result of actions occurring over time. Therefore, any debt involves a plot line: how you got into debt, what you did, said and thought while you were in there, and then — depending on whether the ending is to be happy or sad — how you got out of debt, or else how you got further and further into it until you became overwhelmed by it, and sank from view.”

The problem today is there is no “story” about the consequences of debt in the U.S. While there is a litany of other countries which have had their own “debt disaster” story, those issues have been dismissed under the excuse of “yes, but they aren’t the U.S.”

As I discussed recently in relation to the tax cut/reform package passed by Congress last year:

“Of course, the real question is how are you going to ‘pay for it?’

Even as Kevin Brady noted in our interview, when I discussed the ‘fiscal’ side of the tax reform bill, without achieving accelerated rates of economic growth – ‘the debt will balloon.’”

It is pretty simplistic math:

Cut revenue by $2 Trillion + add $2 Trillion is spending = $4 Trillion shortfall.

While it is true the debt doesn’t have to be repaid today, it does have to be serviced.

Committee for a Responsible Federal Budget president Maya MacGuineas recently published a commentary describing how interest is on a path to quadruple over the next decade, reaching over $1 trillion per year.

“Interest on the debt is the fastest growing part of the budget. While interest had already been projected to rise rapidly the recent tax and budget deals will significantly accelerate that growth. As a result, our latest estimate finds interest costs will almost quadruple between 2017 and 2028 in dollar terms and reach their highest share of Gross Domestic Product (GDP) in history.

As recently as last June, the Congressional Budget Office (CBO) projected interest spending would grow to above $800 billion and nearly 3 percent of GDP by 2027 as a result of rising interest rates and growing debt levels. Since then, lawmakers have added an additional $2.4 trillion to deficits over the next decade, and it will most certainly result in higher interest payments.

By our estimates, annual interest spending will rise from $263 billion (1.4 percent of GDP) in 2017 to $965 billion, or 3.3 percent of GDP, in 2028. The 3.3 percent of GDP total for interest in 2028 would be the highest on record. The previous record was 3.2 percent of GDP in 1991, a time when debt as a percent of GDP was much lower but interest rates were much higher. Under our “Alternative Scenario,” which assumes policymakers borrow an additional $3.6 trillion through 2028, interest spending will rise to $1.05 trillion, or 3.6 percent of GDP, by 2028.”

The Wrong Kind Of Debt

By the end of 2018, the United States, based on its current trajectory, will achieve a new TOP 10 ranking.

“Tell us what we’ve won Bob:

Coming in at #10 – the United States, at 111%, gets nothing but the privilege of being on the list of countries with the highest debt/GDP ratios.”

According to Keynesian theory, some microeconomic-level actions, if taken collectively by a large proportion of individuals and firms, can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession).

Keynes contended:

“A general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  

In other words, when there is a lack of demand from consumers due to high unemployment, the contraction in demand would force producers to take defensive actions to reduce output.

In such a situation, Keynesian economics states:

“Government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.”

Keynes’ was correct in his theory”

In order for government deficit spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

Read that again.

The problem is that government spending has shifted away from productive investments that create jobs (infrastructure and development) to primarily social welfare and debt service which has a negative rate of return.

According to the Center On Budget & Policy Prioritiesnearly 75% of every tax dollar goes to non-productive spending. 

In 2017, the Federal Government spent an estimated $4.3 Trillion which was equivalent to roughly 21% of the nation’s entire GDP. Of that total spending, an estimated $3.68 Trillion was financed by Federal revenues leaving $657 billion to be financed through debt. In other words, it took almost all of the revenue received by the Government just to cover social welfare programs and service the interest on the debt. 

Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

It now requires $3.71 of debt to create $1 of economic growth.

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy growing at an average rate of just 2%, the economic deficit has never been greater.

The unsustainable credit-sourced boom, which leads to artificially stimulated borrowing, has sought out diminishing investment opportunities. Ultimately these diminished investment opportunities lead to widespread mal-investments. Not surprisingly, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which were only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk.

We see it again today with companies issuing massive amounts of debt to buy back unprecedented levels of outstanding shares and issues dividends.

The illusion of economic growth has been fueled by ever increasing levels of debt to support consumption. However, if you back out the level of debt you get a better picture of what is actually happening economically.

When credit creation can no longer be sustained the markets must begin to clear the excesses before the cycle can begin again. That clearing process is going to be very substantial. With the economy currently requiring roughly $3.50 of debt to create $1 of economic growth, the reversion to a structurally manageable level of debt would involve a $25 trillion reduction of total credit market debt from current levels.

The economic drag from such a reduction would be a devastating process, and why Central Banks worldwide are terrified of it. In fact, the last time such a reversion occurred it became known as the “Great Depression.”

Now you understand “why,” despite tax cuts and reforms, the economy continues to grow at sub-par levels. Heading into the future, given the Administrations inability to curb their “spending addiction,” it is highly likely we will witness an economy plagued by more frequent recessionary spats, lower equity market returns and a stagflationary environment as wages remain suppressed while costs of living rise.

Sure, $21 trillion isn’t a problem as long as we “print the money” necessary to make those payments. However, the longer-term consequences of doing so has a very negative consequence. One of those consequences is the ongoing detraction from economic growth.

As Ms. Atwood concluded:

“There’s nothing we human beings can imagine, including debt, that can’t be turned into a game — something done for entertainment. And, in reverse, there are no games, however frivolous, that cannot also be played very seriously, and sometimes very unpleasantly.

But when the play turns nasty in dead earnest, the game becomes what Eric Berne calls a ‘hard game.’

In hard games the stakes are high, the play is dirty, and the outcome may well be a puddle of gore on the floor.”

There is likely only one way the current lack of fiscal control turns out. History is replete with countries that have attempted the same. For now, the limits of profligate spending by Washington has not been reached and the ending of this particular story has not yet been written. But it eventually will be.

Just be careful where you step.

There Will Be No Economic Boom – Part II

On Tuesday, I presented at the Financial Planning Association (FPA) Conference in Houston at which I discussed the issues surrounding financial planning in an environment of high valuations and low forward returns. After my presentation, a few CFP’s approached me to discuss the premise that recent “tax cuts/reforms” will lead to a resurgence of economic growth which will boost earnings and therefore negate the overvaluation problem.

This is unlikely to be the case and something that I discussed recently in “There Will Be No Economic Boom.”  However, that article focused on the impact of the passage of the 2-year “Continuing Resolution” which will lead to a surge in the national deficit as unconstrained spending negates the effect of “tax reform” on the U.S. economy.

But there is more to this story.

When the “tax cut” bill was being passed, everyone from Congress to the mainstream media, and even the CFP’s I spoke with yesterday, regurgitated the same “storyline:”

“Tax cuts will lead to an economic boom as corporations increase wages, hire and produce more and consumers have extra money in their pockets to spend.” 

As I have written many times previously, this was always more “hope” than “reality.”

Let me explain.

The economy, as we currently calculate it, is roughly 70% driven by what you and I consume or “personal consumption expenditures (PCE).” The chart below shows the history of real, inflation-adjusted, PCE as a percent of real GDP.

If “tax cuts” are going to substantially increase the growth rate of the U.S. economy, as touted by the current Administration, then PCE has to be directly targeted.

However, while the majority of consumers will receive an “average” of $1182 in the form of a tax reduction, (or $98.50 a month), the increase in take-home pay has already been offset by surging health care cost, rent, energy and higher debt service payments. As shown in the table below – the biggest constituents of the “non-discretionary family budget” are rising the most.

So, since tax-cuts, by themselves, are unlikely to offset rising prices of essential goods and services it’s hard to see how they fuel a significant surge in consumer spending.

“No problem. The ‘windfall’ to corporations (since that is where the bulk of the tax-reform legislation was focused) will lead to a surge in employment, higher wages and increased production.

After all, since corporations can now repatriate those ‘trillions of dollars’ sitting overseas they will surely be magnanimous of enough to ‘share the wealth’ with the workers. Right?

Maybe. But anyone who has watched corporate behavior since the “financial crisis,” should know that such a belief is heavily flawed.

However, now that we are a couple of months into the New Year, the data is in and we can see exactly what “corporations” are doing with their dollars.

Wage Increases

Immediately after the passage of the tax reform bill, companies lined up to garner “political favor” by issuing out $1000 bonus checks to employees. While the mainstream media, and the White House, gushed over the “immediate success” of tax reform, the bigger picture was entirely missed.

A $1000 bonus to an employee is a one-time “feel good” event. Wage increases are “permanent and costly.”

The reality is that companies are NOT increasing wages because higher wages increase tax liability, benefit costs, etc. Higher payroll costs erode bottom line profitability. In an economy with very weak top-line revenue growth, companies are extremely protective of profitability to meet Wall Street estimates and support their share price which directly impacts executive compensation.

So, while companies are gaining media attention, and political favor, by issuing one-time bonus checks; the bottom 80% of workers are falling woefully behind the top 20%.

Wages are failing to keep up with even historically low rates of “reported” inflation. Again, we point out that it is likely that your inflation, if it includes the non-discretionary items listed above, is higher than “reported” inflation and the graph below is actually worse than it appears.

But this is nothing new as corporations have failed to “share the wealth” for the last couple of decades.

Buybacks

The conundrum from “corporate executives” is that if consumers don’t have more money to spend, they can’t buy the goods and services offered which drives corporate revenue. If revenue does not substantially rise at the top line, profits will be impacted at the bottom line ultimately threatening “executive compensation.”

Not surprisingly, the easiest cure for that little problem has been, and remains, share buybacks. As I discussed previously:

“The use of ‘share buybacks’ to win the ‘beat the estimate’ game should not be readily dismissed by investors. One of the primary tools used by businesses to increase profitability has been through the heavy use of stock buybacks. The chart below shows outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buybacks.”

I want to draw your attention to the bottom part of the graph Since 2009, the TOTAL growth in sales per share has only been 39% or roughly 3.9% a year and yet earnings grew at 253% or roughly 25.3% a year. The 21.4% differential has been heavily driven by the reduction in shares outstanding.

The important point here is that 70% of the economy is driven by consumption and the very weak rates of sales (or consumption) show why economic growth remains weak.

So, are companies using their newfound wealth to boost wages? Not so much. As Jesse Colombo recently showed:

“The passing of President Donald Trump’s tax reform plan was the primary catalyst that encouraged corporations to dramatically ramp up their share buyback plans.”

SP500 Buybacks & Dividends By Year

Dividends

Of course, corporate executives (who tend to own a LOT of company stock and options) can also reward themselves through increases in the dividend payout.  Not surprisingly, as noted by Political Calculations, corporate boards have used the recent tax reform to their advantage.

“When it comes to the number of dividend increases declared during a single month, the U.S. stock market just recorded its best February ever.”

Conclusion

This issue of whether tax cuts lead to economic growth was examined in a 2014 study by William Gale and Andrew Samwick:

“The argument that income tax cuts raise growth is repeated so often that it is sometimes taken as gospel.However, theory, evidence, and simulation studies tell a different and more complicated story. Tax cuts offer the potential to raise economic growth by improving incentives to work, save, and invest. But they also create income effects that reduce the need to engage in productive economic activity, and they may subsidize old capital, which provides windfall gains to asset holders that undermine incentives for new activity.

In addition, tax cuts as a stand-alone policy (that is, not accompanied by spending cuts) will typically raise the federal budget deficit. The increase in the deficit will reduce national saving — and with it, the capital stock owned by Americans and future national income — and raise interest rates, which will negatively affect investment. The net effect of the tax cuts on growth is thus theoretically uncertain and depends on both the structure of the tax cut itself and the timing and structure of its financing.”

While tax cuts CAN be pro-growth, they have to focused on the 80% of American’s that make up the majority of the consumption in the economy. With the benefits of tax cuts being hoarded by the top-20%, which already consume at capacity, there is little propensity to substantially increase consumption as opposed to the accumulation of further wealth.

Furthermore, tax reform does little to address the major structural challenges which provide the greatest headwinds for the economy in the future:

  • Demographics
  • Structural employment shifts
  • Technological innovations
  • Globalization
  • Pensions
  • Financialization 
  • Debt

These challenges have permanently changed the financial underpinnings of the economy as a whole. This would suggest that the current state of slow economic growth is likely to be with us for far longer than most anticipate. It also puts into question just how much room the Fed has to extract its monetary support before the cracks in the economic foundation begin to widen.

Simply, until you can substantially increase the consumptive capability of the bottom 80%, there will be no “economic boom.” 

Debt vs Growth: Correlation or Causation

Recently, my article on weak economic underpinnings led to an interesting exchange, via Twitter, with Steve Chapman regarding debt and the impact on economic growth.

This question has been a point of contentious debate over the last several years as debt levels in the U.S. have soared higher.

According to Keynesian theory, some microeconomic-level actions, if taken collectively by a large proportion of individuals and firms, can lead to inefficient aggregate macroeconomic outcomes, where the economy operates below its potential output and growth rate (i.e. a recession).

Keynes contended that a general glut would occur when aggregate demand for goods was insufficient, leading to an economic downturn resulting in losses of potential output due to unnecessarily high unemployment, which results from the defensive (or reactive) decisions of the producers.”  In other words, when there is a lack of demand from consumers due to high unemployment, the contraction in demand would force producers to take defensive actions to reduce output.

In such a situation, Keynesian economics states that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

Keynes’ was correct in his theory. In order for government deficit spending to be effective, the “payback” from investments being made through debt must yield a higher rate of return than the debt used to fund it.

The problem is that government spending has shifted away from productive investments that create jobs (infrastructure and development) to primarily social welfare and debt service which has a negative rate of return.  According to the Center On Budget & Policy Priorities nearly 75% of every tax dollar goes to non-productive spending. 

policybasics-wheretaxdollarsgo-f1

Here is the real kicker, though. In 2014, the Federal Government spent $3.5 Trillion which was equivalent to 20% of the nation’s entire GDP. Of that total spending, $3.15 Trillion was financed by Federal revenues and $485 billion was financed through debt. In other words, it took almost all of the revenue received by the Government just to cover social welfare and service interest on the debt. In the financial markets, when you borrow from others to pay obligations you can’t afford it is known as a “Ponzi-scheme.” 

Debt Is The Cause, Not The Cure

Debt, if used for productive investments, can be a solution to stimulating economic growth in the short-term. However, in the U.S., debt has been squandered on increase in social welfare programs and debt service which has an effective negative return on investment. Therefore, the larger the balance of debt becomes, the more economically destructive it is by diverting an ever growing amount of dollars away from productive investments to service payments.

The relevance of debt growth versus economic growth is all too evident as shown below. Since 1980, the overall increase in debt has surged to levels that currently usurp the entirety of economic growth. With economic growth rates now at the lowest levels on record, the growth in debt continues to divert more tax dollars away from productive investments into the service of debt and social welfare.

Debt-GDP-Presdient-022216

It now requires $3.71 of debt to create $1 of economic growth.

Debt-GDP-Growth-022216

In fact, the economic deficit has never been greater. For the 30-year period from 1952 to 1982, the economic surplus fostered a rising economic growth rate which averaged roughly 8% during that period. Today, with the economy growing at an average rate of just 2%, the economic deficit has never been greater.

Debt-Economic-Deficit-022216

But it isn’t just Federal debt that is the problem. It is all debt.

When it comes to households, which are responsible for roughly 2/3rds of economic growth through personal consumption expenditures, debt was used to sustain a standard of living well beyond what income and wage growth could support. This worked out as long as the ability to leverage indebtedness was an option. The problem is that eventually, the debt reaches a level where the level of debt service erodes the ability to consume at levels great enough to foster stronger economic growth.

In reality, the economic growth of the U.S. has been declining rapidly over the past 35 years supported only by a massive push into deficit spending by households.

Debt-Total-GDP-022216

What was the difference between pre-1980 and post-1980?

From 1950-1980, the economy grew at an annualized rate of 7.70%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There were a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily on production and manufacturing which has a high multiplier effect on the economy.  This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980.

The obvious problem is the ongoing decline in economic growth over the past 35 years has kept the average American struggling to maintain their standard of living. As wage growth stagnates or declines, consumers are forced to turn to credit to fill the gap in maintaining their current standard of living. However, as more leverage is taken on, the more dollars are diverted from consumption to debt service thereby weighing on stronger rates of economic growth.

Austrian’s Might Have It Right

The massive indulgence in debt, what the Austrians refer to as a “credit induced boom”, has now reached its inevitable conclusion.  The unsustainable credit-sourced boom, which leads to artificially stimulated borrowing, seeks out diminishing investment opportunities. Ultimately these diminished investment opportunities lead to widespread mal-investments. Not surprisingly, we clearly saw it play out “real-time” in everything from sub-prime mortgages to derivative instruments which was only for the purpose of milking the system of every potential penny regardless of the apparent underlying risk.

Debt-Austrian-Theory-022216

When credit creation can no longer be sustained the markets must begin to clear the excesses before the cycle can begin again. It is only then, and must be allowed to happen, can resources be reallocated back towards more efficient uses. This is why all the efforts of Keynesian policies to stimulate growth in the economy have ultimately failed. Those fiscal and monetary policies, from TARP and QE to tax cuts, only delay the clearing process. Ultimately, that delay only potentially worsens the inevitable clearing process.

That clearing process is going to be very substantial. The economy is currently requiring roughly $4 of debt to create $1 of economic growth. A reversion to a structurally manageable level of debt would involve a nearly $30 Trillion reduction of total credit market debt from current levels. 

Debt-Structurally-Maintainable-Level-022216

The economic drag from such a reduction would be a devastating process which is why Central Banks worldwide are terrified of such a reversion. In fact, the last time such a reversion occurred the period was known as the “Great Depression.”

Debt-GDP-Annual-022216

This is one of the primary reasons why economic growth will continue to run at lower levels going into the future. We will witness an economy plagued by more frequent recessionary spats, lower equity market returns and a stagflationary environment as wages remain suppressed while costs of living rise.

Correlation or causation? You decide.

Lance Roberts

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Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter, and Linked-In

The Economy In Pictures – Seen This Before

Last week, I gave a presentation discussing the current market environment and the economy. As I was preparing the slide presentation, I noted some concerning similarities to a presentation that I gave in 2007. At that time, I was regularly discussing the potential onset of an economic recession, and then like now, I was dismissed as being a “perma-bear.” There was no inverted yield curve, the vast majority of the media saw no recession in sight, and the Federal Reserve continued to tout a “Goldilocks” economy. Yet, a year later, it was quite evident. 

Currently, there is a plethora of commentary strongly suggesting that the U.S. economy is nowhere near recession currently. That may very well be the case, however, by the time the data is revised to reveal the recession it will be far too late for investors to do anything about it. The market, a coincident indicator of economic recessions historically, may already be revealing future economic data revisions will eventually disclose.

With the economy now more than 6-years into an expansion, which is long by historical standards, the question for you to answer by looking at the charts below is:

“Are we closer to an economic recession or a continued expansion?”

How you answer that question should have a significant impact on your investment outlook as financial markets tend to lose roughly 30% on average during recessionary periods.  However, with margin debt at record levels, earnings deteriorating and junk bond yields rising, this is hardly a normal market environment within which we are currently invested.

If you have any questions, or comments, you can email me or send me a tweet:  @lanceroberts


Leading Economic Indicators

LEI-Coincident-Lagging-012016

Durable Goods

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Durable-Goods-020816-2

Investment

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Private-Investment-GDI-020816

GDI-SP500-020816

ISM Composite Index

ISM-Composite-020816

Employment & Industrial Production

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Capacity-Utilization-Production-020816

Retail Sales

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Retail-Sales-EconomicCycle-012016

PCE & Imports

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Corporate Profits As % Of GDP

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The Broad View

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If you are expecting an economic recovery, and a continuation of the bull market, then the economic data must begin to improve markedly in the months ahead. The problem has been that each bounce in the economic data has failed within the context of a declining trend. This is not a good thing and is why we continue to witness an erosion  in the growth rates of corporate earnings and profitability.  Eventually, that erosion combined, with excessive valuations, will weigh on the financial markets.

For the Federal Reserve, these charts make the case that continued monetary interventions are not healing the economy, but rather just keeping it afloat by dragging forward future consumption.  The problem now is the Fed has opted, by tightening monetary policy, to not “refill the punchbowl.” Eventually, when the drinks run out, the party comes to an end.

With the Fed hiking interest rates, and talking a tough game of continued economic strength, the risk of a “policy error” has risen markedly in recent months. The markets, falling inflation indicators, and plunging interest rates are all suggesting the same.

Lance Roberts

lance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of “The Lance Roberts Show” and Chief Editor of the “Real Investment Advice” website and author of “Real Investment Daily” blog and “Real Investment Report“. Follow Lance on Facebook, Twitter and Linked-In