The End Game Draws Nigh

From John Mauldin's Outside the Box blog, comes this essay from Dr. Woody Brock (his website is www.sedinc.com), on the debt-to-GDP ratio, and the consequences of increasing debt faster than GDP.

An excerpt:

Preface: In this new report, we link together three quite different concepts that have been discussed in these publications during recent years. First, the problems posed for classical fiscal and monetary policy when extremely large deficits must be financed; second, the critical importance of the rate of economic growth as primus inter pares of all economic variables; and third, the all-important concept of "incentive-structure-compatibility" introduced by Leonid Hurwicz in the 1960s, and recognized in the award to him in 2007 of the Nobel Memorial Prize.

We weave these three concepts together so as to make possible an extension and generalization of "macroeconomic policy" as normally understood. Central to this extension is the need for policies that drive down the nation's Debt-to-GDP Ratio over time. Accordingly, we identify 15 policies that jointly reduce the growth of federal debt and increase the growth of GDP over time.

Doing so not only points to a new set of policies for exiting today's quagmire, but also permits an appraisal of the Obama administration's current policy proposals. Regrettably these proposals do not fare well. Furthermore, the extension of macroeconomics we propose applies not only to the US economy, but to most all others as well. It should thus be of interest to readers everywhere.
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D. The Critical Dynamics of the Debt-to-GDP Ratio

There is nothing new about a nation running into trouble and running up large amounts of debt in bailing itself out. There is also nothing new about attempting to monetize (via "quantitative easing") the resulting accumulation of debt. The good news for the US is that its total federal debt of some $10T at the outset of the crisis in 2008 was a manageable 70% of current GDP of $14T.2 Suppose debt rises $3T by the end of 2011 as the Congressional Budget Office now predicts, and then rises $7T more by 2020. The result will have been a doubling of federal debt between 2008 and 2020, rising from $10T to $20T.3 While this increase is shocking, some forecasts are much worse.

Suppose, moreover, that GDP rises conservatively to $17 trillion in 2020 from today's $14T as a result of a modest 2% GDP growth recovery between 2011 and 2020. Then the federal Debt-to-GDP ratio would rise from today's 0.7 to 1.18. Interestingly, this does not represent the disaster many observers assume. To begin with, there are nations where a disturbingly high Debt-to-GDP ratio proceeded to fall way back down over time. Thus, the US Debt-to-GDP ratio was 1.25 at the end of World War II, yet it fell to 0.25 by 1980. Britain's Debt ratio upon defeating Napoleon in 1815 was over 2.7, and it fell back to 0.2 by the end of the 19th century.

In other cases, the Debt-to-GDP ratio has stayed persistently high, neither increasing nor decreasing dramatically over time. Thus Japan has had a very high ratio of 1.5 to 1.8 for the past decade. Italy and Belgium, too, have sustained high ratios in the range of 1 to 1.25. Finally, there are the countries where the Debt ratio continues to rise after some initial shock with either hyperinflation or outright default being the end result. Such has been the fate of myriad banana republics including some large players such as Brazil, Argentina and Russia. What exactly determines which nations dig their way out, or else go under? This will be our primary focus in the pages ahead.

Rebounders versus "Banana Republics": To begin with, note that what matters is not a onetime rise in the Debt-to-GDP ratio due to a particular shock (e.g., today's US housing and credit crises), but rather the dynamic trajectory of the ratio in the years subsequent to the initial rise. It is the direction of this trajectory that is all-important. If the Debt ratio continues to rise, then it tends to accelerate due to the ever-rising cost of servicing this ever-rising "primary" deficit. Not only does the increasing debt-load itself cause ever-higher servicing costs, but the rising real rates that typically result from ever-greater debt make the spiral ever worse. The result can be economic and social collapse.

If, on the other hand, the Debt-to-GDP ratio stagnates, it tends to be associated with very low real growth, political paralysis, and a degree of social disenchantment. If the ratio falls, it is usually because of a combination of two developments: higher real growth and vigorous fiscal discipline. Rising living standards, dreams of a better future, and a sustained belief in democracy are associated with this happiest of trajectories.

Three Sets of Scenarios: Figures 3.A – 3.C illustrate the stunning range of outcomes that can result from sustained differences in the growth rates of debt versus of GDP. We have adapted the analysis here to the case of the US. We assume an initial federal debt burden of $12T for 2011, and an initial GDP value of $14T. We then grow these forward at the stipulated growth rates.

At the one extreme of very low economic growth and very high debt growth, the Debt ratio rises to an arresting 18—a half-way house to Zimbabwe. At the opposite extreme, the ratio falls to a paltry 0.4, half of today's level. These two extreme outcomes are circled in the table.

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Read the whole thing here. A bit wonky, so it's not breezy reading, but it shows various scenarios of what happens if we fail to keep growth of debt in check relative to GDP growth.