Saturday, June 19, 2010

The Rising Debt, Shrinking GDP Conundrum

A country's Gross Domestic Product is comprised of personal and business consumption, government spending and exports.

The state of a nation's economy is dependent on whether the private sector and the government are borrowing money or paying down debt. In the case of the US government, it is always borrowing money to pay off old debts and to maintain its deficit spending.

The US economy is heavily reliant on consumer spending, which accounts for 70 percent of GDP. However, after a decade of unbridled spending, American consumers are tapped out and trying to reduce debt. Due to job losses, foreclosures, and the general fear generated by the recession, consumers have pulled back. That has created a drag on the US economy.

This restraint has gotten the attention of economists and bankers alike. No less than William C. Dudley, President and CEO of the Federal Reserve Bank of New York, recently noted, "Households are still in the process of de-leveraging."

No kidding.

Into the breach leapt the federal government, initiating a $487 billion spending bill last year. Though it was widely billed as a $787 billion spending package, $300 billion of it was dedicated to tax cuts for 95 percent of taxpayers.

However, all those billions are now drying up, which is creating a drag on the economy.

Further, exports account for just 12-13 percent of the US economy and cannot make up for shrinking consumer spending. As it stands, the US consistently runs a gaping trade deficit because we import more than we export.

The ability to increase exports won't just happen overnight. It would require a rapid expansion of our diminished manufacturing base. In addition, higher American wages, plus a rising dollar relative to other currencies, make US products less competitive than those from developing nations. That's a disadvantage that will be difficult to overcome.

For years, the US has been simultaneously running a trade deficit and rapidly growing its government debt. The government mantra has always been, "We can grow our way out of debt."

However, the only way to grow an economy is to either increase your population or increase your productivity. But US debt is far outpacing both population and productivity growth.

The problem for the US is that its debt is growing faster than nominal GDP. And at some point, the market will begin to think the US won't be able to repay its debts. The reality is that no nation can continually grow its debt faster than its income because at some point it is no longer able to borrow money. Eventually, the interest expense consumes a crushing portion of that nation's budget.

For the US, and most of the other industrialized nations, reducing debt will require some combination of tax hikes and budget cuts. But both have consequences.

Tax hikes reduce discretionary income and therefore consumer spending. They can also lead to diminished job creation, and perhaps even layoffs.

And when the government eventually decides to cut spending (which it must do), it will inevitably shrink GDP. A record-low 41.9% of the nation's personal income came from private wages and salaries in the first quarter, down from 44.6% when the recession began in December 2007.

This means that 58% of personal income is coming from government-provided benefits — like Social Security, unemployment insurance, food stamps and other programs.

If the government decreases spending, either private business would have to increase their deficits, or the trade balance has to shift from negative to positive, or some combination. Yet, the fact that the US imports two-thirds of the oil it uses implies that the trade balance will not change any time soon.

In essence, reduced government spending will lead to slower growth – at least in the short run. The cruel reality is that even as a country acts to cut spending and debt, its debt-to-GDP ratio can actually worsen.

As noted, the typical hope of any country in deep debt is to grow its way out of the problem. But advanced economies are mature, and therefore harder to grow. Most of the potential growth is long since realized.

Under the current recession conditions, government revenues are dropping. Because the government is taking in less revenue, there is already downward pressure on GDP. This is happening at the federal, state and local levels.

In the first quarter, spending by state and local governments declined by the largest amount since 1981. That's because they are all going broke.

Last year, federal tax revenues suffered the biggest single-year decline since the Great Depression. And nothing has changed. In fact, indications are that it's now even worse. Through April 30, the federal government’s nonwithheld income taxes were down 17.6 percent from a year earlier.

With less income to tax there is less government revenue, which could necessitate even more cuts. It could beget a vicious cycle that would be very difficult to get out of.

First-quarter growth was revised down to 3.0% from 3.2%, due to smaller increases in consumer spending and purchases of business software. Economists expected first quarter GDP to be revised upward to 3.5%.

All of the happy mainstream media talk about economic recovery appears to be nothing more than false optimism. It's time for some realism. The process of de-leveraging and debt reduction by consumers and the government will be a long and painful one that will have unintended consequences, such as a shrinking GDP.

Our entire economic system needs to be rethought and shifted away from debt creation/expansion and perpetual growth. We need to learn to live with less and accept a new economic reality, or a new normal.

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