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On Thursday, I took the students who manage The MBA Investment Fund to Dallas to visit three asset management firms.  I don’t want to name the firms or the investors we spoke with.  But, all three firms reported seeing signs of recovery.  We heard of companies that were planning on hiring more people, management that was forecasting future growth and expectations of lower defaults (from fixed income investors).  I didn’t hear much that was bearish.




In today’s blog, I have two parts.  In the first part, I discuss an important academic paper that describes the impact of government debt on future growth.  In part two, I discuss a well-known investor’s comments on our debt issue.

Now, on to what I read today…

Today, I want to address a long-term issue that everyone should be thinking about – whether you’re an investor or you’re running a business.  The issue is the effect of government debt on GDP growth.  Many of you enjoyed Wednesday’s blog (about the Harvard historian).  This is different.  You don’t have to believe that we’re headed for Armageddon.  Even if you believe that everything is going to be okay, you have to ask yourself about whether our increased debt level is going to impact our economic growth.




I spent some time reading a paper, “Growth in a Time of Debt,” by Carmen M. Reinhart (University of Maryland) and Kenneth S. Rogoff (Harvard).  They wrote a paper (January 2010) that addresses this very issue.  Here is a summary of their paper:




1.      Authors studied 44 countries over 200 years.




2.      Found that when debt reaches a level that is equivalent to 90% of GDP, the median GDP growth rate drops by 1%.  (In other words, countries with high debt levels have lower GDP than countries that don’t have high debt.)




3.      The average growth rate drops much more – 4% (implying that sometimes there is a real disaster).




4.      When the debt is less than 90% of GDP, there is not much correlation between the debt level and GDP.  In other words, debt basically doesn’t matter until it reaches a high level.




5.      The authors attribute the 90% cutoff as important because of “debt intolerance.”  As debt levels reach historic levels, the cost of debt rises.  Governments then tend to tighten fiscal policy.  (In addition, countries which rely on short term debt can face a sudden loss of confidence.)




6.      In a separate study by the same authors (which I discussed in a blog last year), they found that financial crises tend to result in government debt rising by 86%.




7.      Debt increases after a financial crisis because of bail-out costs, stimulus packages to deal with recession and lower tax revenue.  If you look at countries that have had significant crises (Iceland, Ireland, Spain, UK and the US), the average debt level is already up 75%!  Interestingly, the US has added the least debt (on a percentage basis) of the five countries, but we have the highest debt (as a percentage of GDP).




8.      Increasing taxes or reducing government spending will result in less output.  Simply think about an individual – if they allocate more to taxes, less money is spent buying goods and the result is that there is less demand.  Similarly, if the government demands less, GDP also drops.




9.      If there is inflation (think of the government printing money), we can reduce the “real cost” of our debt (i.e., we pay back our debt with cheaper dollars).  But this really only works if your debt is long-term debt.  If it is short term debt, the country will immediately be refinancing at significantly higher rates.




10.      It’s not fair to compare all debt build-ups.  If you build up debt because of a war, it’s probably not as bad.  That spending will go away and you will have significant manpower (and purchasing power) return to the economy.  If you look at the current build-up, nothing is going to get better on its own.




11.      In emerging markets, high debt levels also lead to lower growth.  In addition, high debt often leads to inflation in emerging markets (but not necessarily in advanced economies).

Some Thoughts About This Paper

Our 2009 – 2010 fiscal year deficit is expected to be approximately 11% of GDP.  That means that our debt (as a percentage of GDP) will increase by a similar amount.  As we plan on doing this for several years, this problem will get worse.




When debt equals GDP, you can simply think of the interest rate as the percentage of GDP that the government is paying in interest.  While you can’t think of this as a direct reduction of GDP, this is a huge burden that will hold back our economy.




The average maturity of our debt is approximately four years.  We probably made a mistake in not issuing longer term debt.  While short term debt lowered our cost – it will actually increase the cost of our debt if we have inflation.  In other words, if inflation jumped to 10%, you would rather have locked in money for 30 years, rather than four years (at which point you’ll have to refinance at higher rates).




While our unfunded liabilities don’t have a financing cost, they should be considered in this analysis.




If you believe that this is correct and growth will be slow, it’s hard to believe that we’re going to create three million jobs per year – the amount of jobs necessary to lower unemployment by 1% per year.

Part 2: Mohamed El-Erian’s Op-Ed Piece

Mohamed El-Erian is CEO of PIMCO.  (He basically runs PIMCO with Bill Gross.)  This week, he wrote a piece in The Financial Times.  Here’s a summary of what he said:




1. Every once in a while, the world faces an economic development that they don’t understand and they consider irrelevant.




2. Examples include China’s influence on growth and prices, as well as the growth and collapse of housing and shadow banking.




3. Now, we should be paying attention to the deterioration of public finances of many advanced economies.  This will have long term effects (it’s much more than just Greece!).




4. The US debt to GDP has grown 20% in two years!  This will continue to increase over the next ten years.




5. Approximately 40% of global GDP is coming from countries running deficits that are 10% or higher.




6. It’s probably no longer appropriate to think about advanced vs. emerging economies.  Many advanced economies are more vulnerable.




7. Governments will certainly adjust.  The question is whether the adjustment will be orderly, when will it happen and what will the collateral impact be.




8. Governments normally try to solve the debt problem with growth and convincing the private sector to hold more debt.  This will be hard with high unemployment, lower growth and persistent deficits.




9. Governments will have to decide between heavier taxation or lower spending.  If we don’t mess with this immediately, we will have to inflate our way out or default.




10. The situation is more complex because we don’t know what other countries will do.




11. We can’t dismiss this balance sheet shock as isolated, temporary and reversible.  People need to recognize this problem AND we need to figure out the CORRECT solution.




Have a good weekend.
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