Is Economic Growth Fake if it is Fuelled by Exponentially Increasing Debt?

The question in the title relates to the period leading up to the crash of 2008 where economic growth in the UK and US coincided with rises on house prices, rising levels of private sector debt and a general financial sector boom. The idea of this post is to ask whether this growth was real and sustainable or whether it was based on borrowing growth from the future and that we are suffering the inevitable comedown now.

This post is part a response to my own previous thoughts on this subject (as well as others whom I have seen propounding the same view) and in part a continuation of my previous call to look at money in a different way. In the current paradigm, my previous thinking was correct but if we can change our mentality it need not be.

Economists often draw a straight line through trend economic growth, which goes through 2008 and continues upwards as if there had been no crash. They point out the gap between where we are now and where we would be now - often arguing that austerity has caused the gap. But that's unfair, I used to say, because the growth in the period leading up to 2008 was debt fuelled growth and now we are deleveraging so we are paying some of that growth back. The idea behind this was that by using debt we were in some way borrowing from future growth.

From one point of view, this was completely correct. In this post, I discuss my empirical study that shows how private sector debt causes a stimulative increase in GDP in the year that it is borrowed. This amounts to around 11% of the amount of debt taken out - so if private sector debt rises by 10% of GDP then we could expect a 1.1% increase in GDP that year. 

But this growth is not cost free. The increase in debt creates changes in structure of the economy so that money flows to people with a lower propensity to spend, as I discuss here. Higher levels of debt correspond to lower GDP growth (all else being equal) as it causes a structural reduction in demand. In fact for just that 10% of GDP of private sector debt, the demand in future is lowered so much that the GDP growth of a country with that extra debt is lowered by 0.15% per year for every year. The only way around this was to lower interest rates and encourage even more debt to replace the missing demand. 

In that sense, every increase in private sector debt bought trend growth in that year, but caused a loss in future years. So it was borrowing from the future.

However, my thinking has evolved since then. The belief above is only true if one uses the standard money paradigm - which unfortunately is also the one used by every major government and central bank in the world. In this paradigm there are two ways of regulating the amount of money flowing through an economy:

1) Fiscal policy; using government borrowing and repayment of debt to put money in or take it out of the economy.

2) Interest rate policy; either by setting the short term rate or also, as more recently because demand has become so low, using Quantitative Easing to reduce the long term rate. This then encourages/discourages private sector borrowing which increases the money supply to the economy.

Unfortunately, partly because of the very high level of debt and partly because of the increased ability of the corporate sector to extract rents (maybe through technology, patents, offshoring etc.), this has led to what we have now, which is a structural deficit in demand. 

If, for every £1 spent in the UK economy, 1p gets saved and only 99p is spent next time around then the result is a shrinking economy and unemployment. I have built a flows model which shows in a simplified way how this happens. The only way for the government to stop this shrinking economy is to increase demand in one of the two ways above and put the 1p of spending back into the economy. By creating approximately 10p of mortgage debt to put that 1p back, the government is making the demand next year lower and the problem larger.

I believe that unless we add a third tool to the box then we will not be able to easily and quickly extract ourselves from this low demand spiral. This third tool is:

3) Central Bank Cash. The Central Bank is able to regulate demand by printing new money which it gives to the government for public spending or tax cuts. The Central Bank can also demand a return of money from the government to reduce the money supply; leading to tax rises or spending cuts. No interest is charged on this money.

The reason that it is vital is that we need to break out of the debt spiral we are in. There is no other obvious way out, short of large default, revolution or other major event. Unless we wish to wait it out - but it could be a very long wait.

In my flows model, I show why this is no more dangerous than using interest rates to control the economy. This is also discussed here. 

One sometimes sees frankly idiotic comparisons to Zimbabwe. It is a bit like saying that you should never eat meat because if you ate a whole cow you would burst and die. A credible Central Bank removes any risk from this. The only way to get an economy similar to Zimbabwe's is to put in place a policy that takes away most of the productive capacity of your economy, while at the same time needing money to fight a war abroad. Then, if you are printing money to pay the soldiers and government employees and there is nothing to buy in the shops - guess what? You get inflation. But this is a symptom of a collapsed economy, not a cause. 

We need to stop thinking about money as a stock - a fixed quantity. We need to start thinking about money as a flow that keeps the economy at full capacity. 

Yes, money as a stock is a store of value. But as I argue here, we can not simply protect this value regardless of the costs. The store of value can only be as a share of the future economic activity - not a fixed amount when that amount is unpayable.

I argue here that it is an economic crime to run the economy at lower than full capacity. It is clearly better for everyone if everyone has a suitable full time job. This makes the economic product of the country at a maximum. 

Note that I say a maximum. This brings me back to the initial argument. I would now argue that no, the economic growth leading up to 2008 was not fake. An economy can only grow at the maximum that it is allowed to by certain constraints. These constraints are that you can not have more than full employment, you can not take more from the environment than is allowed by regulation, you can not grow unless you have invested time in developing technology that increases productivity. All of these are not related to money. 

The economy needs enough money to be flowing through it in order to achieve the full capacity. Too much spending relative to productivity and the result is inflation. There is a maximum to the amount of growth that can be achieved and this is called full capacity. And there is no reason not to be there except mismanagement of money. Too little money, and the result is an economy running under capacity. 

In the period up to 2008 the growth was very real because the economy was running at capacity and real productivity growth was achieved. The problem with it was that the way that we chose to keep the economy at full capacity was with private sector debt. 

But it need not have been. It could have been with Central Bank money or government spending. The only problem we have for the future is that the ways of the past are unsustainable as they create structural shortfalls in demand. If we were to start printing Central Bank money now, then we can continue to enjoy an economy running at full capacity and growing at trend growth in the future. 

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Bernanke: This is the Real Reason that the Taylor Rule is Dangerous

A couple of weeks ago Ben Bernanke argued in his blog against John Taylor's suggestion that the making of monetary policy should be rule based, and that the rule it should be based on is Taylor's eponymous Taylor Rule. 

This rule was based on looking at past interest rate decisions and placing a line of best fit through the response of policy makers to changes in inflation and growth expectations. It was set up to be descriptive of past monetary policy decisions and Taylor believes that it provides a good basis for monetary policy going forwards.

Like any man faced with his job being replaced by a computer, Bernanke responded by voicing the opinion that human discretion would trump robot decision making. Most people tend to agree with Bernanke on this. 

It is not that I disagree with Bernanke here, but it brought to mind a study of university admission processes which I now can't find (I have found this one instead which is similar). If you ask any professor who conducts university admission interviews, they will normally state without doubt that their interview adds value to the admissions process. However the study showed that, in the subjects in the sample group, the interview score added no value in terms of predicting the prospective student's final grade. Thus including the interview in the process alongside other hard data such as exam results gave a worse selection of students. The human discretionary input made the selection process worse.

However, when the researchers, instead of taking the actual individual interview scores, did a regression of the qualities that the admissions tutors looked for (using interview scores regressed against qualities shown) - and then they applied a interview score based on the implicit weightings given by the professors - they found that the qualities-weighted interview score proxy was actually a good indicator of performance. So the problem was not that the admission professors did not know what to look for. The problem was inconsistent application of the rules they had in their head but had not formalised.

One could argue, as Taylor does, that the inconsistency of human decision making is sub-optimal and a rule that describes the average decision making gives better results.

How relevant is this idea here? I don't know. For one thing, the researchers had a lot more data than John Taylor had formulating his rule. For another, the experiment assumes that the overall environment is the same in the past as the future (that it is ergodic). It is not clear that the economic situation now can be compared to that when the rule was trained. The third criticism would be that when a descriptive rule becomes prescriptive it can change the reaction of the system that it is supposed to describe.

Overall, I am probably more on Bernanke's side here. But actually that whole discussion was something of a digression. The main point here is to talk about the real danger of using the Taylor rule - a danger that is orders of magnitude larger than that described by Bernanke.

To do so, I need to go back to my flows model of the economy first discussed here. It takes nominal GDP at the end of one time period and looks at money spent during the next time period to give nominal GDP at the end of the next time period. It is very simple and, because it is set up as an accounting identity, unless I have made an error in setting it up, it should be correct.

The flows model connects GDP at time t to GDP at time t+1 like this:

At the beginning of every time period all the money is paid out and then during the time period it is either spent or saved. At the beginning of next time period we start again.

The sources of money are: 

1) 'GDP' from work done the previous time period.

2) 'New Cash' printed by the Central Bank, C. This could, in theory, be negative.

3) 'New Loans' created by private banks, L. This could also be written as New Deposits. This can be positive or negative.

4) Money taken 'From Existing Savings' to be spent in the economy. Eg pensioners spending their private pension. In terms of the Stocks model, the existing savings, ES,  can be seen as the sum of CB cash, equity and debt.

The GDP is divided into three flows:

a) Dividends - this includes eg. rental payments on houses. It is any return on equity as defined in my post on Stocks. This is denoted by d.

b) Interest, i.

c) Wages, w.

There is not much more required for this simple system in order to calculate the path of nominal GDP. Real GDP depends on actual productivity increases, but nominal GDP in this closed system is just how much money is spent (if there is more money spent but no increase in productivity then it is just inflation). To calculate the nominal GDP and net new savings/debt, I just need to put in how much is spent on consumption.

I will call α the coefficient of consumption. So αd is the proportion of the dividends paid that are spent in the economy. Similarly, αi, αw, αL  and αC  are the coefficients of consumption of interest, wages, new loans and new cash. Also, I will define γ as the proportion of existing savings that are spent in the year.

We can then find the next year's nominal GDP and the amount of net savings by using the following:

GDP(t+1) = αd*d + αi*i + αw*w + αL*L + αC*C + γ*ES     (1)

And we can define Unspent Income (UI) as:

UI  = (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αL)*L + (1-αC)*C - γ*ES  (2)

In order to proceed further, I will need to provide a new concept of equilibrium. This is not a Neo-Classical equilibrium; it is the equilibrium of an economy that does not need further debt to achieve GDP potential. For this equilibrium, the following must apply:

Equilibrium:

 γ*ES  = (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αC)*C  (3)

This means that the spending of existing savings exactly matches the amount being saved without any new debt being taken out. 

This is the true equilibrium in an economy that we need to aim for.

In any case, you can see how the dividends, interest and wages from GDP at time t, as well as the external sources of money (from existing savings, new loans and new central bank money) make up the next period nominal GDP.

What has gone wrong:

I would say that during the 1945 to 1975 period, a period of excellent growth across the developed world, we were broadly in equilibrium (or at least the total private debt levels were low enough that it didn't matter). The savings broadly matched the spending of exisiting savings. Governments, using Keynesian policy tools would increase their spending (the government component of L) when savings were too high and reduce when more savings were being spent than new savings made. It all worked pretty well.

What changed in the 1970s was the rise of credit. Looking at the Equilibrium equation (3) above, the share of GDP going to interest and dividends went up relative to the share going to wages. The coefficients of consumption (α) for the interest and dividends is lower than that for wages so we had the following inequality:

γ*ES  < (1-αd)*d + (1-αi)*i + (1-αw)*w + (1-αC)*C 

This means that the economy is out of equilibrium. The GDP shown in figure 1, will now go down because of the excess savings. 

Previously fiscal policy would have been used to stimulate growth and return the system to equilibrium. 

Increased government debt is far more efficient at stimulating the economy than increased private sector debt. I show here that a 10% net increase in private sector debt stimulates the economy and adds approximately 1.1% to GDP growth in the year that the debt is taken out. So the multiplier of private sector debt to GDP here is 11%. However, the cost in future years due to the increase of interest repayments at the expense of wages is 0.15% of GDP for every year going forwards. 

The same amount of increased government debt costs only 0.9% of GDP going forwards, but crucially the multiplier on this spending is much higher. Therefore much less government debt is needed to create the same amount of economic stimulus as private sector debt. In fact, I estimate that government debt is an order of magnitude more efficient.

But from the early 1980s, policy makers deregulated markets and switched to monetary policy as the tool of demand moderation. They used something equivalent to a Taylor rule before the Taylor rule was invented.

How does the Taylor Rule work - using the Flows model:

As Wikipedia will explain it better than me, I will give their definition of the Taylor Rule:

According to Taylor's original version of the rule, the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates and of actual Gross Domestic Product (GDP) from potential GDP:

In this equation,  is the target short-term nominal interest rate (e.g. the federal funds rate in the US, the Bank of England base rate in the UK),  is the rate of inflation as measured by the GDP deflator,  is the desired rate of inflation,  is the assumed equilibrium real interest rate,  is the logarithm of real GDP, and is the logarithm of potential output, as determined by a linear trend.

In this equation, both  and  should be positive (as a rough rule of thumb, Taylor's 1993 paper proposed setting ).^[7] That is, the rule "recommends" a relatively high interest rate (a "tight" monetary policy) when inflation is above its target or when output is above its full-employment level, in order to reduce inflationary pressure. It recommends a relatively low interest rate ("easy" monetary policy) in the opposite situation, to stimulate output. Sometimes monetary policy goals may conflict, as in the case of stagflation, when inflation is above its target while output is below full employment. In such a situation, a Taylor rule specifies the relative weights given to reducing inflation versus increasing output.

So the Taylor rule states that the nominal short term interest rate should be a function of the difference between current inflation and desired inflation and the difference between the current rate of GDP growth and the potential GDP growth - which is GDP when the economy is at full capacity (to get this he suggests linear trend extrapolation). Using Taylor's rule of thumb above, it suggests that a 1% increase in inflation should correspond to a 1.5% increase in interest rates and a 1% decrease in growth should correspond to a 0.5% increase.

How does this work in our Flows model? Looking at the equation for GDP (1) we can see that if the right hand side of the equation gives a GDP lower than potential, the monetary policy needs to adjust the right hand side to increase the total.

How would lowering interest rates increase the total GDP. There are three ways:

1) It would increase the appetite for new borrowing - making L go up.

2) It would increase the value of assets - making ES go up. 

3) It would increase the spending of existing savings - making γ go up.

I would say that the biggest impact here is 1); it increases the amount of debt in the economy.

But by increasing the amount of debt what does it do? It pushes the system further away from equilibrium in equation (3). Interests payments in the next period go up, and so demand is further reduced. And GDP goes further from potential in the next time period. So interest rates need to be reduced further next time. This continues until we reach the lower bound. Here is a graph of the US 10 year government bond rate since 1975 - the trend is clear apart from the spike in the early 1980s, and we now have the lowest interest rates ever:

One more minor point which I disagree on, is that the inflation targeting does not separate inflation with a domestic source compared to that with a foreign source. I discuss the error that I believe that they are making here.

But the main problem is that, as with the whole orthodox macroeconomic profession it seems, is that IT IGNORES PRIVATE SECTOR DEBT.

I can not stress how obviously important this is. It assumes that debt can grow indefinitely. It assumes that previous debt has no impact on growth. It ignores financial instability. And ultimately, it creates a positively reinforcing feedback mechanism that ends in the zero lower bound and economic stagnation.

This is the real danger of the Taylor rule, Dr Bernanke. 

And the solution, once again I point out, is to regulate the money supply not using interest rates but by using central bank cash. I describe here why it is an economic crime for an economy to be running under capacity because of lack of money. And I describe here why printing money for government expenditure is essentially the same as the government borrowing to spend in a Keynesian framework, just at 0% interest rate indefinitely. There is nothing to fear from allowing the government to create money instead of relying purely on private sector debt to fuel the economy. The sooner we realise this, the better for us all.

This is not even ideological. The money could be spent on research, infrastructure, education and other investment; in my opinion this is the most sensible place to start. But it could be given in tax cuts to lower income workers. Or it could be given as tax cuts to top rate tax payers  - although more money would be needed to keep the spending at the same level due to the higher rate taxpayers' lower propensity to consume. The important part is to work out a multiplier on the spending and make sure that total spending of money created matches the amount taken out of the economy by savings.

It is my view that, due to the debt levels and corporate rent seeking, we have a structural and chronic problem of excess savings in the economy. We have only three choices to keep demand up. 1) Private Sector Debt, 2) Government Debt and 3) New Government money. By refusing to use choice (3), we are forcing upon ourselves (1) and (2). And the eventual consequences will not, I fear, be pleasant.

Unfortunately I worry that it will take a long stagnation before we work it out.

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The Bund and the Paradox of Tranquility

A joy of reading about Post Keynesian Economics is that the whole basis of the subject is that economics a) must make sense for the whole system rather than for individual rational agents and b) must be empirically observable.

It is so refreshingly correct - obvious in fact. And yet Post-Keynesian economics has been relegated to an economic backwater whilst neo-classical economics, with mathematical precision, makes a mathematically precise complete hash of understanding the bigger picture.

One of the miserable things about reading about Post Keynesian economics is that they have been broadly right for 30-40 years and yet are still generally ignored.

One idea, simple but beautiful, is summed up by Marc Lavoie's term, coined in 1986 and based on Hyman Minsky's ideas, the 'Paradox of Tranquility'. To quote Lavoie in his book 'Post Keynesian Economics' (italics are mine):

According to Minsky, a stable growing economy is a contradiction in terms. A fast-growing free-market economy will necessarily transform itself into a speculative booming economy. In a world of uncertainty, without full information about the fundamentals, a string of successful years diminishes perceived risk and uncertainty. People tend to forget the difficulties encountered in the past... As time goes on memories fade and economic agents dare to take higher levels of risk. Or else, as time goes on, the risk levels as computed by engineering models of finance, such as the very popular value at risk model, appears to get smaller because the last recession is just one remote observation among a series of more recent successful years. The longer the economy is in a tranquil state of growth, the less likely it is to remain in such a state.

This was intended as a description of the equity market, but it could recently be also applied to the government bond market. 

What this paradox states is that a long period of growth with low volatility will, by its very nature, eventually lead to a crash. That the low volatility, rather than a signal of low risk, is a signal of overconfidence and thus is a signal of high risk when the confidence suddenly disappears.

I was reminded recently looking at the German government bond (Bund), which was for a long time seen as a one way bet. This is the Bund performance until April this year:

Up 19% , with 14.5% annualised returns on a 3.7% annualised volatility. The steadiness of this rise is exceptional.

Meanwhile, this was happening to the one year realised volatility since 2012:

At this point, FT Alphaville, who considered this a bubble, were running a competition to guess the date that Bunds would reach negative yields (for the record they reached about 0.06% positive yield). 

The assumption that the ECB would buy back the Bunds from you whatever the price (up to a negative 20bps yield) led to overconfidence. Narratives of pension funds forced to buy this debt even at negative yields made this a greater fool theory play (although unusually the greater fool was largely a Central Bank here).

Of course, as Lavoie states above, the longer the market appears to be calm the less likely it is to remain that way. As was found soon after:

The nature of the unceremonious crash of the Bund was not a surprise to anyone who regularly observes the behaviour of markets. All of the hedge funds that had amassed large positions now had to get out of their positions at the same time. Consensus was slow to build up but quick to reverse.

What is in store for the Bunds in future? I don't know. I don't believe that the economic growth that we will see in Europe will facilitate large rises in yields (falls in price) for a while. I may be wrong - I am not an expert here.

To me this was just an interesting example of how Post Keynesian economics has got it right and Neo-Classical economics, based as it is on efficient markets, can not explain the real world in anywhere near as realistic a manner.

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The Supremacy of Savings in our Economic System

When a politician says something along the lines of this:

People who have worked hard all their life, done the right thing and saved up money; they deserve to have the rewards of that now and they should not be penalised for having done the right thing and saved.

it is very difficult to disagree with this logic. What kind of wrong thinking person would deny the hardworking people the chance to enjoy the fruits of their hard work?

However, I am about to make the wrong thinking case...

To make my argument, the first point I need to make is about the nature of savings. What are they? Note that these people who saved up did not squirrel away food or fuel or kitchen appliances or holidays or any actual fruits of their labour. What they saved was money, which in the end is just a number on a computer screen. 

And what is money? It is an IOU from the people of the future to provide services to the holders of that money. Therefore what savers actually hold are large bundles of IOUs.

Over the past 40 years, the amount of debt has risen exponentially. Private sector debt (mortgages and corporate debt) has risen on average about 10% of GDP per year in developed economies. What does this mean? More savings every year. As soon as someone takes out a mortgage and buys my house, I have money in my bank account that didn't exist before (someone has a debt against that but it is a mortgage against a house). So the amount of savings has grown exponentially too.

So the IOUs from people in the future to people in the past have got larger and larger. The wages share of GDP has shrunk by around seven percentage points. Rents as a proportion of income have risen. The current workers are struggling to service their debt to past workers. I discuss this more here. Young people today are saddled with far more of a burden than anyone in the recent past.

An economic system must divide up the production of the economy between the people who live in it. Therefore, assuming that the amount produced remains the same, the politician above is arguing that savers deserve more of it than workers.

So, put another way, what the politician above is actually saying is this:

People who work hard in the future and do the right thing do not deserve to receive a fair proportion of what they produce because they should give most of it to savers who worked hard in the past.

In policy terms this means that savings are always protected. If banks go bust, savers are protected by the taxpayer and workers must pay. If there is a trade off between inflation and growth, inflation is kept low. 

The economy is crying out now for more money and more inflation. But printing money is seen as an attack on savers and therefore is not even considered as an option (I do not count quantitative easing as genuinely printing money as it is just a temporary swap for existing debt).

Savers have been given this primary position in the economy. They must get their money no matter whether or not the workers are reasonably able to pay them. It can be seen in the Eurozone crisis. It can be seen in the economic stagnation in the UK and other Western economies.

So the incentives are completely misaligned. Instead of having an economy where hard work and productive investment is rewarded, we now have a rentier capitalist economy where low risk and rent-seeking are rewarded. This is not capitalism as it was supposed to work.

And the cost of this I have discussed here, here and here among other places. The money from economic activity in this rentier economy is largely going to people with a lower propensity to spend (pension funds, high net worth individuals etc) and the effect on the economy is to reduce demand below an equilibrium level necessary for the economy to grow.

Young people today are entering a workforce where skilled jobs are hard to come by. High achieving university leavers are working in coffee shops. Zero hours contracts are the norm. Uber type contracts, where pay is low, competition is high and the risk is all on the individual, are seen as a necessary way to get by. The power has swung from workers to savers because no politician could countenance increasing demand by reducing the value of savings.

Until we can rebalance this position we are going to continue having a stagnating economy fuelled only by the taking out of even more private sector debt. Until, of course, we can't any more because we have another crisis. Then this might happen.

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Two Possible Outcomes When Savings Rates are Too High

In previous posts, I have described a Stocks and Flows model which attempts to model the interaction between workers and savers in an economy.

I have built a very simple version of this model in order to simulate economic outcomes. As I make clear in a previous post, I don't believe that non-linear models such as this can be used to make measurable predictions (eg. what will GDP be next year). However, as Steve Keen has showed, these models are very good for getting an idea of economic dynamics. 

Anyway, I have modeled a very simple economy with various simplifying assumptions all of which can be modified. I have kept it as simple as possible to capture the essence of the dynamic. Some of my assumptions are as folows:

• The economy does not grow (this can be adjusted by putting an investment coefficient in to the model and assuming returns on investment).
• The coefficients of spending all stay constant. There is no change in a recession/boom.
• Corporate profit share stays constant
• Debt can not be defaulted upon
• Interest rate stays constant
• Taxation is ignored
• And many many more

In this simulation, potential GDP (that is GDP at full employment) is 1. The economy can adjust to a lower GDP through deflation so, at an equilibrium lower than 1 we can still have full employment. The adjustment would presumably be painful though.

The equilibrium is the point at which GDP stays unchanged and debt does not increase or decrease - in other words, the saving for the future exactly matches the spending of existing debt.

My simulations here are of an economy where the savings rate is too high. In other words people are spending less income than they are receiving. In order to stop the economy declining, the government here increases private sector debt and government debt. This is similar to what has happened in the Western economies over the past 40 years.

Because each year the debt has gone up, so too do the interest payments. Because the marginal propensity to spend of the receivers of interest payments (eg pension funds) is much lower than that of the payers (the workers) this increases savings further.

In the end an equilibrium is reached where the total new savings from income are matched by the amount of existing savings spent. If the debt is very large, then the workers' share of income will be lower, but the pensioners' spending will make up for the workers' low consumption.

However, in order to be consistent with reality, I am putting in a limit on the total amounts of government and private sector debt. At this level, I assume that no more money will be lent. I have set these as both 250% of GDP. At this point the credit line stops but existing debts must still be serviced.

In this simulation, there are two possible broad scenarios. The benign scenario is one at which equilibrium is reached below the debt limit. This is shown below:

Good-ish Scenario:

The total debt levels off at around 400% of GDP. At this point the spending of existing debt exactly matches the savings from income. The economy is running at full capacity.

However, this benign scenario assumes that the equilibrium level can be reached before we hit the debt limit. What if we hit the debt limit before the equilibrium level is reached? This scenario is not so great. 

Bad Scenario:

As the 'debt ceiling' is hit and the savings rate is still too high, GDP starts to decline. This makes paying back the debt harder and so the next month GDP declines further. This continues until a new equilibrium is reached here at 50% of capacity.

In this scenario, public and government debt levels to GDP rise as GDP collapses. Interest payments as a proportion of GDP rise and the workers share of GDP collapses.

Eventually the economy finds a new equilibrium, but it is one in which the workers are effectively slaves of the savers and it is one where deflation, unemployment and depression will continue for a long time until the new equilibrium can be found.

And note that this contains no extra saving during a depression or overconfidence in a boom which many models suggest will also occur. This is just the result of the dynamic between savers and borrowers.

Is this scenario ridiculous? In an economy where no new money can be printed (see the Eurozone), where debts can not be defaulted upon and where no new money will be lent, it is actually difficult to see another scenario. Greece's trajectory in fact, has not been too different from this.

So the question for us is, have we hit the equilibrium yet or are we still net savers? Taking the UK as an example, Simon Wren Lewis presents the following graph of net national disposable income per head since 2008.

As can be seen, we have had no growth. But at the same time the government has been running net deficits of on average 6 % of GDP:

This suggests that there is a natural shortfall of demand in the economy that requires further borrowing to fill. On top of this, we have had zero interest rates and programmes such as Help to Buy which have encouraged private sector debt and raised asset prices.

If the economy requires all of this help to stay flat, I fear that our problems are of the deeper kind, and that we are closer to scenario 2 than scenario 1.

There is a solution though...

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Debt Causing the Stagnation; Demonstrating A Missing Empirical Link

A few weeks ago I wrote this post which showed the results of my empirical study on the effect of private sector debt on the economy. It found that a 10% increase in the level of private sector debt corresponded to a 0.15% decrease in GDP growth every year going forwards. Considering that the levels of private sector debt in many advanced economies is around the 200% level, this is a pretty big drag and on its own would explain the current secular stagnation.

I then formulated a simple model which gave a possible mechanism which could explain how debt is responsible for the lower GDP growth. 

This post here will provide further empirical evidence that the model represents a reasonable hypothesis. I realised that I started with the idea of debt causing stagnation, and then assumed that it was due to a reduction in workers share of income and that this caused the stagnation. However, on reflection, I realised that I had not empirically shown the intermediate part - that there has been a decline in workers share of GDP.

I will summarise this model here briefly. I divide the economy into 'savers' who have invested money in bonds, property, shares and put it in the bank, and 'workers' whose work in the future will pay the savers dividends, rent and interest from their future work. By definition, all value of savers savings comes from work done by people in the future. If the workers decided not to work then the savings would be worthless. 

There is nothing wrong with saving; it is an important way of transferring consumption from the present to a time when it is needed in the future, for example old age. However, my thesis is that the rise in debt - which is matched, as an accounting identity, by an equal rise in savings - has made the amount owed by the workers to the savers too high. Because of debt there are now too many savings.

Now, this would be fine for the economy (if harsh on the workers) if the savers spent the same proportion of their income as the workers. However my argument is that the marginal propensity to spend of the receivers of dividends, interest and rentals is much lower than the marginal propensity to spend of the workers who pay it (either directly or indirectly).

So I argue that the situation we are now in is one in which too much money is diverted from the workers to the savers. Workers today are burdened by corporate profit share of GDP that is very high, with interest payments on a huge amount of debt and with rental payments that are very high. This drains demand from the economy as the money is diverted to people likely to save it. 

If the savings in the economy go up then one of two things must happen. Either more debt must be taken out (either by the government or the private sector), or the economy will decline and unemployment will result. 

For the past 30 or 40 years debt has been rising on a huge scale. This has helped growth when it was taken out, but cost in the future. The rising cost had been masked, up until 2008, by even more debt and everyone was happy (with a few exceptions). Now we have reached a stage where we can't take out much more private sector debt, governments are reluctant to spend more and developed economies are in a stagantion. Even with share prices at all time highs, in many countries the economy only just stays in growth with large government deficits.

So this is where we are now. The liabilities of the workers to the savers are too high for them to afford. And the cost to the economy is that we can't get growth any more without further debt.

My model explains the empirical link between rising private (and public) sector debt and slowing growth. But I realised that I hadn't checked the intermediate points.

Specifically for the model to be correct, the following must be true:

1) Increasing private sector debt causes an increase in liabilities from workers to savers.

This would appear at first glance to clearly be true. The lower interest rates we have seen recently will reduce the servicing costs but even now, a lot of private sector debt is at as high real interest rates as ever.

2)  Therefore the workers share of GDP should go down.

I realised that I had not checked this empirically. The point of this post is to look at empirical evidence which shows that this is true.

3)  The marginal propensity to spend of the workers is higher than the savers

This is almost certainly true. Average workers (with fewer assets) tend to spend 90% of their income. Richer people spend closer to 50%. The super rich, much less. 

4) This shortage of demand is the main reason for the stagnation

The main argument I have for this is that empirically the cost of debt appears to be so high. And on its own it, if this were further verified, it could explain the entire stagnation we are suffering.

So for my thesis to be true, it would be necessary to show that 2) is true. That the workers share of GDP has come down. I realised that I have not shown this so I did some searching.

The first port of call was the St Louis Fed Fred database. Here I found the following graph for the US.

This is a remarkable graph for a number of reasons. The first is that it shows that the percentage of wages as share of GDP has gone down from around 50% until the mid 1970s to around 42.5% today. The greater corporate interest payments caused by corporate debt must have taken a large proportion of this. 

This is very important as it is verification that the thesis I put forward does hold in practise.

On top of this, the graph is interesting because they have shaded the periods of US recession. You can see that every single one of the last 10 recessions coincided with a drop in the value of compensation to workers. 

Looking on the internet, this pattern is repeated across the world. There are different ways of measuring but in every case I have seen there is at least a 5% reduction in GDP share to the worker.

But this is not even the whole story. This shows lower share of GDP going to the workers from their employers. But then even when the money arrives they still have to pay rent and interest on their houses and consumer credit. 

Martin Wolf states in a recent piece on the UK election that 70% of net bank loans outstanding are to individuals secured on property. What is the result of all this credit? House prices have rocketed. And because of the unaffordability of housing, most young people are forced to rent which has driven up rents. 

This piece of research shows how rents in the US have gone from just over 20% of income to almost 30% of income in the last 35 years.  This means that of the 42.5% still going to employees, an extra 10% is still going on rental. And in the UK the situation, due to planning restrictions on house supply is worse. This reliable source suggests that the proportion in the UK is 50%. For those not from the UK it is not a reliable source, but it does show the problem.

Yet another consequence of the rise in debt is that the banking sector becomes a lot larger. As intermediaries they take a spread on the debt between borrower and lender. This estimate suggests that the banking sector takes 9% of GDP. A reasonable proportion of this will go to highly paid employees with lower propensity to spend.

If we try to calculate the difference between the situation in 1970 and that now, making a lot of assumptions, we get the following:

Assumptions:

Marginal propensity to spend of savers and rich bankers is 40% lower than workers.

Financial sector bounty to bankers in 1970 was negligible

Rental was 20% of earnings in 1970

Housing costs have risen by 10% of income for everyone, including owners

Tax is ignored

Too many more to list, but this is only a rough estimate 

Share of GDP to workers not including very highly paid financial sector, after housing costs:

1970: Total to workers minus rental: 

50.5%*80% = approx 40%

2014: Total to workers minus rental minus 4% to banking/financial sector rich people:

42.5%*70%-4% = approx 26%

Cost to the economy in lost demand:

Difference in marginal propensities to spend times difference in share of GDP:

40%*14% = approx 5.5%

This is obviously very back of the napkin but you can see the potential cost in demand. Every year savings are 5.5% more than equilibrium (assuming equilibrium in 1970).

This saving has to be compensated for by either a rise in private sector debt, an increase in government debt or unemployment. This is, I believe, the problem the economy is currently facing. And it is all caused by debt.

I will end, as usual, with a restatement of my belief that we need to print central bank money slowly to spend and invest in the economy, stimulate growth and inflation and reduce the real burden of all the debt we have amassed.

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