Debt is Your Frenemy

Posted by Jeff Carter
on February 10th, 2013

Because we are approaching another milestone in American debt, there is a bit of news about it. Paul Krugman struck first with an opinion piece that says debt is meaningless. It is, if all you do is stare at a blackboard all day. In the real world, debt isn’t meaningless. It can help you grow, but debt can kill. When it kills, it’s a brutal death.

How can debt be friendly?

Businesses can grow three ways. They can grow from cash receipts, borrowing against expected future cash receipts (debt) or they can sell equity to bring cash into the business. Businesses that have stable cash flows can borrow from a bank and use the cash injection to grow to supercharge their revenue. They can try and compete in new areas. Because of US tax code, there are some tax advantages to having debt on the balance sheet.

Beware. Debt always has to be repaid and the debt borrowers supercede anyone else when the business can’t pay. If the future cash flows don’t pan out, debt becomes an albatross around the growth of a business and usually chokes it until it dies.

Borrowing against future cash receipts is what the US government does every time it holds an auction. Future cash receipts for the government are? You guessed it, tax revenue. Whose on the hook for that?

If the country is growing at a relatively good clip, it can afford to take on more debt. Higher growth means higher tax revenue no matter who’s tax plan is in place. The reason America was in such good shape during the Reagan era was the economic growth we experienced. The Reagan tax cuts supercharged that growth because they changed incentives-which changed behavior.

However, we are rapidly reaching a danger zone today. Here is GDP graphed along with US Government Debt. GDP growth is anemic, while the debt continues to grow. The shaded areas are US Recessions.

US Real GDP Growth data by YCharts

Our economy can’t support the kind of debt its taking on because we can’t afford to pay it back.

Meanwhile, the US Treasury and Federal Reserve continually auction off new debt to pay off old debt. They call this “rolling debt over”. Most people say the Chinese are our creditors and we will owe them. The reality is the government is its own biggest creditor. The US government buys the largest percentage of debt from itself. This artificially keeps interest rates low-combined with poor Federal Reserve 0% interest policy.

Ironically, the US Treasury has shortened the “duration” of the US debt base. We used to do a lot of financing with 30 year treasuries and in the past 12 years switched to 10 year notes and less- the US has greater near term obligations. The pressure to grow is higher than it would have been had we issued longer term debt like a 100 year bond.

Cutting back on spending will not harm our economy. The multiplier effect of government spending is 0. The only thing a spending cut will do is slow down job creation within the federal government. By the way, all this talk about how Obama has eliminated government jobs is bunk. State and local governments have eliminated jobs, not the Fed.

Today, the US is living in a Miss Havisham world of macroeconomic finance.

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thanks for the link Instapundit

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