Friday, June 4, 2010

The Debt Cycle

A while ago, I read a comment on another website about this blog. The commentator was very positive about my analysis, but also pointed out that I was not so good on market timing. I thought that this was a very fair comment. The reason for this weakness is that I struggle with how the individuals in the market get so much so very wrong.

I thought of this today, as I saw the news on the latest falls in stock markets. The reason for the falls are the potential problems in Hungary, with yet more sovereign debt woes, and poor US unemployment data. In the case of the unemployment data, the really bad news is that much of the increase in employment is down to the mass hiring for the short term to conduct the US census. In fact, nearly all of the new jobs created were a result of the census. The really worrying aspect of this is that this abysmal performance is that it is taking place in the context of such massive government borrowing.

I have copied the chart of US federal surplus or deficit from the St. Louis Federal Reserve. It was not so long ago that such charts were seen as regular feature of economic commentary, but they seem to have fallen out of fashion. Sometimes, it seems that it might be a good idea to remind everyone of exactly how much money is really being poured into the US economy through borrowing.

This from the Wall Street Journal:

THE US deficit has reached $US13 trillion for the first time in history, the Treasury Department said yesterday.

Amid vast Government spending designed to stave-off economic calamity, the debt reached $US 13,050,826,460,886.97 on June 1.

The debt has increased by around $US 1.6 trillion in the last year and more than doubled in the last 10 years.

It now stands at just under 90 per cent of annual gross domestic product.

Below, we have the US current account. It is not a pretty sight.

In other words, the US government is borrowing mountains of money that is barely denting unemployment, and the money is helping to support ongoing over-consumption. What can be good about such a situation?

The supporters of deficit spending would argue that, without the massive deficits, the unemployment situation would be far worse. I am actually in agreement with this, and what the level of unemployment might be without deficit spending would otherwise be does not bear thinking about. However, these levels of deficit and the over-consumption can not be sustained. The cost of such massive borrowing is to just push the unemployment into the future, and that is really no solution.

I am highlighting these underlying problems for a very simple reason. As the Euro crisis accelerated, the US became (once again) the 'safe haven' destination for investors. How can we explain such a perspective? Below is a chart of US GDP, which goes some way to explain why there is a false confidence in the US economy.

If we compare the chart for the accumulation of debt and the GDP chart, the source of this 'growth' is obvious, but that does not seem to have deterred investors. The US is only 'safe' if the US government keeps on borrowing and if it stops borrowing at these levels it will very quickly become 'unsafe'. The problem is that, as fast as the US government borrows to spend the situation of the economy is still deteriorating. As the unemployment figures are showing, there is no real recovery, and the lack of a recovery is coming at a monumental cost.

$US 1.6 trillion is buying no real jobs growth. It is just preventing a massive jobs slide.

The real question that needs to be asked is where the real growth in jobs might come from. When thinking of the horrendous underlying unemployment (i.e. the level without the borrowing), it is apparent that there needs to be a huge surge in employment in many sectors of the economy. This looks to be highly improbable. What we are looking for here is not jobs growth, but a jobs miracle.

Then there is the context in which such a miracle must take place. Europe is about on the edge of commencing considerable fiscal retrenchment. With such retrenchment, the export market for US goods is about to shrink, with Europe accounting for over one tenth of US exports. Then there is the ongoing strengthening of the $US against the Euro, which will disadvantage US exporters in an already declining market. The rush of money into the 'safety' of the $US has the perverse effect of making the $US less safe by strengthening the dollar. It is the curious situation where the more a currency strengthens, the more it will build weakness in the long term. Imports will rise, and exports will fall. In this case, it is not a strengthening on the basis of underlying economic performance, but just a panicked movement of money.

This is a quote from Geithner, from a recent letter sent to the G20:

"Given the broader shifts under way in the U.S. economy towards higher domestic savings, without further progress on rebalancing global demand, global growth rates will fall short of potential," Mr. Geithner wrote, according to a copy of the letter viewed by The Wall Street Journal. "In this context, we are concerned by the projected weakness in domestic demand in Europe and Japan."
From the same article as the quote, The Wall Street Times says the following:

"The necessary shift toward higher savings in the United States needs to be complemented by stronger domestic demand growth in Japan and in the European surplus countries, and sustained growth in private demand, together with a more flexible exchange rate policy, in China," Mr. Geithner wrote.

U.S. Treasury secretaries have been delivering that message in various forms for more than a dozen years, pleading with Europe, China and emerging Asia to adopt policies that encourage their own consumers to boost purchases of U.S. goods and services while vaguely promising to shift American economic patterns toward savings.

How this magic transformation might take place is the big question. Europe will not pick up the slack, and China can only continue to allow its economy to grow bubbles for so long. Emerging Asia might have potential, but it is not clear why the US would win from such growth, in particular as long as the safe haven effect continues to hold up the value of the $US. The other problem is that, with a weakened Euro and £GB, Europe will see competitive strengthening in relation to the US in all export markets. As I have said, the movement of money into a 'safe haven' undermines itself.

What this suggests is that there will be no chance of export led growth as long as the $US remains a safe haven. The greater the borrowing of the US, the greater the demand for the $US to put into 'safe haven' lending, and the greater the demand for the $US, the more the value of the currency is subjected to upward pressure, and the more entrenched the problem of export led growth becomes. It is a circular process, and all the while in the background, the debt in the US continues to mount, and unemployment persists even as the borrowed money pours into the economy.

As the situation stands, there is no probability of a jobs miracle in the US that might come from export led growth. As long as the US remains a safe haven, the effect will be the opposite with import led job destruction. This in turn leads to the problem that, the more jobs that are destroyed, the greater will be the reliance on borrowing to support employment in the US, and this in turn provides the instruments to meet 'safe haven' demand for $US.

What you can see is a process in which the US economy becomes increasingly structured around debt. The more the US government borrows (as long as demand continues), the greater the job destruction in the US from increasing imports and falling exports, and the more the government must borrow to maintain unemployment, and the more the economy becomes structured around the borrowed money, the more entrenched the problem of stopping borrowing becomes........and so on, and on, and on.....

Within all of this, there is the question of where the demand for the $US would come from, were it not from buying $US to lend to the US government. The US is still a huge exporter, but nevertheless has a current account deficit. In addition, the $US is the reserve currency and the currency of trade, and there is therefore demand for the $US for transacting trade. World trade has been increasing of late, which might be a driver for demand for the $US, but that increase commences from a low point. There is also demand for $US to buy assets, such as stocks, but the greater the demand for this kind of investment, the greater the chance of asset bubbles, and the greater the perceived risk for investors.

In other words, without the government borrowing to soak up demand for 'safe haven' currency, it is unlikely that the $US would be able to hold the current valuation. In other words, it government borrowing that is entrenching and expanding the problems in the US economy. By borrowing so much, the US is both accumulating unsustainable debt, but is also providing an asset that meets the demand for 'safe haven' $US. That safe haven status is just a spur to further destruction of the US economy, as it points the US economy into a downward spiral of debt dependency. It destroys sustainable jobs, even whilst it creates (eventually) unsustainable debt supported jobs.

In a world in which many countries are seeking to export their way out of trouble, being a safe haven is not a solution, but is actually a medium/long term problem. The answer is, of course, to break the cycle, but nobody dares to do so. In breaking the cycle, the underlying problems will rapidly emerge, and the economy will tank. As such, the cycle continues, and the problem of an economy being shaped by debt dependency just grows ever more acute. It can only mean greater destruction in the future, as the underlying economy must eventually move from debt dependent employment to sustainable employment. And that means a period of massive unemployment.


I hope that the post makes sense. I have re-read it a couple of times before finally deciding to post. I have a niggling doubt that I have missed something out. Please feel free to point out where you might think that I may have missed something.


  1. Pretty sobering stuff. I guess the last time we were in this situation was during the Great Depression. What's your view on the UK in comparison? GDP seems weak but we seem to have an interesting combination of a currency that has taken a hit (hence your point on a positive export effect might work, albeit if Europe is stuck in a deflationary depression this will not be sustainable withou a radical shift in markets) and 'safe haven' gilts... But then we've also got a serious property bubble relative to the collapses in US and Spain...

  2. We all know the system is broken. We just don't know when its going to go bang. The West over consumes and under produces. The East vice versa. Somehow thats got to be turned round. Either its done in an orderly fashion (govts explain reality to their electorates and implement plans to achive their objectives) or govts stick their fingers in their ears, go la-la-la and continue borrowing to put off the evil day a few more years.

    We WILL get to the end point, either slowly over decades, or suddenly in a massive civilisation shocking crash. Its our choice. But the point beyond which we can't have the orderly option is fast approaching.

  3. To adapt Richard Mottram:
    "We're all fucked. I'm fucked. You're fucked. The whole world is fucked. It's the biggest cock-up ever. We're all completely fucked."

    In which case, don't worry about any minor omissions from your argument.

  4. It is all a mess, but bit by bit people are realising that we have to live within our means. The Keynesian approach is utterly discredited and I hope we finally have a fair wind blowing. We have some tough years coming but we'll get through them!

    And speaking of Keynes, no sign of the Lord on this thread yet? Happy days. : )

  5. Your post unintentionally strengthens the case for large Keynesian fiscal stimulus policies and industrial and trade policies in Europe and the US to create both domestic demand and domestic production. This reduces trade deficits and cures unemployment.

    Given that a return to export-led growth is unlikely, domestic demand and domestic production is the obvious solution.

    Other points:


    In previous posts you propose cutting wages and prices to stimulate export-led growth, but in the depressed global conditions, why would that work?


    Because investors in financial markets are given over to irrationality and herd behaviour, and are themselves deeply ignorant of economics because most of them use neo-classical macroeconomics.

    The absurdity of letting financial market dictate government policy is plain for all to see.

    On the US current account deficit, it has been running deficits in every year since the 1970s and will continue to do so in the future without any real problem, because (as you have noted) the US dollar is the world’s reserve currency.

    On the issue of fiscal stimulus, you neglect to mention that the US financial system is broken.

    Budget deficits alone won’t fix the problem until the banks are cleaned up and they start lending.

    It is obvious that with unemployment at 22%, the US is in a situation almost as bad as the Great Depression.

    The US needs to
    (1) fix its banks,
    (2) adopt trade and industrial policies to rebuild domestic production, and
    (3) adopt very large fiscal stimulus programs to get it out of high unemployment.

    It may need budget deficits as high as 15% or more to break the back of unemployment and restore business confidence. Note that in WWII the US ran a budget deficit of 30% of GDP in 1943, 22% of GDP in 1944, and 21% of GDP in 1945.


    How does it “push the unemployment into the future”?


    Unemployment is still very high, but US GDP is growing. The US economy is not “deteriorating” in the accepted economic sense of that word: it’s stabilised but with high unemployment.

  6. Reply to Steve Tierney


    Don’t worry, I am still here, mate :)

    The Keynesian approach is utterly discredited

    On the contrary, the Keynesian approach is vindicated.

    Every time you hear some nonsensical statement like "Keynesian has failed", all you need to do is point to China.

    This is a case that leaves the anti-Keynesians stumped – and looking fairly ridiculous.

    In the face of a massive collapse in their export-led growth economy, what did China do?

    They implemented a massive $586 billion dollar Keynesian stimulus – and then got a very impressive recovery, so impressive in fact that with growth in the first quarter of 2010 at 11.9%, there is talk that they may need to cool down the economy.

    Does that sound like a “failure”?

    Australia also implemented a large Keynesian fiscal stimulus, which worked very well, and benefited from China's stimulus as well.

    Conclusion? Countries that are close trade partners benefit tremendously from Keynesian stimulus in both countries.

    Meanwhile in policy circles and academia there has been an astonishing Keynesian resurgence

    All in all, the Keynesian approach is alive and well and may well become stronger in the future.

    See also

  7. Keynesian Deficit Spending in China

    Some details:

    Chinese Budget Deficit
    111 billion RMB - 2008
    950 billion RMB - 2009 (lagest deficit since 1949)
    1 trillion RMB - 2010 (estimated)

  8. More on Asian Keynesianism:

  9. Another great post, as usual.

    I've had an idea, which I would be interested in hearing what people think of.

    Hundreds of thousands of British civil servants face redundancy. They will be expecting handsome severence deals from the government.

    What if the government was to offer them the opportunity to set up their own businesses, with a much smaller redundancy payment, and enjoy two years free of corporation tax (or some other tax/vat/rates break)?

    If the business succeeds, then they will create jobs and eventually contribute corporation tax like everybody else.

    If the company fails, then the state is no worse off. The individual will be looking for a job, but will not have trousered a fat cheque from the government.

    What do you think?

  10. @Lord Keynes: yes China is the classic case of how Keynesianism SHOULD work. Run huge surpluses in the good times, spend the money saved (and borrow some more) in the bad times. It may work for them (the jury is still out).

    Contrast that with us, who haven't had more than a handful of budget surpluses in the last 50 years. We have lived beyond our means for decades. That is not sustainable.

  11. OK you get a Grade A+. That is the good news. The bad news is that there is so much going on out that is not good that what is really there is worse than any of us thinks.

  12. Lord Keynes makes a valid point in pointing to the success of Keynesian policies in the surplus countries, is a just a pity that debt laden governments think they can emulate the actions of a rich man.

    Dave O'Carroll Romford

  13. Reply to Sobers

    I take it you have no arguments against the effectiveness of Keynesianism in Australia or China?


    Actually, this shows simple ignorance of the basic nature of our modern monetary system.

    Since a government is perfectly capable of having its central bank monetize a budget deficit in whole or in part (or indirectly via QE), it has the power spend as much money as it wants whenever it wants – it is only constrained by the amount of real goods and services in the community, the external balance (current account), and inflation targets.

    When it runs a budget surplus, it effectively DESTROYS that money by withdrawing it from the economy (assuming it does not buy financial assets with it). Investing it in private financial assets is utterly foolish, as it may contribute to bubbles and is simply no guarantee that it will be available later, because private financial assets might collapse in value at any time.

    A government running a budget surplus in good times in is no sense “saving” for later – because an entity that has the power to create our money at will has NO need of saving.

    You run a budget surplus in good times to control inflation, reduce demand, or pay down debt.

    It isn't about national saving.


    Actually, the early New Labour ran budget surpluses, including a record surplus in 2000.

    The budget deficits in the early 1980s were the result of Thatcher’s disastrous experiment with monetarism and the severe recession she caused, and the ones under Major in the early 1990s the result of the severe recession of 1990-1991. The budget deficits from 2001 onwards were largely the result of the 2001 recession and the wars, with some extra public spending. All in all, it hasn’t deviated far from normal Keynesianism, Sobers


    This is simply false.

    If the UK managed to attract a capital account surplus to fund its current account deficits over the past 50 years, then it was NOT living beyond its means.

    It attracted the money to pay for imports – the means to pay for current account deficits were available because foreigners bought UK financial assets and real assets and the US dollars to pay for imports flowed in. Simple as that.

    All this talk about “living beyond your means” just shows an ignorance of the basic facts of the balance of payments.

  14. Reply to Dave O'Carroll Romford

    The UK and US are extremely rich – they have a huge amount of goods and services and skilled labour.

    You confuse “money” with wealth.

    Money is just a tool we use to create wealth and control the eocnomy.

    Under fiat monetary systems, the state controls the money supply.

    Western countries can create all the money needed to mobilize resources and rebuilt productive industries.

    See my reply to Sobers above.

  15. Incidentally, to Dave O'Carroll Romford, Australia isn't a "surplus" country. It has a virtually persistent current account deficit.

  16. A General Note:

    The use of terms like ignorance are not very useful, and I would generally prefer that debate used less offensive language. Commentators, when commentating on the views of others should also bear in mind that so called 'facts' are set within context, and that any theory is just that - a theory.

    As yet, I have never seen any economic theory that does not have an alternative view that contests the theory - all with piles of studies, empirical support, and so forth. As such, I would suggest that the use of words like ignorant are unwise.

  17. Cynicus,
    A fair point in view of differing theories! - I am happy to not use the word "ignorance" in future. Apologies to Sobers...
    However, one can't have a debate without stating that you think someone's view is false, surely.
    I am not in the least offended if someone states they think I am "wrong" or have a "false" view.


  18. @Lord Keynes 'Under fiat monetary systems, the state controls the money supply.'

    I can assure you the 'state' isnt controllling the US money supply. Nor is it doing it directly in the UK.

  19. Maybe it’s your good self that is confused Lord Keynes, if the conclusion you reached from reading my post was to offer a lesson in spelling.

    You’re correct in one respect though; Australia does indeed run a deficit, so I retract my earlier assertion that they operated a successful Keynesian policy on the basis that it only appears that way. Could it be due to the effect of the Chinese (Key-ne-si-an) spending, and an abundance of exportable Australian commodities?

    Emotive terms like discredited and dysfunctional do result in emotive responses, but surely all they’re doing is what’s written on the can.

    If we lived in a bubble and the UK was the only girl in the world and the £ was the only boy then what you espouse could come to pass.

    The central banker would simply discharge the billion/trillion/whatever debt by creating money from thin air, almost as if by magic, with some mad bowler hatted, pin stripe suited Paul Daniels lookalike chanting Zimbabwecadavre rather than the more familiar Abracadabra, as the £50 notes flutter to the floor.

    But we’re not the only girls and the Great British Pound isn’t the only boy LK, we live by and large in a world of ever increasing disbelievers. The kind of disbelievers who realise that magic is merely sleight of hand, simple trickery designed to fool the less discerning. Perhaps it’s magic that should take the heat of discreditation rather than perfectly functional strategies for perfectly functioning worlds.

    Those damned Johnny foreigners demanding substance to sustain the stash of wonga they’re holding as reserves throw the proverbial into the workings somewhat, don’t you think?

    ‘Lost in Translation’ springs to mind when I imagine their cute expressions as The Great Mervyn ‘The Magician’ King explains that they must DESTROY those worth-less pieces of paper they’ve diligently been saving for a rainy day. Those awfully nice green people are bound to have an idea or two on the best method of disposal, personally I’d suggest burning, at least that way they could turn the rain to steam and generate a trillionawatt of electricity to sell back to the grid for a bob or two

    Of course, I could be thinking too small, thinking of countries in the singular rather than the plural and missing the bigger picture altogether. Unilateralism’s never a good idea; we’ve seen it fail at so many levels.

    If the West could take a multilateral approach and collectively ease the fortunes out of the pockets of those less fortunate, it just may work. It would need the G7, or even better the G8, to get with the G9, work as a team, agree to operate as a single entity in their ‘Greatest Show on Earth’ moment and all wave in unison at those G20 muppets foolish enough to walk on the wrong side of the line.

    Who could lead such a show, who could become the Ringmaster, Tony, Gordon, no, it would have to be someone bigger, a giant amongst leaders and a convert of all things Keyneist?

    Sarkozy of course! Who could possibly be better at fronting the fraud, than the diminutive Sarkozy, pretending to be a giant as the front for the giant pretence?

    Sadly Lord Keynes it’s all academic as all academics know, for I fear all the theorising and postulating will be sorely tested in the very near future (date TBA), then we will see for real who is right and who is righter.

    I’d prefer to think not me, for I fear the worst, with the worst being that the $ a day worker truly becomes a global phenomenon and the decades of adjustment beckoning the West will not be an adjustment easily made.

    Thanks for the spelling lesson anyway LK, truly a Keynesian gesture given that you would be fully aware that I have a perfectly functioning spell checker on my PC courtesy of a certain American Billionaire.

    Now there’s someone who knows how to spend his money and increase his riches simultaneously.

    Dave O’Carroll Romford

  20. @Keynes: a general comment as well.

    There appears to be something of a gap between your assertions about the viability of specific countries (which are somewhat dubious), and sweeping statements such as the one quoted above about 'western countries'.
    Governments can only 'create inf money' at the expense of private savings. Luckily for the US/UK, consumers there don't have private savings anymore anyway, so at least that isn't a threat - but that's not the case in most of Western Europe. (Having said that, I do think it's fairly sad that Brown/Blair pretty much destroyed your pension funds)
    Anyway, to my second point: What wealth creating industries does the UK have that can employ a substantial enough number of your unemployed? It seems to me that the financial industry's settling itself on the UK pretty much ruined your industries by increasing demand for the GBP, while drawing away creative minds from other, more useful industries by promising them 6-figure salaries.
    Your suggestion that 'the UK will be fine' thus seems somewhat overly optimistic to me.

  21. Respone to DLT

    My statement "the state controls the money supply" is indeed misleading, if you are talking about MMT.

    I should have said, "the government's central bank controls reserves and the interest rate".

    It is indeed a myth that the central bank can directly control the broad money stock or the growth rate in the broad money stock.

    When Thatcher and Carter/Reagan tried monetarism, it was a complete diaster: the central banks could not meet their targets and the fiction that the central bank controls the money supply directly was quickly given up.

    In particular, Paul Volker's attempt at targetting broad money stock growth rates with a "floating interest rate" policy caused a massive recession, deindustrialization in the US, and a Third World debt crisis.

  22. Response to 0spinBoson


    I advocate trade and industrial policy to rebuild manufacturing.


    All completely true. That's why the financial sector needs regulation and the state needs to use trade and industrial policy.

  23. Can anyone highlight how we as individuals are going to be affected on a day to day basis in the future when the financial world does come to an end?

    I assume unemployment will rocket, but i want to know how the average man / woman will be affected. Does it mean we will be paying £700 for an average TV as opposed to £350 in a tesco store?

    Will a meal out cost an average £40 a head as opposed to £20 now? (I am not a big drinker so this doesnt include much alcohol).

    I read and read how much pain is coming, but has anyone any ideas on how this may play out on a day to day basis? If it is a case of basic belt tightening then i reckon most can cope this this. If it means changing the car every 5 yrs as opposed to 3 yrs then that is not a hardship. my family live pretty frugally and so i reckon we wont feel much impact.

    what do others think?

  24. New high in gold today, touched £870.77/oz. You'd think, having been 'debunked' as a barbarous relic all those years ago it would have rolled over and died by now...


  25. the only job creation i can see that would get us out of trouble is agricultural farming of Hemp, with the material provided from that either giving us massively reduced fuel costs ( think of the money saved if people could buy hemp methanol at half the price of regular petrol!) or lots of cheap food for domestic consumption and export, and material to make composites for use in industrial products. We no longer have a technological or military edge over the rest of the world, and china alone massively outnumber us and have more money to buy resources. fact. we need to co-operate with each other as a society to survive, or tear ourselves apart through economically induced conflict, which won't strengthen us in anyway at all.

    no-one is recognising the link between natural resourceprices and the economy. Our economies are totally dependent on the availability of particular resources, so isn't it obvious we need to switch to something that is easily available.

  26. One for the Lord: "Time to plan for post-Keynesian era"

  27. Good article and very logical and I would buy it, however the most important exchange rate of them all (the US$/RNB) exchange rate is controlled and not subject to market movements.

    All this talk of running deficits is a misnomer. There will be no recovery in the Western world until there is a redress to this horrendous imbalance.

  28. Reply to Jonny

    Jeffrey Sachs' FT article is refuted here:

  29. More analysis on the G20 plan for global austerity:

  30. I said it before and I'll say it again, your thesis keeps showing that the current form globalization of labor doesn't work because it divides the world into two camps: workers and spenders.

    The only way globalization will work is with ONE global currency that is finite and cannot grow like traditional currencies grow. Let's say the global economy is a 600 trillion note economy. That supply of money should not grow unless there's a significant increase in a major wealth creating input, such as a major boost in agricultural production, discovery of a new but viable energy source, etc. This would eliminate the government debt that bond markets encourage. This way, the world would be completely flat. The way things are now, where the arbitrary wage advantage, "cheap labor" has created a binary system composed of debt and surplus based economies. A global currency would make labor throughout the world "cheap". Wage differences would still exist but the differences would be smaller than they are today. A global currency would please capitalists and environmentalists. A global currency would provide the maximum amount of sustainability and the maximum amount of competition.

    The only real risk in adopting a global currency like the one described above is a total dependence on international capital. It could be argued that this is already the case. A global currency would make it official.



Please allow up to two days for the comment to appear.



