By Bill Wilson — In high-brow business seminars as well as casual conversations and in every form of discourse in between, there is a strong sense of foreboding; a nagging sensation that something is fundamentally wrong.
There is, of course, no end to the partisan and ideological warriors claiming to know the answer and offering solutions. And, to some degree, this missive must fall into that category.
But I offer no solutions because I am not sure there are any. There is, however, a set of relationships that I believe explain our collective dread. Simply put, the economic, fiscal, and monetary system that has been in place since the end of World War II just doesn’t work anymore. What we expect is not happening. Let’s examine the numbers.
Total debt to GDP
This table is alarming for several reasons, but first we need to study the relationship between total outstanding credit nationwide and the economy to understand them.
Beginning in 1945, the growth in total debt — government, corporate and household — has had a direct relationship to the growth in the overall economy. For 25 years up to 1970, the relationship of total debt to GDP remained relatively constant. True, there were variations. But the relationship remained inside a narrow range of 140 percent to 160 percent.
There was another relationship that was pretty constant as well. For every additional unit of debt we incurred, we saw an equal or greater expansion of GDP — as debt grew the underlying economy grew at an equal or greater amount.
From 1945-1950, GDP grew at 31 percent versus a credit expansion of 20 percent. From 1950- 1955, the economy grew 42 percent and credit 37 percent. And from 1965-1970, GDP expanded 56 percent while credit at 44 percent. During those days, credit expansion was predicated on economic growth.
All’s good. Credit, otherwise known as debt, expanded at varying rates but always related to underlying value. Then, with the stroke of a pen, these basic relationships were changed.
End of the gold standard
In 1971 Richard Nixon ended all ties of the dollar to a gold standard. What this did was sever all ties of credit and debt expansion to an underlying value. Debt could, in theory, be expanded as greatly as a politician wanted, there was no limit. And from that point on, we were off to the races.
Yes, there were periods of time when the economy grew faster than debt, but they were all before 1971.
Once the dollar lost its anchor in true value in 1971, the following decades saw the most unprecedented expansion in our history. Credit exploded in the period that immediately followed, growing at a rate of 63 percent from 1970-1975, 80 percent from 1975-1980, 82 percent from 1980-1985, and 60 percent from 1985-1990.
Since 1970, we have gone from a debt to GDP ratio of 155 percent — 155 units of debt for every 100 units of economic activity — to 367 percent in 2010. This huge debt overhang would, in and of itself, be cause for concern. But the way that debt impacts the economy is of far more concern.
Ever since cutting all ties to a gold standard — or any other form of hard fixed valuation — the fundamental relationship in the economy has been inverted; where before growth determined the amount of debt expansion, now debt expansion determined growth. And over time, an ever-greater amount of credit expansion has become required to yield the same amount of economic growth. In the 2000’s, credit expansion outpaced economic growth nearly 2 to 1.
The highest that ratio had ever been was 1.61 to 1 from 1960-1965. It peaked during other periods, too, and then came back down. But the increased need for greater debt to produce even a modest amount of growth has been the hard reality of the past dozen years. That makes the 2000’s by far the least effective period of credit expansion in the entire 65 years examined.
Credit expansion stops, so will growth, too?
Since the financial crisis in 2008, credit expansion in the U.S. economy has ground to a halt. And unless it picks up in the coming years, it is safe to assume that the White House Office of Management and Budget’s (OMB) rosy economic projections over the next ten years are almost certainly wrong.
The numbers are clear. In 2008, outstanding credit — all debts public and private — in the U.S. was $53.293 trillion. In 2011 as of the third quarter, it has only risen to $53.824 trillion. That’s just an expansion of $531 billion in three years. This relatively tiny number, even in the face of zero percent interest and every “stimulus” scheme imaginable, tells the real story of what has become known as the “lackluster recovery.” There is no recovery because the Keynesian formula of debt yields growth simply is not working and can’t work with government debt alone. Without corporate and households taking a risk — a private sector risk — there is no growth.
Whereas for 25 years we got 1 unit of growth for 1 unit of debt, today, we get 1 unit of growth for 2 units of debt. Since 2000, debt has grown at double the rate of the underlying economy. And that is where the danger and fear come in.
If this relationship continues, we will have to have debt increases on a mind-numbing scale just to meet modest growth projections. And with a growing population we have to grow.
The Obama Administration is projecting the GDP to reach $18.448 trillion in 2015, and $23.659 trillion by 2020.
For that to be true, based on the relationship analyzed above in the post-gold standard period, credit will need to expand greatly this decade. That could be by $33 trillion if credit and GDP grow at exactly the same pace we see in 2010 or better. But, that is something that has not happened once since we came off the gold standard.
Therefore, the more likely credit expansion required for Obama’s rosy projections to come true is probably between $41 trillion to $64 trillion. It will need to grow at a pace of about $4.5 trillion to $7 trillion a year from here on in to reach that level.
But in 2011, outstanding credit grew at a pace of less than $1 trillion. That explains why the Administration’s projection of 2.5 percent economic growth in 2011 was wrong — it was just 1.7 percent, and is likely to be revised downward as more data comes in. If credit continues to remain flat, do not expect the 3 percent growth in 2012 the Administration is projecting to materialize either.
When Barack Obama took office, it was with a promise that if the government went on a borrowing and spending spree, it would jump start the economy. But there appears to be a cycle of diminishing returns on debt creation. If ever more debt and credit expansion leads to less and less growth, what gets us out of the trap we find ourselves? If strict austerity ensures an economic contraction and more debt simply leaves us in a zombie state, is there a third way? Is there a formula that allows us to stop the debt expansion?
With the $15.3 trillion national debt now surpassing the economy in size, the search for solutions continues. It is becoming increasingly clear that we must return to a sound money system, but how to get there is anyone’s guess.
So, under these unfavorable conditions, nobody in Washington, D.C. dares to seriously and aggressively propose really cutting spending, let alone suggest a return of the gold standard. Better to float along in the near-death state until someone figures this out. That is what passes for political “wisdom” today. But the truth cannot be denied, there is something fundamentally wrong with our economy. We are flying right off the cliff, and it looks like it will take something shocking to get the politicians to take notice and start an honest discussion of how to get out of this box.
Bill Wilson is the President of Americans for Limited Government.