In America, Money Grows On Trees, Right?


Famous rapper, actor and filmmaker Ice Cube caught on to a recent trend in economic policy and proclaimed on Twitter that in the US, money grows on trees.

This idea has been popularized by economist and professor Stephanie Kelton, a major proponent of Modern Monetary Theory or “MMT.”

Advocates of MMT typically take on two slightly different policy paths, both worth describing.

One part of the MMT crowd simply states that deficits have no impact on the economy, and any inflation problem can be solved by raising taxes. In short, we keep the same monetary framework, issuing new debt to cover budget deficits, and we can more or less ignore the interest expense or the scary debt numbers that result. The goal of the politician is to maximize employment, investment, and consumption without causing inflation.

Ice Cube Joins The MMT Crowd:

Source: Twitter

The second faction of the MMT crowd argues for a change in the way our monetary system operates. Currently, the Federal Reserve cannot pay the bills of the Treasury directly, nor can the Federal Reserve absorb losses from bad loans. Changing current laws and allowing the Federal Reserve to create spendable dollars by directly purchasing bonds from the Treasury or pushing money directly to consumers would change the current monetary framework. This would tilt the scales massively toward inflation, but the probability of the second camp seeing a full change to the monetary system is far less likely than the first camp getting their wish for larger and larger budget deficits.

Ice Cube Confuses QE With “Money Printing”

Source: Twitter

I recently created a short YouTube video explaining Quantitative Easing or “QE” and why the impact, under the current monetary system, is not inflationary.

QE is not inflationary because newly-created money does not make its way into the real economy. QE can boost speculation in financial markets, but new money generally comes from new bank loans or fiscal spending from the Treasury/Congress.

The logical question or answer that follows suggests that if banks are not lending, Congress should spend more money (bigger deficits), which will put more money in the hands of consumers – this policy is back to the first crowd of MMT, which states that budget deficits are not significant, nor is the existing pile of debt.

A massive amount of academic research has been done on this topic and the conclusion, replicated dozens of times, adamantly disagrees with the MMT camp. The problem with larger budget deficits is not that the market will not accept the new debt. The market will buy the debt without a problem. The consequence of running larger deficits and adding more debt to the already massive pile of public and private borrowing is the negative impact on real GDP growth or the standard of living.

Below we will take a look at the recent data on debt outstanding in the public and private sector, reference the most relevant research, and conclude with the problems that stem from ignoring the debt build-up.

The US Reaches 400% Debt To GDP For The First Time

Each quarter, the Federal Reserve publishes the Z.1 Financial Accounts report, which details debt outstanding by sector of the economy, household net worth, savings, and more comprehensive metrics.

Debt outstanding can be broken down into four critical sectors: Federal government, state and local government, household, and business.

Each sector can be broken down further, but we’ll stick to the high-level problem. These four sectors together are called the domestic non-financial sector.

If we add debt held by the rest of the world and the US financial sector, we have a comprehensive overview of debt in the US economy.

In the second quarter, the largest quarterly increase in debt came from the domestic non-financial sector, adding over $3.5 trillion in new debt. Most of this increase came from the federal government, borrowing more than $2.8 trillion in Q2.

Quarter over Quarter Change In Debt (Billions):

Source: Federal Reserve, EPB Macro Research

So far this year, every major sector has increased debt outstanding, except for the foreign sector. Total debt this year ballooned $5.4 trillion, with about 60% of the increase coming from the Federal government, mainly due to the CARES Act.

Year-To-Date Change In Debt (Billions):

Source: Federal Reserve, EPB Macro Research

The year-over-year increase in domestic non-financial debt was the largest on record, jumping more than $6 trillion. It’s clear we have chosen the path to “re-leverage” the economy rather than deleverage.

Year over Year Change In Domestic Non-Financial Debt (Billions):

Source: Federal Reserve, EPB Macro Research

For the first time, total debt in the US rose above 400% of GDP. The increase in all the following debt to GDP ratios is due to both an increase in debt and a significant decrease in the denominator, GDP.

As GDP normalizes, these ratios will correct slightly but remain at a new historical high relative to the last peak.

Total Debt As A % of GDP:

Source: Federal Reserve, BEA, EPB Macro Research

Domestic non-financial debt, which includes the government sector, household sector, and business sector, increased above 300% of GDP for the first time, crossing all well-established thresholds by which debt starts to impact economic growth negatively.

Domestic Non-Financial Debt As A % of GDP:

Source: Federal Reserve, BEA, EPB Macro Research

Q2 economic data had several counterbalancing points. The net national savings rate moved into negative territory, falling $188 billion in Q2. In economics, savings equals investment.

Investment is one of the major determinants of increasing productivity over time.

A lack of national savings will reduce the long-term growth rate of investment and therefore cut into future productivity gains.

The decline in net national savings came almost entirely from the government sector as the federal government savings fell more than $5 trillion.

The household sector saw their savings rise massively in Q2, not quite enough to offset the government dissavings.

National Savings, Federal Savings, Household Savings:

Source: FRED

The household sector benefited from massive stimulus in Q2, which actually raised gross national income. Gross domestic product fell in Q2, the difference coming from the significant rise in the savings rate.

Circling back to MMT, what’s the effect of all this debt? Is it true that the government can continue with massive fiscal stimulus without negative consequences?

There have been numerous studies citing certain thresholds where debt starts to impact real growth in the economy negatively. The issue is not whether or not a country can effectively issue new debt, particularly the US, as the world’s reserve currency. Issuing new debt will not be a constraining factor.

While intangible and tough to conceptualize, increasing debt beyond certain well-studied thresholds will result in diminished marginal gains and start to reduce real GDP growth.

A Bank of International Settlements paper titled, “The Real Effects of Debt” set out to establish debt thresholds for each sector of the economy by which more debt starts to have a negative impact.

Each sector is slightly different, but once debt exceeds 85% to 95% of GDP, in any sector, growth is negatively impacted.

The Real Effects of Debt:

Source: BIS

These thresholds, around 90% of GDP, have been replicated in dozens of studies, cited in the YouTube video embedded below.

Government debt, which includes federal, state and local, has jumped over 130% of GDP as of Q2, well beyond the 90% threshold set out to establish when more debt hurts economic growth, irrespective of the use.

Using more debt, at this stage, even for an inclusive program like universal basic income, will not raise the standard of living for the entire population, defined by real GDP growth per capita.

Government Debt As A % Of GDP:

Source: Federal Reserve, BEA, EPB Macro Research

Debt levels in the US business sector (corporate and small business) has reached 90% of GDP, bumping up against the threshold outlined by the 2011 BIS paper.

Business Debt As A % Of GDP:

Source: Federal Reserve, BEA, EPB Macro Research

Household debt is just 2% shy of the 85% threshold.

These numbers suggest that increasing debt in any major sector of the economy will not yield better real GDP growth per capita, which should be the goal of any policy.

Household Debt As A % Of GDP:

Source: Federal Reserve, BEA, EPB Macro Research

In the following YouTube video, we cover why the increase in debt is hurting GDP growth and cite over five research studies on the topic of debt and growth.

Ultimately, we answer the question, “can fiscal spending create real growth?”

World War II aside, which will be covered in a separate article/video, at this stage of indebtedness, we will continue to reduce the rate of real GDP per capita by adding more debt to an existing debt problem.

This adverse effect largely reflects a slowdown in labor productivity growth, mainly due to reduced investment and slower growth of the capital stock per worker.

– Public Debt and Growth | IMF Working Paper

Summary

Does money grow on trees in the United States? Yes, in the sense that the US, as the world’s reserve currency, has tremendous room to increase debt without suffering an increase in credit risk. Under the current monetary framework, however, “printing” spendable dollars is simply not allowed by law.

Congress can decide to increase fiscal spending via debt to fund any initiative that passes both chambers, but a trade off exists.

If the US decides to increase fiscal deficits to finance universal basic income, lower middle-class taxes, or increased transfer payments, the US will continue to shift towards consumption and away from production.

Consumption financed through non-volatile and non-cyclical government income streams will reduce the volatility of GDP growth, as automatic stabilizers are designed.

Volatility of GDP Growth:

Source: BEA, EPB Macro Research

The negative side of the trade-off, however, in exchange for a less volatile economy, is a weaker rate of growth, identified very clearly by the declining trend in the rate of real GDP growth per capita during expansionary periods.

Each expansion in the US has been progressively weaker, falling to just 1.5% real growth per capita.

Real GDP Growth Per Capita By Expansionary Period:

Source: BEA, EPB Macro Research

The economy became extremely over-indebted around the turn of the century. Total debt to GDP crossed 275% around the year 2000, and the impact was a step function decline in the rate of real GDP growth per capita.

Real GDP Growth Per Capita By Decade:

Source: BEA, EPB Macro Research

We continue to hear policy prescriptions for our current slump in growth and growing wealth gap centered around increasing spending and debt, with proponents claiming the debt has not yet been a problem.

If we continue to ignore the problem of declining real GDP growth per capita, staring us right in the face, we will risk greater social unrest as a larger share of the population will see their personal growth rate slip below 0%.

The result of a lower real GDP growth rate and a decline in the improvement of the standard of living will make investors more willing to accept lower real and nominal rates of return on “risk-free” investments.

The overnight rate will stay pegged at 0% as long as the downtrend in real GDP growth remains intact. A lower real GDP growth rate will weigh on inflation as excess capacity in the industrial sector, office space, and labor offset a rise in consumer inelastic goods like food, clothing, and shelter.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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