This Time Is Not Different. More Debt, Less Growth

This Time Is Not Different. More Debt, Less Growth

I remember that in 2009 three messages were constantly repeated: “In this crisis measures are different, because governments are investing in the recovery by increasing public spending,” “the funds from stimulus plans will strengthen the recovery “and “central banks help a stronger recovery by lowering rates and increasing liquidity”. Then, 2010 arrived and the Eurozone entered a deeper crisis. In many aspects, this recession is similar. Many governments are doing the same as they did in 2009. Extend and pretend. Extend structural imbalances and pretend this time will be different.

It is worrying to see the same level of excessive optimism of 2009 these days, and we must prepare for a complex environment and a difficult recovery if we are to emerge from this crisis stronger.

A recent analysis by Ned Davis Research shows that as government debt rises, growth slows, and jobs recovery is weaker. Using a multi-factor mode analysis with data from 1951 to 2020, as government debt to GDP exceeds 100%, real growth per annum falls to 1.6%, non-residential investment falls and non-farm payroll recovery weakens to 0.6% per annum.

Two factors tell us that the recovery in 2021 will likely be disappointing. Massive liquidity injections, with $26 trillion injected by central banks, have been used mostly to perpetuate elevated government spending, fundamentally current spending, and fund public debt. The second is that corporate balance sheets have been damaged to a level that will make it difficult to see a significant growth in investment above depreciation. SP Global expects global capital expenditure to remain weak in 2021.

Global growth estimates look too optimistic. The consensus assumes a recovery of 4% globally in 2021, returning to the GDP of 2019 at the end of 2022. This assumes an extraordinary and unprecedented fiscal multiplier of debt and liquidity. One of the most important concerns is to see a recovery in GDP led by a bloated public spending and record debt that would not generate enough employment growth. This is what is called a jobless K-shaped recovery, where some sectors rebound rapidly (technology, high added-value sectors) and a majority (Small and medium enterprises, self-employed) either do not recover or worsen.

In this crisis, developed countries have had an enormous fiscal space at their disposal to face the pandemic. An economy doped by high liquidity and low rates. Some countries have used part of this fiscal space to preserve the business fabric and help create jobs. Others, a majority, have taken the crisis opportunity to increase structural imbalances and current spending without real economic return. This means that there is an important risk of a jobless recovery where furloughed jobs are not absorbed entirely.  

A solvency crisis cannot be solved with liquidity. All the central bank quantitative easing programs do not prevent the bankruptcy domino from accelerating in 2021, just as we saw in Europe after the 2009 optimism. This financial crisis after an optimist period comes because the challenged of the economy do not come from lack of access to debt or low rates, but working capital rising way above sales.

Expectations regarding the impact of the European Recovery Fund seem exaggerated. Too much hope is being placed on the magic of the Keynesian multiplier effect of these funds, despite the evidence of their low effectiveness, already contrasted after the disappointment of the Growth Plan and Employment 2009 plan and the Juncker Plan. The probability that these funds will be misused and unproductively is high.

When I look at the estimates of GDP growth for 2021-2022, I see that consensus estimates assume a 1.5x to 2x multiplier to the stimulus packages implemented in 2020. This is almost impossible because it has not happened in the past three decades, there is evidence that the multiplier is very low or zero. The study of Ilzetzki et al” How Big (Small?) Are Fiscal Multipliers? “ (Journal of Monetary Economics, Volume 60, Issue 2, March 2013) shows the history of the cumulative impact of public spending in 44 countries, showing the very low effectiveness of fiscal stimuli. Even if we accepted positive fiscal multipliers, the empirical evidence of the last fifteen years shows a range that, when positive, moves barely between 0.5 and 1 at most. However, in most countries has been negative (as reflected in the FT article “Has the IMF proved multipliers are really large?“, and “Growth Forecast Errors and Fiscal Multipliers” IMF study).

What can be expected? Some relevant downgrades to GDP growth estimates in those countries with the highest indebtedness and where the fiscal space has been used to perpetuate current government spending and finance automatic stabilizers.

We may also see a large increase in debt as GDP growth undershoots expectations and deficits remain elevated, something that will impact 2022 estimates as well. As governments may decide to raise taxes to finance part of the deficit increase, the impact on jobs and growth will likely be larger.

There is also an important factor to consider. Gross Capital formation may likely disappoint as 2020 has seen an unprecedented zombification of the economy which has led to an abnormal rise in overcapacity for such a short crisis with a large bounce in the third quarter of 2020.

Fiscal and monetary space and are not excuses for counter-reforms and wasting money. Countries have the unique opportunity to use these tools to strengthen the productive fabric and create employment, but unfortunately a large part has been squandered.

There is only one way to strengthen the recovery: To reduce structural imbalances by regaining budgetary sanity and implementing serious measures to attract capital. To fall back into propagandistic optimism would be a mistake.

About Daniel Lacalle

Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Author of bestsellers "Life In The Financial Markets" and "The Energy World Is Flat" as well as "Escape From the Central Bank Trap". Daniel Lacalle (Madrid, 1967). PhD Economist and Fund Manager. Frequent collaborator with CNBC, Bloomberg, CNN, Hedgeye, Epoch Times, Mises Institute, BBN Times, Wall Street Journal, El Español, A3 Media and 13TV. Holds the CIIA (Certified International Investment Analyst) and masters in Economic Investigation and IESE.

2 thoughts on “This Time Is Not Different. More Debt, Less Growth

  1. Hello, I read a recent commentary of yours in The Epoch Times. You may be alerting us in the simplest language that you can imagine, but it is not simple enough.

    You end the paragraph that states the ECB is on its way to owning 70% of the sovereign debt of the Eurozone with the sentence, “There is no market.” This leaves most of us confused. We commoners joke about the government printing money, but we do not quite think that is really happening. Experts talk about the balance sheets of the ECB and the Federal Reserve. We commoners know about balance sheet assets; that is where the value of land, equipment and buildings are recorded.

    It is hard to learn things that should not be true. As experts are talking about balance sheets and quantitative easing; we commoners are not connecting the dots. Is there any difference between what is going on today and the printing of Greenbacks during the U.S. Civil War? Secondly, we commoners warn our children about the risks of too much debt, but it is hard to get our heads around the substantially worse proposition that we are only pretending to have sold our debt. As I said, it is hard to learn things that should not be true. Thank you for your warnings; I pray they are heeded.

  2. Hello Daniel,

    I was reading your article in which you claim that the higher the government debt is, the slower the growth.

    That is wrong. What I believe the research should show is slower growth derives from a higher percentage in the economy of government expenditure, of which a large fraction is waste. Looking at one small component of a problem while ignoring the rest does not make for good research or good conclusions.

    For example, let us say a city government funds itself with $100 taxed from resident citizens. If that same city were to borrow the funds from resident citizens, how would the result be any different? $100 leaves the hands of residents whether funds are taxed or borrowed. Why would growth be slower with borrowed funds rather than taxed funds?

    You may argue that the debt is a burden on the city or rather its resident citizens, specifically taxpayers, and grows with interest. But only until the debt is repaid. Very often a public liability remains, rolling over in various forms. The burden would only show when there is actually an effort to reduce the accruing city liability. Until then, it’s not a problem.

    Let us say the debt has grown to $200 with interest. The lenders seek return of funds. The city could roll over the debt, $200 transferring from one set of resident lenders to another with the debt to grow with interest over a further period. Again, no burden. Or it could repay it by taxing $200 from resident citizens, taxpayers, and handing over the funds to resident citizens, specifically lenders. Some residents are out $200 and others are enriched by $200. An individual burden and boon that ends in a collective nullity. I see no retardant for growth with this Ricardian analysis.

    So is the problem really debt? Or is it something else. I imagine that a government, already spending to a wasteful excess, must resort to borrowing when taxes fail to supply enough. Maybe NED should recalibrate their study to reflect this new information.

    As a final point, let us say that the city decided to fund all its expenditures by borrowing. Being forced to go with cap in hand to the financial markets to borrow, it is certain that any wasteful government expenditures would be removed from the budget. Lenders, really resident citizens, don’t like to see their funds go to waste. Suppose city expenditures decline to $50 from $100 as the waste is excised. That leaves the city residents with $50 more to invest, save, retire debt, and consume on worthy projects and goods. That doesn’t sound like a check on growth. And don’t forget the deterrent effect of Taxation disappears. The city economy should grow again with the fetters of Taxation removed.

    So the burden or check on growth arises not from the debt, but from something else, which I believe is the squander of public monies and Taxation’s deterrent effect.

    Perhaps you should give the subject more thought.

    Gary Marshall

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