Interesting piece from well known Canadian Hedge Fund Manager Eric Sprott on government debt
"Despite our firmâs history of investing primarily in equities, weâve spent much of this past year writing about the government debt market. Weâve chosen to focus on government debt because we fear its impact on the equity markets as a whole. Government debt is an intrinsically important part of the financial landscape. It is the bellwether by which we measure risk, and we believe we have entered a new era where traditional ârisk-freeâ assets are undergoing a tremendous shift in quality.
In studying the government debt market, we have inadvertently been led to question the economic theory that most fervently justified recent government spending programs: that of Keynesian economics. The so called âbeautiful theoryâ of Keynesian economics is arguably the most influential economic theory of the 20th Century, shaping the way Western democracies approached the balance between free market capitalism and government initiatives. Like many beautiful theories, however, Keynesianism has ultimately succumbed to the ugly facts. We firmly believe the Keynesian miracle is dead. The stimulus programs are simply not producing their desired results, and the future debt costs associated with funding these programs may cause far greater strife in the future than the problems the stimulus was originally designed to address.
Keynesian economics was born with the publishing of John Maynard Keynesâ âThe General Theory of Employment, Interest and Moneyâ in February 1936. Keynesian theory advocates a mixed economy, predominantly driven by the private sector, but with significant intervention by government and the public sector. Keynes argued that private sector decisions often lead to inefficient macroeconomic outcomes, and advocated active public sector policy responses to stabilize output according to the business cycle. Keynesian economics served as the primary economic model from its birth to 1973. Although it did lose some influence following the stagflation of the 1970s, the advent of the global financial crisis in 2007 ignited a resurgence in Keynesian thought that resulted in the American Recovery and Reinvestment Act, TARP, TALF, Cash for Clunkers, Quantitative Easing, etc., all of which have been proven ineffective, ill-advised and whose benefits were surprisingly short-lived.
The economic historian, Niall Ferguson, recently described a 1981 paper by economist Thomas Sargent as the âepitaph for the Keynesian eraâ.1 It may have been the epitaph in academic circles, but the politicians clearly never read it. Almost thirty years later, we now get to experience the fallout from the latest Keynesian stimulus binge, and the results are looking pretty dismal to say the least.
There are a number of studies we have come across that suggest stimulus is the wrong approach. The first is a 2005 Harvard study by Andrew Mountford and Harald Uhlig that discusses the effects of fiscal policy shocks on the underlying economy. Mountford and Uhlig explain that from the mid-1950âs to year 2000, the maximum economic impact of a two percent increase in government spending was an ensuing GDP growth of approximately three percent. A two percent spending increase inevitably requires an increase in taxes. Due to the nature of interest costs, however, the government would have to raise taxes by MORE than two percent in order to pay back the initial borrowing. According to their data, this increase in taxes would generally lead to a seven percent drop in GDP. As they state in their study: âThis shows that when government spending is financed contemporaneously that the contractionary effects of the tax increases outweigh the expansionary effects of the increased expenditure after a very short time.â2 Stated simply, âborrowing to stimulateâ has never worked as planned because the cost of paying back the borrowed funds surpassed the immediate benefits of the stimulus.
In a follow-on study, Harald Uhlig estimated that an approximate $3.40 of output is lost for every dollar spent on stimulus.3 Another study on the same subject by Câordoba and Kehoe (2009) went so far as to say that, âmassive public interventions in the economy to maintain employment and investment during a financial crisis can, if they distort incentives enough, lead to a great depression.â4
If the conclusions of these studies are even close to being correct, we are now in quite a predicament â not just in the US, but across the Western world. Remember that the 2007-08 meltdown was only two years ago, and as we highlighted in April 2009 in âThe Elephant in the Roomâ, the US government has spent more on stimulus and bailouts, in percentage of GDP terms, than it did in the Gulf War, Operation Iraqi Freedom, the Vietnam War, the Korean War and World War I combined.5 All that spending was justified by the understanding that it would generate sustainable underlying growth. If it turns out that that assumption was wrong, have the governments made a fatal mistake?
Another recently published Harvard study looked at stimulus at a micro-economic level and derived some surprising conclusions. Entitled âDo Powerful Politicians Cause Corporate Downsizing?â, the authors compiled 232 occasions over the past 42 years when either a Senator or a Representative was voted into a controlling position over a big-budget congressional committee. Unsurprisingly, the ascendancy of the politicians resulted in extra spending in their respective districts â typically in the form of an extra US$200 million per year in federal funds. The researchers examined the economic effects of this increase in spending and found âstrong and widespread evidence of corporate retrenchment in response to government spending shocks.â The average firm cut back on capital investment by 15 percent and significantly reduced its R&D spending.
Companies collectively operating in the affected state reduced capital investment by $39 million a year and R&D by $34 million per year. Other consequences included increases in unemployment and declines in sales growth.6,7 Yikes!! That is not the response weâre supposed to get from government spending!
The Canadian governmentâs experience with Keynesian-style stimulus has been no better. The Fraser Institute reviewed the impact of the Government of Canadaâs âEconomic Action Planâ and found that âthe contributions from government spending and government investment to the improvement in GDP growth are negligible.â8 They state that, of the 1.1% increase in economic growth between the second and third quarter of 2009, government consumption and government investment contributed a mere 0.1%. Of the 1% improvement in economic growth between the third and fourth quarter of 2009, government investment and consumption contributed almost nothing. In the end, it was actually net exports that were the largest contributor to Canadaâs growth. No Keynesian miracle in this country.
Our own findings compare favourably to the academic studies cited above. We looked at government spending and current dollar GDP increases in our âMarkets at a Glanceâ entitled, âA Busted Formulaâ. We looked at current dollar increases in GDP as published by the Bureau of Economic Analysis (BEA) and current dollar expenditures and receipts for the US government taken from the Treasury. One current deficit dollar resulted in an increase in current dollar GDP of a mere 10 cents. Again â no miracle Keynesian multiplier
If we use the Fedâs own numbers, the impact of debt on GDP is even more dismal. The marginal impact of debt on marginal GDP since 1966 using data from the Federal Reserve. Deficit spending, which has generated smaller and smaller increases in GDP over time, is now generating a negative impact on GDP due to the costs of servicing the debt. The chart suggests we have already entered what PIMCO refers to as the âKeynesian endpointâ, where the government can no longer afford to increase debt levels.10 No debt = no stimulus. No stimulus = ???
A more timely epitaph for our Keynesian funeral comes from a recent op-ed piece by Jean-Claude Trichet, President of the European Central Bank, that was published in the Financial Times and entitled âStimulate No Moreâ. In it Trichet states that, ââŚthe standard economic models used to project the impact of fiscal restraint or fiscal stimuli may no longer be reliable.â11 He explains that while debt in the euro zone has increased by more than 20 percent in only four years and by 35 to 40 percent over the same time period in the US and Japan, we have very little, if anything, to show for it. We agree. New housing sales are at all time lows, consumer intentions for auto purchases are at multi year lows, the University of Michigan consumer confidence index has turned negative, new jobless claims have started to increase, and the ECRI â a composite of leading indicators â is now forecasting a recession (see Chart C).
Since Keynesian economics is no longer relevant, some are now arguing that tax cuts will save the day. Two of the academic studies we reviewed suggest that tax relief is a much stronger stimulus to the economy than government spending, and under normal circumstances this is probably true. But we are not in a normal economic environment. Even if the tax cuts implemented by George Bush in 2006 are extended by the next Congress, the US will still face the âKeynesian Endpointâ. A Government Accountability Office (GAO) report published in January 2010 states the following: âIn our Alternative simulation, which assumes expiring tax provisions are extended through 2020 and revenue is held constant at the 40-year historical average; roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020.â12 Extending tax cuts wonât solve anything.
In the end, Keynesian stimulus ultimately fooled us all. It roped in the politicians of the richest countries and set them on an unsustainable course of debt issuance. Recent Keynesian stimulus has even managed to fool the sophisticated economic models designed by central banks. The process of accounting for massive government spending âconfusesâ the models into calculating a recovery trajectory when it doesnât exist. The Bank of England confirmed this with its announced ÂŁ3.5 million overhaul of its current model due to its inability to generate accurate inflation and recession forecasts.13
Keynesian stimulus canât be blamed for all our problems, but it would have been nice if our politicians hadnât relied on it so blindly. Debt is debt is debt, after all. It doesnât matter if itâs owed by governments or individuals. It weighs on the institutions that issue too much of it, and the ensuing consequences of paying off the interest costs severely hinders governmentsâ ability to function properly. It suffices to say that we need a new economic plan â a plan that doesnât invite governments to print their way out of economic turmoil. Keynesian theory enjoyed a tremendous run, but is now for all intents and purposes dead⌠and now itâs time to pay for it. Literally. "