Thursday, December 18, 2008

Growth and Debt

The Freakwenter got mail!
Dear. Mr. Freakwenter:

A Lancaster Newspapers blogger recently wrote this on the Fed's commitment to employ all available tools to support the credit markets, including the market for mortgages:

...all this would jolt the housing market and reinflate the bubble, people might "feel" richer, as they did during the bubble proper. But are they richer? Or does that mentality lead even further down the bleak path we're on?

I mean, we're hitting the wall here and no one wants to admit it, or even face it. An economy based upon consumers racking up ever-higher levels of debt as incomes stagnate is simply unsustainable. There has to be some mechanism by which consumers actually see an increase in their income. We're talking, across the board. But because we don't have such a mechanism - other than huge tax cuts at a time when we've taken on so many new billions, even trillions in government liabbilities - we're stuck. We. Are. Stuck.

A system predicated upon sustainable growth, at a reasonable just-above-inflation rate, could stay afloat.

The blogger seems to be advocating a form of mercantilism, labeling substantial economic growth unsustainable. Yet even with the Dow's recent dive, its 40-year return is close 1000%, with inflation over the same period hovering near 500%.

Can economic growth be fueled by debt, or will it merely create a "bubble?"

Sincerely,
Anonymous reader

Dear Marvin,

I won't even attempt to answer the question at the bottom of this, how does one spur new (but sustainable) growth and higher real incomes when we are stuck. That's a question for the ages, with lots of extremely complicated and uncertain answers. But I have a couple observations.

Assuming that your numbers are correct, the cumulative percentage growth of the Dow in the last 40 years is only 83%, which means that the real annual percentage growth was only about 1.5%. [1000% growth makes $1 into $11, for a growth factor of 11, and similarly 500% growth corresponds to a growth factor of 6. Correcting for inflation, we get a growth factor of 11/6 = 1.83 over 40 years. Starting with 1 dollar, and multiplying each year by a growth factor of x for 40 years, you see that x must be the 40th root of 1.83. Then x = 1.015, for an annualized groth rate of 1.5%.]

The second observation is on the relationship between growth and debt. The blogger may be correct that too many people have acquired too much debt. But I suspect that it's more of an issue that too many of the wrong people acquired too much debt. It's not clear to me that debt, or an particular level of debt, is intrinsically harmful.

To understand debt better, consider the role of the Federal Reserve. The Fed aims to keep prices constant, or slightly increasing. As the economy grows, the Fed must increase the money supply to prevent deflation. Historically, the main way the Fed increases the money supply is to loan money to the U.S. treasury, which increases the aggregate level of debt and the money supply by the the amount of the loan. So, to say that the Fed controls the "money supply" is, until recently, almost the same thing as saying that the Fed controls the "debt supply."

But things are getting messier now that the Fed is starting to buy private equities as well as bonds. When the Fed buys stocks, it puts money into the economy without creating a corresponding debt. The effects of this are little understood.

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