The Myth of Debt Financed Prosperity

Let us imagine that one day ‘Mr Kendant’, tired of his wife’s nagging about their old wreck, borrows $550,000 and toddles off to Envious Autos to buy a new Audi, which he has delivered to his doorstep the following day, much to the amazement of his neighbours.
Is Mr Kendant more prosperous, as a consequence? Of course not! He has a stunning new vehicle, obviously, but he also has a dazzling new debt of $550,000 to go with it. Mr Kendant, who presumably understands that this purchase represents his choice to reduce future consumption and expenses, such as fewer restaurant meals, fewer holiday trips, no daily luxuries, cheaper toothpaste and no new clothes, has to anticipate future sacrifices in order to drive his now satisfied wife around today.
On the other hand, if Mr Kendant chooses to pay for his holidays, restaurants, toothpaste and clothes on credit, he can continue to live as if his Audi auto debt costs him nothing, but not forever!
So let’s suppose that Mr Kendant comes to his senses one day and decides to sell the Audi for what it is now worth and pay off what he can of the remaining debt. Does this mean the family is in recession? Perhaps: the flashy car is gone, much of the debt may remain, and the interest on the remaining debt continues to reduce the family “GDP” until the whole debt is paid. But is the family less prosperous because Mr Kendant sold the Audi? Of course not!
It is easy to understand these concepts when speaking of Mr Kendant and his family; it is seemingly less easy to understand these matters when speaking of nations. Suppose a nation decides to spend 10 percent more than it produces. Is it more prosperous as a consequence? Of course not, but like Mr Kendant and his family, the people can enjoy amenities and benefits they have not paid for; they are living on borrowed prosperity.
A nation’s GDP, Gross Domestic Product, is consumption, plus investment, plus government spending, plus exports minus imports. This means that debt-financed consumption and government spending will artificially boost GDP, but they do not boost prosperity.
Too much debt impedes future growth after the debt-financed consumption has temporarily bolstered GDP. Belt-tightening, followed by a drop in GDP, becomes the order of the day. But does a drop in GDP as a result of belt-tightening in the aftermath of binge spending, make a nation less prosperous? No, of course not! In fact, they are better off without the crippling effects of an ever-increasing debt burden.
In the above-mentioned examples, both Mr Kendant and the fictitious nation relied on debt-financed consumption to acquire wasting assets — by “wasting” I mean assets that lose value over time — and padded their respective GDP’s in the mistaken view that consumption equals prosperity.
Since consumption is one element of GDP (consumption + investment + government spending + exports minus imports), debt-based consumption may bolster current GDP, but it also bolsters gross debt. One reason China’s economy has soared, and low-debt developed countries such as Taiwan and Australia are able to weather the global financial crisis, while most of the developed world continues to struggle, is the difference in net debt burdens.
Recently, in the United States, 5,000 billion dollars (five thousand billion) in fiscal and monetary stimulus has been provided to bolster the economy. Today, the US economy is just 4%, or $600 billion dollars larger than it was at its low point in the middle of 2009, which means that the US got about 12 cents in economic growth for each dollar of stimulus.
When the borrowing stops, GDP drops, which terrifies political leaders who continue to borrow and borrow. But one day, as we have seen with Greece and countless other nations, not to mention Mr. Kendant’s credit-addicted family, reality hits home. Suddenly, nobody is willing to lend any more.
By hoping for artificial GDP growth and artificial stock market rallies, we make stocks expensive for investors, most of whom are still saving for their retirement. When debt-financed spending disappears, the inevitable bear market creates bargains for those who are still saving. As Warren Buffett argues, investment success is assured if we are “greedy when others are afraid and afraid when others are greedy”.
The bull and the bear are symbolic animals of the stock market. A bull market is characterized by high investor confidence and anticipation of capital gains in a growing economy. A bear market is accompanied by a general decline in the stock market over a period of time in a shrinking economy.
Higher stock prices in a bull market generally accompany greater economic growth. An increase in perceived wealth will cause people to spend on goods, resulting in short term economic growth. If job creators believe that economic growth is accelerating, this likely means that demand for their goods and services will improve as well. And if demand is improving, companies are more likely to add to payrolls.
Not surprisingly, but most people do not understand this simple fact, bull markets are only good for those who are already selling, because only they will benefit from higher prices. Bear markets, as long as they are not severe and destabilizing, may actually be a good thing for those who continue to invest for the future, as such investments can be made at lower costs.
In the worlds of Adam Smith (1723 – 1790) and David Ricardo (1772 – 1823) who wrote about the benefits of free trade, trade between nations balanced. It had to balance because gold was money and the gold standard contained an automatic adjustment mechanism that ensured that trade did balance. They could never have imagined a world in which a country could incur a trade deficit of $800 billion in one year and finance it with paper money.
If, 150 years ago, for example, England had a large trade deficit with France, England’s gold, since gold was money,  would have been put on a ship and sent to France to pay for the shortfall and England’s money supply would have contracted, leading to a recession, unemployment and deflation.
As gold entered the French economy, credit would have expanded, the economy would have boomed and there would have been inflation. The rich French would have begun to buy more cheap English goods; and the English would have stopped buying expensive French goods. Before long, trade between the two countries would be in balance.
The Bretton Woods system, put in place at the end of World War II, was designed to replicate the gold standard’s automatic adjustment mechanism, but in 1971, Bretton Woods broke down and the United States began running large trade deficits, initially with Japan.
As dollars entered the Japanese economy, they went into the Japanese banking system and caused credit to expand. As a result, the Japanese economy began to boom. However, the United States did not deflate because the US was not paying for its deficit out of a limited amount of gold reserves. It was paying with paper dollars and there was no limit as to how many of those dollars the government could create. The Japanese trade surplus continued to expand, the Japanese economy continued to boom until, in 1990, the Japanese bubble burst, asset prices plunged, banks failed and the government had to go deeply into debt-funding large annual budget deficits in order to prevent the Japanese economy from collapsing into a depression.
By the 2000s, the US trade deficit had become so large that effected the whole world economy. China is the most significant country where an economic bubble has formed as the result of an untenable trade surplus with the United States. The bubble has not yet burst, but it will, and soon.
Between 1971 and 2011, the United States’ cumulative trade deficit of $7.9 trillion was financed on credit. Never before has any country amassed a trade deficit on such a scale. The world trade regime is no longer one of free trade; it is “debt-financed” trade that has produced very rapid economic growth as countries radically expanded their industrial capacity to satisfy the surge in debt-driven demand, resulting in a crisis of excess capacity, insolvent banks and unsustainable fiscal deficits. Debt-financed trade has created unsustainable global imbalances on a previously unimaginable scale.
Large economies in large countries will always have huge resources and industries that can be jolted out of recession. They are too big to fail. Small countries have few resources to call upon in a crisis, and they will almost certainly go under. It is impossible to borrow your way out of debt without developing a wealth-creating debt-management system. One way to do this is to invest in the private sector, which, after all, has a vested interest in making money. The wrong way to do this is to invest in non-productive additional jobs paid for by the public purse.