Why does the Western economy, particularly in the United States, still feel as if it's stuck in the mud? One word: Debt.
Debt can come in the form of a mortgage on your house. As a nation, think of debt as a mortgage on the entire economy. An era of rapidly rising debt may fuel a boom, but once the boom subsides you need years to pay for all the borrowed money. That's the situation we find the US in now, as the nation grapples with historic public debts approaching $15 trillion, or 100% of annual Gross Domestic Product.
A few weeks ago I traveled to Las Vegas for the MoneyShow, where I heard a lot of interesting talks. One presentation I'm still thinking about was well known fund-manager Ron Muhlenkamp's succinct warning about the growing debt burden in the United States.
In a session cheerily titled "Is the U.S. Economy on the Road to Japan and a Lost Decade?" Muhlenkamp, the founder of Muhlenkamp & Co., explained the problem very simply. The US has to cut its debt to improve its long-term economy, much as Canada did over the past 20 years. Or the nation can follow the lead of Japan, loading on more and more debt in an attempt to bolster the economy, but only making the situation worse.
The good news? Muhlenkamp doesn't think our situation is as bad as Japan's... yet. The bad news? It seems things are getting worse, as government spending as a percentage of GDP increases.
Of course, the tradeoff is obvious. Cutting debt in the short-term will be painful and short-circuit any near-term recovery. That's why its unpalatable to many politicians, especially those running for reelection. But like a lot of things (dieting, for example), short-term pain may pay off in the long-term.
As we all know, the federal government took on a lot of debt in the past decade in various forms of tax cuts, wars, economic bailouts, wars, and stimulus packages. Muhlenkamp's study of the debt problem goes further in illuminating more of the "why" behind the persistent economic weakness: A country soaked in public debt just can't perform that well, plain and simple.
Muhlenkamp cited data from GaveKal Research that shows a strong inverse correlation between government spending as a percentage of GDP and structural growth. In other words, as debt rises, long-term growth shrinks.
The chart below illustrates this point. On the left axis, we have public spending as a percentage of GDP, on an inverted scale (as you go lower, the percentage of government spending-to-GDP goes up). On the right side is the annual growth rate. The chart shows a perfect correlation between public spending and growth. As public spending as a percentage of GDP goes up, growth goes down.
Muhlenkamp's explanation: Government spending is less efficient than the private sector and does not create new private-sector business and jobs that can recycle or even multiply the cash. In other words, it doesn't create businesses that actually make money (rather than just spending money).
"The trouble with government spending is that the government doesn't have any money," as Muhlenkamp so succinctly says. Every dollar spent by the government must be raised. It is a consumer of wealth, not a creator of wealth.
As the chart above shows, the two best periods of growth in the United States in the past 40 years, the late 1980s and most of the 90s, came when government spending as a percentage of GDP was shrinking. Since 2000, however, government spending as a percentage of GDP has gone from 19% to 25%, while long-term growth has plunged from 4% to 1.5%.
Of course, if you talk about the public debt you have to talk about politics. For those of you about to put on your political hat, this data doesn't necessarily need to have a partisan, purely political interpretation. As former Reagan budget direct David Stockman recently wrote in The New York Times, the deficit is a bipartisan problem. Neither party is living up to its responsibility to cut public debt.
In fact, the budgetary history of the US indicates that growth has come under a variety of political configurations in the White House and Congress, mostly bipartisan. During the periods of shrinking debt and high growth, there were Republican presidents (Reagan and Bush I) and Democratic presidents (Clinton). There were also both Republican and Democratic majorities in Congress. The politicians will all take credit for the good times, but it's interesting that the happy days coincide with governments that managed the budget, regardless of what party they came from.
Of course, strict Keynesians will take issue with Muhlenkamp's arguments. You need more spending during times of economic weakness, they will say. Maybe. But the tradeoff is such: The more you run up the tab in the dark days, the bigger hole you have to dig yourself out of later. This is basic common sense and requires no advanced economics degree. It's the concept of sacrifice. Maybe the American people, not just the politicians, need to own up to this, too. You can't have everything -- lots of government services, subsidies, and low debt.
The real problem with the stimulus argument is that traditional Keynesian economics (as taught in Econ. 101) says that government stimulus is "temporary," designed to drive the economy out of the rut. Unfortunately, the trend of most governments is that almost all temporary spending becomes permanent spending, resulting in a perpetual rise in the share of GDP spending from the government. That's probably why the economy feels so terrible.
Muhlenkamp made his point clear by pointing to the difference between Canada and Japan, countries that have been heading in two distinctly different directions in the past 20 years. Canada made the decision to cut spending in the early 1990s. Government spending as a percent of GDP has been in steady decline, and the Canadian economy has been steadily improving. Conversely, Japan increased spending. Its total debt now stands north of 300% of GDP! And Japan's struggles are well documented.
Muhlenkamp summed it up nicely: The US can be Canada or it can be Japan. It's our choice.