Thursday, January 26, 2012

You Can't Fool Mother Nature For Long: The Substitution of Debt for Productivity

The "big story" of the U.S. economy is that we have substituted expansion of debt for meaningful increases in productivity.
For the past 30 years, the U.S. economy has become increasingly dependent on explosive debt expansion for its "growth" rather than on meaningful rises in meaningful productivity. Growth is in quotes because growth based on secular increases in productivity--that is, the same investment of labor and capital produces goods and services of greater value--is qualitatively different from "growth" based on a pyramiding of debt.
Real growth based on rising productivity is sustainable, "growth" based on ever-greater expansions of debt is not.
What has kept the Status Quo from falling off the debt cliff over the past four years is the substitution of exploding Federal/public debt for no-longer-rising private debt. If Federal borrowing were to return to 2006 levels, the economy would immediately experience a severe contraction.
We can understand this reaction as that of a debt junkie economy suddenly deprived of massive infusions of fresh credit.
This substitution of public debt for private debt is simply an attempt to fool Mother Nature. The justification of the Status Quo for impoverishing future generations is the massive expansion of Federal debt is needed to "kick start" the economy, i.e. "get us through a rough patch."
After four years of kick-starting and muddling through rough patches, the economy has yet to recover benchmarks set in 2007, much less grown. Meanwhile, the kick-starting added $6 trillion in visible public debt and trillions more in off-balance sheet obligations and backstops.
Substituting debt for productivity is also an attempt to fool Mother Nature. Here's how the substitutiion works: when productivity is flat, then "growth" can be created by leveraging the economy's surplus into greater amounts of debt, which can then be squandered on mal-investments and consumption to foster an illusion of "growth."
Note that I use the phrase "meaningful productivity." If a highrise tower is built in the middle of nowhere and sits empty, the construction and related costs (inspections, transport of goods, utilities, etc.) are added to the gross domestic product (GDP) as "growth," even though the empty building is not adding any real value to the economy.
The same can be said of millions of unneeded medical tests, millions of doses of medications that don't work as advertised, etc.--all the costs of sickcare that rarely add productive value to the economy but which are all added to the GDP as "growth."
If you leverage $100 per month in surplus capital in a household into a $100,000 home equity loan that is squandered on luxury cruises, a new kitchen, boats and dining out, then that explosion of spending boosts "growth" like a shot of cocaine.
But then what happens when the borrowed money has all been spent? What happens when the borrower defaults? The underlying assets--the boat, home, etc.--can all be auctioned off, but a massive loss remains to be swallowed by the lender.
Needless to say, the bankrupt borrower will be unable to borrow another $100,000 any time soon, even if interest rates are lowered to near-zero.
That's what happens when you try to fool Mother Nature by substituting debt expansion for increases in meaningful productivity. Eventually the surplus that is being leveraged into debt reaches the point where it cannot leverage any more debt, and the over-leveraged borrower defaults at the first financial bump.
An economy that is dependent on constant massive increases in debt to fund its "growth" is not sustainable. In a very real sense, the U.S. has been fooling Mother Nature for 30 years. Now we've overleveraged the nation's shrinking pool of surplus capital and assets, and the last rabbit has been pulled from the magician's hat. Mother Nature (i.e. reality in the form of a transparent, marked to market balance sheet) is about to take her revenge on all those who reckoned she could be fooled forever by ever-expanding debt.

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