True Economic Growth vs. a Pyramid Scheme

Once you start thinking about economic growth, it’s hard to think about anything else.

– Robert E. Lucas

Q: What is the difference between maintaining sound fiscal policy and running a pyramid scheme with respect to government debt?

A: It all depends on the economy’s predicted growth rate.

What is economic growth, where does it come from, and how do we measure it? These are simple questions, but it is fundamentally important to get them right in order to understand what is ahead for the U.S. economy, and how its growth relates to government fiscal policy. Here I would like to take a look at how we measure economic growth, and argue that sometimes true economic growth may not be what it seems, at least in the short term.

Positive economic growth means that we are better off today than yesterday and will be even better off tomorrow. This means that we can afford things we couldn’t previously, and our lives are getting better and more comfortable. But what drives the underlying economic growth that makes us wealthier? It is the process of technological innovation that drives economic growth. When we make new discoveries and create new technologies our lives are made easier and we become more productive. In a phrase, we get more “bang for the buck”.

How do we measure economic growth? Traditionally, growth is measured by changes in per capita gross domestic product (GDP). GDP numbers can be partially driven in the short term by government actions – monetary and fiscal policy choices. For example, if a government borrows money by issuing government debt, injecting the proceeds into the economy by way of some stimulus program, the stimulus may boost short term GDP numbers. If government spending triggers technological innovation, the economy also grows in the long term, we all get richer, and the government is able to pay back what it owes because the economy has improved. No harm no foul.

But what if stimulus spending does not lead to greater technological innovation? In that case the economy may not be structurally better when the debt comes due.  Then what? The government only has two options: either it can raise taxes to pay off the debt, or it can refinance the debt itself – by borrowing more money to pay what is due today. The first option is not palatable. Popularly elected politicians know that taxes are not popular, especially when the economy is sputtering and people are feeling the pinch. This is called austerity, and it can be pretty painful. The second option – rolling over the debt – makes the economy look better in the short term but leaves an even bigger bill to pay later. Governments that can issue more debt usually choose to do so in the hope that the economy will eventually recover, and all will be well.

This leads to the key question. When would a government be able to borrow even more money on top of what it already owes? The answer to this question depends on the assessment of the country’s long term economic growth rate. If the long term economic growth rate exceeds the long term government debt growth rate, then it is reasonable to assume that the government will eventually pay back what it owes. On the other hand, if the long term economic growth rate is lower than the long term government debt growth rate, then it is more and more likely that the government will eventually default, leaving creditors in the lurch.

A country’s government debt to GDP ratio gives us a snapshot of its ability to make future payments on its debt. Most important, this ratio must be considered in the context of the long term GDP and government debt growth rates. If GDP grows faster than the debt, the ratio goes down, and the country can afford to take on more debt. On the other hand, if the debt grows faster than the GDP, then the ratio goes up, and the country starts to appear sickly. Rational investors then start questioning the country’s ability to pay back its debts.

In simple terms, if the size of the economic pie increases faster than the size of the slice the government promises to others, then it would be relatively painless to give away the promised slice in the future. However, if the size of the slice promised to others increases faster than the size of the pie, then eventually the slice would exceed the size of the pie, i.e. the promise would end up unfulfilled. In other words, if the assumed future growth rate is high enough then government borrowing is a sound policy and creditors will be repaid. However, if the assumed future growth rate is low, then the government is borrowing money against future revenues that are not there – it’s running a classic pyramid scheme.

The bottom line is that as long as investors believe in the country’s long term economic prospects they may be willing to lend money, i.e. buy government debt. Such a belief can be long lasting, especially in countries with stronger long term economic prospects, allowing a county to issue more and more debt for a long time. When that belief fades, however, and investors suspect a pyramid scheme, governments are unable to raise additional funds. Painful austerity measures are sure to follow, as seen in Greece.

Now let’s consider the difference between “true” long term economic growth, i.e. growth driven by technological innovation and increased productivity, as opposed to “growth” via government spending. Notice that if a government spends more money by increasing its debt then GDP numbers are overstated relative to true economic growth – we are feeling a short term “high” that overestimates long term growth. A prolonged period of increased government spending creates a prolonged period of inflated GDP numbers that hide the fact that true growth is weak.

Finally, how does this apply to the United States? Except for a brief period in the late 1990s the U.S. has been running budget deficits, in other words, running up its total debt.  Since economic growth is measured in changes in GDP, it is likely that U.S. economic growth has been overstated over the past three decades. At some point, spending will need to be reduced and a more realistic growth rate will be revealed. As the current U.S. debt to GDP ratio stands at about 100%, it is likely that the era in which the U.S. could easily use leverage to artificially boost growth is waning…