Friday, November 18, 2016

Establishing Parameters for Debt

How much economic growth can we get by adding a dollar to Total Debt? Not much:

Graph #1: Change in GDP relative to Change in Debt, and the Hodrick-Prescott Trend Line
Not much, but it does vary. The high point was back in the 1960s and '70s. On average, we added 60 to 70 cents to GDP for every dollar we added to TCMDO debt. That's twice as good as we've done since the mid-80s, as the red line shows. (I'm only looking at the "old normal" economy, before the crisis.)

We can say the 1960s and '70s show the best performance, the highest level reached by the red line on Graph #1. But after about 1968, that line is already going downhill. Economic performance deteriorated in the 1970s. So let's just say the 1960s, then, and forget the 1970s.

But the "Great Inflation" started in 1965. So forget the second half of the 1960s. Let's say that the best performance on Graph #1 is from 1960 to 1964. In those years we gained 60 cents of GDP for every new dollar of debt. And the trend in those years is upward, not downward, and not turning downward.

Why does the ratio on Graph #1 vary? It varies because debt is a drag on growth. Having debt is a drag on growth. It's adding debt that boosts growth. But adding debt increases the debt we have. It's a conundrum.

We need to keep total accumulated debt at the level that gives the most GDP for each new dollar of debt.

Graph #2: Total (Public and Private) Debt as a Multiple of GDP
In the years of its best performance, 1960 to 1964, total debt was about one and a half times the size of GDP. In all of the 1960s and '70s, really, where the red line runs high on Graph #1, total debt was about one and a half times the size of GDP.

Together these graphs tell me that we had the best economic performance when total debt was about 1.5 times the size of GDP. Each new dollar of debt added the most to GDP in the years when total debt was half again the size of GDP.

That's not just the Federal debt, by the way. These graphs show the Federal debt and everyone else's debt added together.

There is something to be said about public versus private debt. But we can't see it on the above graphs. We have to separate public debt from private, and compare the one to the other. This next graph takes the debt we've been looking at (TCMDO at FRED) and separates the Federal debt from all the rest, from the debt other than Federal. Call this other debt "non-Federal". The graph shows non-Federal debt relative to Federal:

Graph #3: Non-Federal Debt as a Multiple of the Federal Debt
In the years 1960 to 1964, our years of best economic performance, non-Federal debt runs between two and three times the size of Federal debt. After 1964, there was never again so little non-Federal debt.

We get the most output from an increase in debt when we have about $1.50 of debt for every dollar of GDP. And the best distribution of that debt is to have non-Federal debt between two and three times the size of Federal debt. So, for one dollar of GDP we want 40 to 50 cents of Federal debt and $1.00 to $1.10 of debt other than Federal. These are ballpark targets for maximizing economic growth.

Graph #4: Targets for Federal and Non-Federal Debt-to-GDP Ratios

// The Excel file (contains VBA code for the Hodrick-Prescott)

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