Long-term outlook: How does it all end?

What economic path are the US and major allies likely to take over the next decade? Here is my take on how this is likely to pan out.

First, let’s start with a template of what a healthy, growing economy looks like.

A Virtuous Cycle

Growth is dependent on two factors:

  • Demographics — that is a growing, skilled workforce; and
  • Productivity — where output grows at a faster rate than the workforce.

Growth requires not only a growing population but a growing workforce. An ageing population or large population under the age of 25 is unlikely to contribute much to output. What is needed are people of 25 to 55 who hold down productive jobs. We also need to ensure that they have the necessary skills — productivity tends to rise with education levels. Education that is skills-based is worth a lot more than a barista with a bachelors degree.

The most important source of productivity growth, however, is investment. More specifically, private investment — government investment tends to provide a short-term boost to the economy but acts as a long-term drag on growth (Dr Lacy Hunt). Mechanization and automation increase the output per worker, boosting productivity.

The chart below shows US private domestic non-residential investment (blue) at a healthy 13.5% of GDP, while productivity (magenta), calculated as real GDP/total non-farm employees, has grown steadily since the 1950s.

Private Investment/GDP & Real GDP/Total Non-farm Payroll

Savings are needed to fund private investment. Either domestic savings or offshore borrowings. Domestic savings are better than foreign debt, especially if debt is denominated in a second currency which can cause volatile short-term capital flows. Workers tend to consume what they earn, with low rates of savings, while the wealthy tend to have far higher savings rates. High levels of inequality increases the amount of saving but depresses consumption. Low consumption leads to fewer investment opportunities, so it is important to get the balance right. Forcing workers to save (e.g. through compulsory superannuation) is one solution.

Low deficits are essential to ensure that government borrowing does not crowd out private investment. Government investment — as we mentioned earlier — is no substitute for private investment as it leads to low productivity and low growth.

Monetary policy is often used to prime the pump — stimulating consumption and investment through low interest rates. But cheap debt has short-term benefits and long-term costs that are often not carefully considered. First, low interest rates discourage private savings which are the lifeblood of a healthy economy. Second, low interest rates are effected by the Fed (or central bank) growing the supply of money at a faster rate than output (GDP). But that causes inflation after a lag of one to two years, forcing the Fed to contract the supply of money and destabilize growth. Third, cheap debt and high inflation (with negative real interest rates) encourage malinvestment in speculative assets that are expected to grow in price without necessarily growing output. The net result is that productive investment is crowded out by both malinvestment (speculation) and government deficits, harming long-term growth.

There is also a fourth, far more insidious factor, that operates with much greater lags. Home prices tend to grow at a much faster rate than incomes during times of low interest rates, reducing access to homes by younger workers entering the workforce. New household formation slows and so does the birth rate, undermining long-term demographics. This can be remedied to some extent by skilled immigration but often migrants are unskilled and face both language and cultural challenges that lead to poor assimilation and a two-tier economy.

In summary, what is needed is a growing, skilled workforce with rising productivity from healthy private investment. Private investment requires stable growth — to facilitate reliable projections rather than unstable boom-bust cycles — and sufficient funding from private saving. Government deficits need to be kept low and real interest rates reasonably high (say 3%) to ensure low inflation and encourage efficient allocation of capital (to productive private investment).

In the Wilderness

We are a long way from the above ideal.

The chart below shows the decline in 10-year average real GDP growth, since 1960, and rising debt relative to nominal GDP.

Total Debt/GDP & Real GDP Growth

Growth is slowing due to poor demographics, rising government deficits, and malinvestment from negative real interest rates. Geopolitical tensions and the need to secure supply chains and sources of energy mean that government spending is likely to exceed tax revenues by a wide margin for the foreseeable future.

Ballooning government debt is likely to crowd out private investment, ensuring low future growth. The chart below shows CBO projections of debt-to-GDP for the next thirty years.

CBO Projection of Debt/GDP

The Fed will likely have no choice but to suppress long-term interest rates in order to assist government in servicing the massive interest burden on its debt. That is likely to lead to high inflation, negative real interest rates, malinvestment in speculative assets, low growth, and rising instability (Hyman Minsky).


We are likely to face a decade of stagflation, with low growth, high inflation and unstable financial markets.

Hopefully, inflation will boost nominal GDP relative to government debt, increasing serviceability, over time. That would provide an opportunity to reduce fiscal deficits and establish healthy monetary policy.

In the meantime, don’t fight the Fed. When interest rates are low and inflation is high, invest in real assets. Look for value — with stable income streams which can withstand tempestuous cycles — rather than speculative growth.


Professor Percy Allan, University of Technology Sydney: Looking Beyond 2024

‘It could be on the scale of 2008’ | SMH

Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.

“People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.

“China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told UK’s The Daily Telegraph, speaking before the World Economic Forum in Davos.

“There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.

Read the full article from Ambrose Evans-Pritchard at smh.com.au: ‘It could be on the scale of 2008’: Expert sends warning on China downturn

US public debt growing at unsustainable rate

We often blame Fed monetary policy for the GFC, with interest rates at exceptionally low levels leading to “Greenspan’s bubble.” Treasury was just as culpable, however, with the massive 2004-2005 surge in public debt flooding the market with liquidity. The repeat in 2008-2011 was more justifiable: the spike in public debt was necessary to offset the sharp decline in private (non-financial) debt which would have caused a deflationary spiral. The effect was to smooth out the fall in total domestic debt (public and private) and create a relatively “soft” landing for the economy.

Government, Domestic and Private (Non-Financial) Debt Growth

Quick Glossary

  • Domestic debt is all local debt, both government and private sector
  • Non-financial excludes the financial sector from debt calculations as it largely acts as a conduit for other sectors.
  • Government debt includes federal, state and local government borrowing
  • Private debt is all Domestic debt other than Government. It includes both Corporate and Household debt.
  • Household debt is all debt owed by private households, as opposed to the corporate sector.
  • GDP is the market value of all final (excludes intermediate) goods and services produced within a country in a given year/quarter.
  • Nominal means before adjustment for inflation.

Government and Domestic Debt Growth compared to GDP

Public debt growth is slowing but needs to fall further in order to keep the economy on a sustainable path. A rough rule of thumb is that public debt should grow no faster than GDP — so that it does not outgrow the nation’s ability to repay. With public debt growing at 8.6% and GDP at a nominal rate of 4.1%, Treasury’s ability to repay — and its credit rating — is deteriorating. Reduction of public debt growth to a rate of no higher than 4.1% is necessary. Increases in tax collections as a percentage of GDP would alter this basic equation, but are highly unpopular and act as a disincentive to further GDP growth.

It should be evident from the above chart that GDP contracts when the rate of domestic debt growth slows. If domestic debt ever had to contract (below zero growth), you can imagine the impact that it would have on GDP. That is a debt-deflation spiral and should be avoided at all costs. So, although we would all like to see a sharp reduction in debt levels, there are limitations on how quickly this can be achieved — without smashing the economy into a brick wall.

We can also see that GDP growth for the past decade has been largely debt-fueled. Only recently has GDP growth surged above the growth rate of domestic debt, reflecting an increase in productivity. That is what we (not just the US) have to strive for: to widen the positive gap between GDP and domestic debt growth, while bringing public debt growth below the nominal rate of growth in GDP.

Reducing the rate of growth in public debt will not be easy, however, with private debt growing at a miserly 0.8% compared to domestic debt at 3.0%. The difference is made up by government debt, growing at a whopping 8.6%. Private capital expenditure, however, has in many cases been brought-forward to take advantage of accelerated tax write-offs and is likely to slow in the months ahead. Even worse is household debt which is contracting at an annual rate of 0.9%. So the medium-term outlook for private debt may be near-zero growth. And further slowing of public debt growth would court another recession.

Domestic, Household and Private (Non-Financial) Debt Growth

Canberra is fighting the last war – macrobusiness.com.au

As we know, the Western world has passed an historic moment when credit driven growth is no longer viable. We are in the early years of a decades long deleveraging. And, as we know from the sectoral balances of macroeconomics, an economy can only grow through the expansion of the external sector or by expanding credit in either the government or private sectors. Is it useful, therefore, to be comparing Treasury’s triumphant victory over the seventies bogies of wage breakouts and inflation via a tradable goods destroying currency appreciation when the world is now set on a course in which the ONLY economic growth that has lasting value in this new milieu is that driven by expansion in the external sector?

For me the answer is absolutely not.

Treasury is busy fighting the last war. The new war is for export revenues to drive investment and growth to offset the enormous debt stocks that exist in the public and private sectors of Western economies, including Australia. That’s why destroying parts of your tradable goods sector in order to make room for other tradable goods is about as sensible as cutting off a leg so that you’ve lost weight. Sure you have, but now you just gonna sit there and eat.

via Canberra is fighting the last war – macrobusiness.com.au | macrobusiness.com.au.