A superb economic tutorial

Every now and again I come across an article that's so clear, so precise in its explanation of something, that I just have to recommend it without reservation. Such an article has been written by John Mauldin in his latest weekly newsletter. This edition's titled 'The End Of Europe?' (Link is to an Adobe Acrobat document in .PDF format).

I can't reproduce the entire 12-page newsletter here, but I'll give you a few excerpts to illustrate how useful his exposition is in explaining the economic climate in Europe, and - by extension - here in the USA as well. I hasten to add that this is only an excerpt. Read it in the context of his whole article to get its full impact, and extract maximum value from it. It's worth your time to do so.

Let’s assume a country that has a gross domestic product (GDP) of $1,000. In the beginning it taxes its citizens about 25% of GDP and spends the money for the public’s benefit. But alas, it spends about 30% of GDP, so it must borrow the overage (about $50) from its citizens or from the citizens of other countries. Because the country starts out with relatively little debt, interest rates on this loan are low, because those who buy the debt can easily see that the the country can pay them back. If the debt of the country is only 5% of GDP ($50) and the interest rate is 4%, then the amount that must be paid as interest is only about $2 per year. Not a whole lot, about 0.2% of GDP.

But this goes on year after year. Sometimes the deficits get smaller and sometimes they get larger, depending on the economy; but government expenditures grow at the same rate as the country grows, and the debt keeps growing at an average of 5% of GDP per year. Now, if the country is growing at 3% a year, after 24 years the economy will have doubled to $2,000 GDP. That means the debt has grown (roughly) to a total of $1,800, which is now a debt-to-GDP ratio of 90%. Debt has grown faster than the country’s economy. Note that if the country had held its budget down to where it grew slower than GDP, thus reducing its need for debt, that ratio would be lower, even if the debt had grown. You can indeed grow your way out of a debt problem if the growth of government spending is less than the growth of the economy. But what if the size of government grows to about 50% of GDP, rather than 25% or 30%, over the 24 years, as politicians decide to spend more money and voters decide they want more benefits? (Think France.) Then the private sector must pay about 50% of its production to the state – plus, the debt is now growing unwieldly. The private sector has less to invest in new businesses and tools, and the growth of the economy slows.

And then along comes a very nasty recession. The revenues of the government fall as the economy shrinks. If the economy shrinks by 3% and total taxes are 50%, then tax revenue falls to $970. But the government does not cut back; and indeed, because it must pay unemployment benefits and welfare (because unemployment rises in a recession), its expenses actually rise by 5%! So it now needs $1,050 to pay all its budgeted expenses. And it must now borrow $80 to pay everyone it has promised to pay, in addition to the $100 it was already borrowing every year to cover its deficit, or a total of $180 a year, which is 9% of GDP.

. . .

Now, government bond investors are a curious breed. They invest in government bonds because they actually think there is not supposed to be any risk. They want their money to be safe. If they wanted risk, there are lots of opportunities to invest with the potential for more reward.

The moment that government bond investors begin to think they might be at risk, they leave. And history suggests they tend to leave seemingly all at once. It is the Bang! moment. Someone fires the starting gun, and they all head for the exits. They start selling their bonds to speculators at discounts, which makes the effective interest rates in the market rise, sometimes by a lot. That means that if a country wants to borrow more money, it will have to pay the effective price in the market, or maybe as much as 15-20% IF – a big IF – it can even get someone to buy the bonds, which of course makes it even more difficult to pay their debt as interest costs rise.

There's much more at the link. Indispensable reading, IMHO, and very highly recommended. Also, if you haven't already subscribed to Mr. Mauldin's free e-newsletter, 'Thoughts From The Frontline', may I respectfully suggest that you should do so as soon as possible? I look forward to it every week.

Peter