Our economic conundrum

John Mauldin, whose views on our economic situation we've often mentioned, has just published his latest 'Thoughts From The Frontline' newsletter (link is to an Adobe Acrobat document in .PDF format).  In it, he examines what he calls an 'Economic Singularity':  the conflicting demands of growing our economies, whilst simultaneously repaying debt and avoiding incurring more debt.  The two appear mutually incompatible, even contradictory - but unless a balance can be struck, disaster lurks.  Here's a brief extract.

A business-cycle recession can respond to monetary and fiscal policy in a more or less normal fashion; but if you are at the event horizon of a collapsing debt black hole, monetary and fiscal policy will no longer work the way they have in the past or in a manner that the models would predict.

There are two contradictory forces battling in a debt black hole: expanding debt and collapsing growth. Without treading again on ground covered in many past letters, let’s take it as a given that if you either cut government spending or raise taxes you are going to reduce GDP over the short run (academic studies suggest the short run is 4-5 quarters). To argue that raising taxes or cutting spending has no immediate effect on the economy flies in the face of mathematical reality. Note that I’m not arguing for one approach or the other, just simply stating that there will be consequences, either way. The country might be better off with higher taxes and/or more spending, or the opposite. But those choices are going to have consequences in both the short and long term.

Second, there is a limit to how much money a government can borrow. That limit clearly varies from country to country, but to suggest there is no limit puts you clearly in the camp of the delusional.

. . .

The policy problem is, how do you counteract the negative pull of a black hole of debt before it’s too late? How do you muster the "escape velocity” to get back to a growing economy and a falling deficit – or, dare we say, even a surplus to pay down the old debt? How do you reconcile the competing forces of insufficient growth and too much debt?

The problem is not merely one of insufficient spending: the key problem is insufficient income. By definition, income has to come before spending. You can take money from one source and give it to another, but that is not organic growth. We typically think of organic growth as only having to do with individual companies, but I think the concept also applies to countries. The organic growth of a country can come from natural circumstances like energy resources or an equable climate or land conducive to agricultural production, or it can come from developing an educated populace. There are many sources of potential organic growth: energy, tourism, technology, manufacturing, agriculture, trade, banking, etc.

While deficit spending can help bridge a national economy through a recession, normal business growth must eventually take over if the country is to prosper. Keynesian theory prescribed deficit spending during times of business recessions and the accumulation of surpluses during good times, in order to be able to pay down debts that would inevitably accrue down the road. The problem is that the model developed by Keynesian theory begins to break down as we near the event horizon of a black hole of debt.

. . .

Deficit spending can be a useful tool in countries with a central bank, such as the US. But at what point does borrowing from the future (and our children) constitute a failure to deal with our own lack of political will in regards to our spending and taxation policies? There is a difference ... between borrowing money for infrastructure spending that will benefit our children and borrowing money to spend on ourselves today, with no future benefit.

In my mind I am playing reruns of old Star Trek episodes with Capt. Kirk shouting, “Dammit, Scotty, you’ve got to give me more power!” as they try to escape a looming black hole. Except, in our national version it’s Paul Krugman playing Capt. Kirk (badly), demanding that Ben Bernanke provide even more QE and Congress more stimulus spending. (I should note that Paul Krugman, like myself, is a science fiction aficionado. That may be the one philosophical point, a singularity if you will, that we agree on.) Of course, the Republicans (Romney) are playing the part of Scotty, yelling back at Kirk, “Captain, I can’t give you any more power! The engines are going to blow!”

The deficit has to be controlled, of course. To continue on the current path will only feed our Black Hole of Debt even more “mass,” making it that much harder to escape from. But to try and power away (cutting the deficit radically) all at once will blow the engines of the economy. Suddenly reducing the deficit by 8% of GDP, either by cutting spending or raising taxes, is a prescription for an almost immediate depression. It’s just basic math.

There's much more at the link.  Bold print is my emphasis.  Highly recommended reading.

Some authorities, such as Karl Denninger, state flatly that we have no choice but to accept an immediate reduction in the deficit, accepting that we will thereby reduce GDP and induce a deeper recession or even a full-blown depression.  Others, such as Federal Reserve chairman Ben Bernanke, argue that we should take on as much more debt as we need to in order to stimulate the economy and return it to growth.  (He defended this position today against international criticism).   I'm more on Karl Denninger's side than on Ben Bernanke's, but John Mauldin is also correct that we probably can't afford to plunge ourselves into an immediate depression by over-precipitate action.

What's the answer?  I don't know;  but I suspect it will have to involve both borrowing just enough to avoid a full-blown depression, and simultaneously cutting back on borrowing and deficit financing as much as possible (which will inevitably entail accepting an economic recession for the foreseeable future).  It's not a happy thought, but the alternative - fiscal and economic collapse in a few years - is unthinkable . . . at least I hope it is!

Peter