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Thursday, June 17, 2010

Economics: Debt to GDP Ratios, the U.S. Predicament, and Japan's Unemployment Rate - Somehow, Life Goes On? Yet, We Can't Borrow into Perpetuity

In recent posts, we presented data on positive corporate fundamentals and offered other commentary that points to a more bullish outlook. Generally, we focus on individual companies and their underlying fundamentals. Our goal is to buy dollars for fifty cents (or better), then wait for the Market to come around. However, we also can't operate in a complete economic vacuum, oblivious to what's going on around us. For this reason, we offer our "How's the Economy Doing" series (which we will soon update).

Given recent events in Europe and stateside, an increasing concern is government debt levels. A common way to look at this is through public debt to GDP levels and we can find this data through The World Factbook from the CIA. Here are the top 15 using 2009 estimates (click to enlarge):

The U.S., not in the top 15 above, ranks 42nd according to CIA data with debt to GDP of 53%. Note that Japan is second at 192%. For another view, we came across this visualization from Visual Economics (click to enlarge; data source is also CIA World Factbook, although the figures don't match):

Higher levels of debt with increasing obligations are a real problem if counterparties lose faith that debt can be serviced and, ultimately repaid (or rolled over). Further, high debt levels can crowd out investment that is critical to driving productivity gains and growth.

Drilling further into the U.S. predicament. We often watch and/or listen to Consuelo Mack's weekly WealthTrack program and highly recommend the show. She featured Rob Arnott the other week, founder and CEO of Research Affiliates, and his commentary neatly summarizes current (and future) challenges. -- from the transcript:
  • CONSUELO MACK: So Rob, what are the bigger seeds that have been planted that you think we’re going to have to face at some point?
  • ROB ARNOTT: Last fall we wrote a piece entitled “the 3-D hurricane.” It talked about deficit, debt and demographics. We’re spending more than we produce as nation, which is leading to a buildup of debt to be paid for by whom, a shrinking population of workforce as a percentage of the population. So how bad are each of these problems? Deficit: 10% of GDP last year. There are those who say, don’t worry about it. It’s a one-off. We have a global financial crisis; we need to spend this money to spend our way out of this mess. I could almost buy that if I believed that it was a one-off. Simple fact is that the 10% was tip of the iceberg. The accounting that got us there would have made Enron execs blush. You have off-balance sheet spending, that’s the pre-funding of social security and Medicare trust funds and a few other items. They’re off balance sheet, but they’re prefunding future obligations. They are legitimate spending. That takes you to 14% of GDP. You have the GSEs, government-sponsored entities: Fannie Mae, Freddie Mac and several others. Those take us to 17% of GDP. They’re now backed by full faith and credit of the U.S. government.
He then goes on and, after more detail, gets to this:
  • .... We have a government and a society addicted to debt-financed consumption. That leads to the debt level. The debt level for the national debt officially is approaching 90%. That doesn’t include state and local and it doesn’t include GSEs.
  • CONSUELO MACK: 90% of total output.
  • ROB ARNOTT: Of GDP. And if you include state and local and GSEs, you’re now up to 143%. Greece, as the crisis has been blowing up there, has been in the 120% range. We’re above 140%. If you add in the unfunded portion of social security and Medicare, we’re at 420% of GDP. The corporate debt is 320%. Household debt is 100% of GDP. Combined private debt is another 420%, the largest in the world. So we have aggregate debt and unfunded future obligations eight times our annual income. If you borrowed eight times your annual income, how comfortable would you feel about your ability to service that debt in the years ahead?
Thus, Mr. Arnott provides an alarming summary of just how big our big government obligations are relative to more widely discussed figures. On top of the challenge of continuous deficit spending, large entitlement programs are seemingly poised for failure under aging demographics. Clearly, something needs to change -- someday, politicians will need to do unpopular things: cut spending (programs and jobs) and benefits. Will they do this? Hard to say. Rhetoric is cheap and action can be costly (beyond merely the monetary component).

HOWEVER, one thing we find interesting is the following: Japan's debt to GDP is the second highest in the world (based on the CIA data) and, yet, somehow the Japanese seem to get along pretty well even in a stagnant economy with a shrinking population. Not just the basics - food, water, shelter - but the populous enjoys a highly productive, technologically advanced, modern society. AND, even with the downturn, unemployment remains around 5% (down from a peak of 5.6% last year, though up from a low of 3.6 in 2007 - *acknowledge cultural and business differences that support higher employment):

Extremely high debt levels, as in Japan, are suboptimal from a growth, savings, and investment standpoint. This isn't where a country wants to be, particularly ever dependent upon foreign borrowing to finance consumption and government spending. We don't have the all of the answers to this challenging scenario, but perhaps Japan's experience is a sign that one way or another, we'll also survive. Of course, we can't keep borrowing more and more into perpetuity.

Happy investing,

Jeffrey Walkenhorst

Disclosure: n/a.

© 2010 Jeffrey Walkenhorst
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