Thursday, September 2, 2010

Context


Everybody looks at debt relative to GDP and says debt is high.

GDP is the same as "output" but (in the double-entry world of economics) it is also the same as "income." I think people look at debt in the context of GDP because it is a way of comparing debt to income.

When you go to the bank to get a loan, they want to know how much debt you already have, and how much money you make. They compare your debt and your income. It's the same, big-picture, when economists look at the economy. They want to compare how much debt we have (in total) to the nation's total income. And they all seem quite satisfied to look at it that way.

That approach is fine for the individual bank and borrower. But it is not okay for the economy as a whole. The trouble with it is that when the reliance on credit is high, any increase in income will likely be associated with an increase in debt. If I take a loan to buy a car, if you use a credit card to buy a cell phone, if an employer borrows to cover payroll, we add to debt and income at the same time.

The banker’s test of debt and income may be valid for individual borrowers. But it cannot be applied with confidence to the economy as a whole. For in the economy as a whole, income can be created entirely out of debt. Indeed, as this graph from The Economist shows, it takes more than a dollar of debt to create a dollar of income.

Moreover, if the economy suddenly stops, there is no income. There is only debt.

If the economy slows down, there is less income. But there is no less debt.

Debt is not volatile. Debt is cumulative. Income is calculated annually. Debt incurred years ago still affects current levels, but GDP from prior years does not count in this year’s number. GDP is volatile: It evaporates. Because debt is cumulative and GDP is volatile, the debt/GDP calculation exaggerates changes in GDP and misrepresents debt. The ratio of debt to GDP is not a good measure of the burden of debt.

We need a better way to gauge the burden of debt. To what shall we compare debt? Not to GDP. Not to the national income. Shall we compare it to alcohol? For entertainment purposes only, perhaps. As for myself, I compare debt to the quantity of money.

I compare debt to M1 money. M1 is spending-money. This is the relevant measure. M2 is spending-money plus money in savings. That's not relevant. We don't generally spend the money in savings. The main use of it is to be a source of funds for investment and other uses of credit. The main use of savings is to allow for the increase of debt.

To compare debt to the source of funds used to create debt may tell us something. It may tell us how easily we can expand debt further. But it does not tell us whether we have a lot of debt, or only a little.

What makes sense to me is to compare the total debt to the total quantity of money we can use to pay down debt: to compare debt to M1 money. M1 is the money we use to make payments on our debt.

It doesn't make sense to compare debt to GDP, because income is created out of debt.

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