Can the U.S. Grow its Way Out of Debt?

The S&P500 slipped about 0.4% last week, the final week in February.  Once again, the volume seemed to confirm the slide in prices: volumes rose last week, above the levels from the prior week when prices rose.  The VIX (or fear) index rose slightly, infusing the week’s activity with a sense of complacency.

The economic data were weak and starting to point to further erosion.  Consumer confidence tumbled to levels far below consensus estimates.  New home sales not only fell (when they were expected to rise), but also reached depths not reached in the history of the survey (since 1963).  Existing home sales also sorely disappointed; they fell when they were expected to rise (because of the government home buying incentives).  Jobless claims spiked to 496,000, well above estimates and almost above the ominous 500,000 level.  Although GDP revisions for Q409 were strong, many economists are starting to worry that the inventory restocking force that drove this growth will soon disappear.

Technically, the weekly downtrend is still in effect.  However, the uptrend on the daily charts has also not been broken.  Over the next two weeks one of these two trends will get broken. 

Over the last year, Paul Krugman, the Nobel winning economist, has argued that the U.S. government should have implemented a larger fiscal stimulus program than the $787 billion package that actually passed.  He also argued that the additional borrowing that the government would require to fund the larger stimulus will not overly burden the total debt load because the resulting growth in GDP will more than compensate for the debt growth.  In other words, Krugman argued that the long-term GDP growth rate will exceed the debt growth rate; this would cause the ratio of debt to GDP to come down and avert a sovereign debt crisis.

It sounds perfectly logical.  In theory.

In reality, things may not actually work that way.  Carmen Reinhart and Ken Rogoff (professor of economics at Harvard University), in their new book, This Time is Different, identified 22 countries that lowered their external debt to GDP by at least 25% between 1970 and 2000.  Their goal was to determine whether the ratio fell because debt fell (through paydown or some form of default ) or because GDP grew, as Krugman predicts would happen in the U.S.

15 of the debt reversals occurred because of some sort of debt default.  Six debt reversals occurred because of simple debt repayment.  And only one reversal (Swaziland, 1985) occurred because the country grew out of its debts.

Rogoff and Reinhart concluded that “countries typically do not grow out of their debt burden”.

That’s not a good sign for Paul Krugman.  Experts in almost all countries with high external debt levels will argue that their debt levels are sustainable and manageable simply because they will outgrow them.  Historical evidence suggests they’re wrong.

This evidence is currently most relevant to the impending debt crises in Greece, Iceland and perhaps Spain and Portugal.  Soon, it may express itself in Italy, the U.K. and Japan.

And finally, history could repeat itself in the U.S.  The evidence is clear–the odds are high that the U.S. will someday default on its debts.

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