Diminishing Returns:

Linear Output Expansion Through

Exponential Debt Expansion
Andrew Bell, December 14th, 2010

ONE LINE: The debt to GDP ratio as a method of evaluating the economic health of a nation is in need
of revision in order to account for the complexity of highly advanced financial markets.

There are many trends that can be discovered by examining the debt that the United States has built
up over the course of thirty five years. With the help of armies of statisticians there is no end of
correlations, time series, and ratios which can be invented, tinkered with and reported upon. Yet it is
difficult to parse the valid indicators of economic performance from the coincidental.

A first step in untangling US economic data is to realize that traditional methods of evaluating a
country’s economic performance have been primarily applied to countries with poorly developed
financial markets. By accepting this step in the evaluation of the US balance sheet, and any other
country with an advanced financial system, one acknowledges that the standard measure of
economic sustainability, the debt to GDP ratio, needs significant revision. This is because of a
phenomenon called debt decentralization; the distribution of national debt to sectors of the
economy other than the federal government. By doing so a country appears to have a more stable
economy than it would if all the debt were held by the federal administration. This phenomenon
becomes more pronounced as the complexity of a county’s economy advances.

To correct for the decentralization of debt in national accounts a new metric needs to be used.
Much like many other economic tallies, debt aggregation is a straight forward means of correcting
for the complexity of a nation’s dispersed financial markets. The resulting number is best described
as the consolidated debt of a nation. This number represents the amount of money which all sectors
of the economy owe to another party. As a cautionary note it is reasonable to assume only a portion
of the debt held by sectors outside of the government will be backed by the administration. This
consideration makes it clear that the risks associated with equivalent values of federal government
debt and consolidated debt will be different but by how much is uncertain.

It is assumed that after further research a rough estimate of the percentage of non-governmental
debt that will be covered by the government if it is in default can be determined. This percentage
will help to determine the equivalent amount of government debt which is represented by a given
amount of consolidated debt.

Using the approach of evaluating a country based on the consolidated debt gives rise to a metric
called the consolidated debt to GDP ratio. This ratio is calculated in the same manner as a country’s
debt to GDP ratio was calculated in the past with the exception that the debt held by government is
replaced with the debt held by the whole of the society. As an exercise, data on the US economy
from 1975 until the present can be used for analysis. This is done using the data collected by the
Federal Reserve Board and released quarterly in their Z1 Flow of Funds Report along with GDP
estimates compiled by the OECD.
The first graph shows how the consolidated
Graph 1: US Consolidated Debt to GDP
debt amassed by the US economy over the Comparison
course of thirty five years has risen much faster
$40,000
than the output of the economy. This shows
$35,000
that the economy, when examined as a whole,
$30,000
requires debt to be acquired exponentially in

US $ (billions)
$25,000
order to maintain linear growth. The changes of
$20,000
the past three years illustrate the effects of
$15,000
slowing the acceleration of debt accumulation
$10,000
on the economy. This graph shows early
$5,000
indications that the US economy requires
$-
constantly accelerating debt accumulation in

1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
order to maintain positive growth. This is an
unsustainable system as increasing debt
GDP (expenditure aproach)
includes increasing amounts of economic
support for debt servicing. Consolidated Outstanding Debt (billions)

The second graph calculates the consolidated debt and GDP ratio time series and displays it. What is
striking about this graph is that in the past countries that experienced currency crises did so as their
debt to GDP ratios reached 80 to 90 per cent, in the cases of Argentina, South Korea, and the Brazil.
The Indonesian case was an outlier as it was
Chart 2: US Consolidated Debt to GDP
Ratio
allowed to reach a debt to GDP ratio of 110% before
the crisis in the later years of the 20th century.
300%
Seeing as the comparison is not exact it is no
250% surprise that the ratio is elevated well above the
levels reported by pre-crisis countries but it begs
US $ (millions)

200%
the question, how high can the consolidated debt
150% to GDP rise before a currency crisis consumes a
nation? Has it already begun?
100%

50% Additional analysis of the same data set can be

used to create the third chart of this article. This
0%
chart has been created to show the amount of
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008

debt required to grow the US economy. Once

again this analysis uses the consolidated debt of
the US because it is seen as a more valid expression of the workings of the complex financial market
in the US than simply considering the debt held by the federal government. The calculation is done
by dividing the yearly change in consolidated debt by the yearly change in GDP to develop the
consolidated deficit to GDP ratio. The intention of this calculation is to be able to roughly determine
how much debt the economy accumulated for each dollar worth of economic output expansion. It
was assumed that economic expansion would occur at a rate of between 0 and 100 per cent which
would fall in line with basic principles of capitalism where debt is used to create output above the
amount borrowed. At no point in the past 35 years was this the case in the US.

In the late seventies and for most of the nineties the ratio hovered between 180 and 200 per cent.
This means that for every dollar worth of economic expansion the United States had to go into debt
almost two dollars.
In the eighties the ratio was significantly Chart 3: Consolidated Deficit to Expansion Ratio
higher, swinging widely between 200 and
800%
300% and framed by two years below 200 %
(‘80, and ’88 at 121%, 185% respectively). 600%
Over the course of this decade the majority

Delta Debt / Delta GDP

400%
of the expansion in the US cost upwards of
2 and even 3 dollars in debt for each dollar 200%
worth of reported growth.
0%

1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
st
The dawn of the 21 century was also the -200%
dawn of hugely expensive growth.
Between the years 2000 and 2006, inclusive, -400%

the only year where growth required less -600%

than 3 dollars in debt per dollar of GDP
growth was 2003 when the consolidated deficit to expansion ratio was 276%. The incredibly high
price of growth reached in 2007 is no surprise given that it was the start of the financial crisis as the
mortgage melt down became the credit crunch became The Crisis. In this year, borrowing in the US
reached the astounding high of 6.07 dollars per dollar of output.

After the crisis set in the consolidated deficit to expansion ratio swung negative, representing the
first of two years worth of negative growth. In these years the negative ratio represents the
startling fact that for every 4.05 dollars added to the consolidated debt (2.59 dollars in 2009) the
economy contracted by a dollar. It is interesting to note that the contraction of credit is seen in
these years of crisis. In 2008 $1 trillion US was added to the consolidated debt of the nation while
growth contracted by $0.25 trillion, while in 2009 the consolidated debt grew by only $0.81 trillion as
GDP contracted by $0.35. These lending levels were the lowest since the turn of the century when in
1999 $0.875 trillion dollars in debt was added to the US economy and in 2000 $1.13 trillion dollars in
debt was added. This shows two things quite well, that credit throughout the US economy really did
disappear significantly over the course of the crisis and, more speculatively, that the US economy
requires not just a constant supply of credit but a constantly expanding credit to grow the economy.

On the political front this analysis is also extremely interesting because the changes in the observed
trends match so closely with the changes in the US administrations over the past 35 years. Ranking
the administrations in order leaves Carter at the top, followed by Clinton and George H.W. Bush who
were only slightly worse than Carter, and then the volatile Regan years. The twin administrations of
George W. Bush managed to eclipse all of the others, over his years as President G.W. Bush reigned
as the US economy had the most costly growth of the past 35 years in terms of the debt burden
added to the national accounts.

It should be of no surprise that the economy of a nation which has long championed the commercial
sector paired with private consumption over government as the engines of economic growth needs
to be evaluated by including the debt held by these sectors of the economy. What really needs to be
done to understand exactly what these measures of economic performance signal is additional case
studies. Most importantly estimates (and/or methods of developing estimates) of what valid
government coverage rates of non-governmental debt might be would allow for the comparison of
economies with complex financial markets to economies where government is the primary holder of
debt. These estimates are important because of the number of case studies which would then be
available for comparison.