Debt Fueled Spending Won’t Create Growth

More debt equals less growth. In October, I discussed the “2nd Derivative Effect” and the ongoing cost of the stimulus. With the passage of the $1.9 trillion “American Rescue Plan,” will the math of debt to growth change?

Now, even Deutsche Bank credit strategist, Stuart Sparks, got the memo.

“History teaches us that although investments in productive capacity can in principle raise potential growth and r* in such a way that the debt incurred to finance fiscal stimulus is paid down over time (r-g<0), it turns out that there is little evidence that it has ever been achieved in the past.

The chart below illustrates that a rising federal debt as a percentage of GDP has historically been associated with declines in estimates of r* – the need to save to service debt depresses potential growth. The broad point is that aggressive spending is necessary, but not sufficient. Spending must be designed to raise productive capacity, potential growth, and r*. Absent true investment, public spending can lower r*, passively tightening for a fixed monetary stance.”

(Click on image to enlarge)

Debt Growth, #MacroView: Debt Fueled Spending Won&#8217;t Create Growth

Such is a logical conclusion, but one widely dismissed by economists and politicians. However, some fundamental analysis will underscore Mr. Sparks’ comments.

A Review

To keep some consistency in the analysis, let’s review the actions to date.

As the economy shut down in March of last year due to the pandemic, the Federal Reserve flooded the system with liquidity. At the same time, Congress passed a massive fiscal stimulus bill that extended Unemployment Benefits by $600 per week and sent $1200 checks directly to households.

In December, Congress passed another $900 stimulus bill extending unemployment benefits at a reduced amount of $300 per week, plus sending $600 checks to households once again.

Now, the latest iteration of Government largesse comes in a solely Democrat supported $1.9 trillion “spend-fest.” Out of the total, only about $900 billion goes to consumers in the form of $400 extended unemployment benefits and $1400 checks directly to households. The remaining $1.1 trillion will have little economic value as bailing out municipalities and funding pet projects doesn’t boost consumption.

Using current economic data, we can calculate estimates for the estimated impact of the economy’s stimulus through 2021. As shown in the chart below, in Q3, the inflation-adjusted GDP surged 29.91% from the Q2 reading of -35.94%. As stimulus ran out, Q4 GDP only increased by 3.95%. If we assume that Q1 will increase by the Atlanta Fed GDPNow estimate, GDP will show an 6.2% advance. That advance is the result of the $900 billion stimulus bill in December.

Debt Growth, #MacroView: Debt Fueled Spending Won&#8217;t Create Growth

Add-In Federal Spending

If we assume the next round of direct checks to households hit by April, GDP will rise by 6.67% in the second quarter. In other words, the “2nd derivative effect” of a larger economy reduces the rate of change from the stimulus and its ability to create growth.

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