Tuesday, April 17, 2007

Sell the Grand Canyon.

So Mike Murray asked, "Is the US economy in jeopardy?" Standard worries about the debt, deficit, etc. He sees trouble ahead but is baffled that some folks don't, and he wants someone to make a cogent explanation of the other side of the argument. Here goes.

Hi Mike. Ah, one of my favorite topics! Get ready to check the "Best Answer" box! Defecits most certainly DO matter, and anyone that says otherwise is a hack. However the degree to which they matter is affected hugely by other factors. It often helps to create a simplified example.

Let's say that you and your friends represent all the countries in the world. Let's say you have a rich friend Sam, and he represents America.

If someone told you that Sam had 8.9 million dollars of debt and asked you if he was financially solvent and/or headed for bankruptcy, what would you say? You would have to know more information first! If his net worth is 100 million dollars, and he has 8.9 million in debt, and he is going to borrow an additional 1 million next year, then he is in fine shape. You might want to know why he is borrowing money if he is worth so much though.

The answer is that he has cash flow problems. Much of his wealth is tied up in large assets, like land and construction projects. It makes sense for him to borrow to finance these projects because R&D, infrastructure, and a happy family make his home more productive, which has effects on the rate of economic growth that mitigate the interest on the money he borrows.
Many Economists think that rather than measuring national debt as a % of GDP, it should be measured against a composite that includes national wealth (the country-equivalent of net worth). Using this as a benchmark, the Debt/Book ratio of the U.S is about .1, even including all the "off budget" debt to social security.

That is why the sky isn't falling. But note that this is an explanation of why it could make sense to incur a debt, NOT a justification for why it is growing out of control. Just as each individual and each company should carefully examine the option of borrowing money to finance project, so should each country. Deficit spending that does not have a positive expected ROI will result in future inflation and/or currency devaluation, both of which reduce consumer purchasing power.

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