Bigger Government Leads to Slower Growth

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Editor's Note: This is Part 1 of a two-part series in which John Mauldin provides readers with a preview to a chapter in his forthcoming book, â??The End Game,â? co-authored by Jonathan Tepper. It is excerpted from his weekly newsletter, Thoughts From the Frontline, which can be found here. To read last weekâ??s chapter preview, see The Rules of Economics. Look for Part 2 to follow tomorrow.There are a number of economic forces in play in today's world, not all of them working in the same direction, which makes choosing policies particularly difficult. Today we finish what we started last week, the last half of the last chapter I have to write to get a rough draft of my forthcoming book, The End Game. (Right now, though, it appears this will actually be the third chapter.) It's More Than the DeficitWe talked earlier about how increasing government debt crowds out the necessary savings for private investment, which is the real factor in increasing productivity. But there's another part of that equation, and that's the percentage of government spending in relationship to the overall economy. Let's look at some recent analysis by Charles Gave of GaveKal Research.It seems that bigger government leads to slower growth. The chart below is for France, but the general principle holds across countries. It shows the ratio of the private sector to the public sector and relates it to growth. The correlation is high. (In the book we'll show the same graph for other countries.)That's not to say that the best environment for growth is a 0% government. There's clearly a role for government, but government does cost and that takes money from the productive private sector.Charles next shows us the ratio of the public sector to the private sector when compared to unemployment (again in France). While there are clearly some periods where there are clear divergences (and those would be even more clear in a US chart), there's a clear correlation over time.And that makes sense, given our argument that it's the private sector that increases productivity -- government transfer payments don't. You need a vibrant private sector and dynamic small businesses to really see growth in jobs.And at some point, government spending becomes an anchor on the economy. In an environment where assets (stocks and housing) have shrunk over the last decade and consumers in the US and elsewhere are increasing their savings and reducing debt as retirement looms for an aging baby boomer generation, the current policies of stimulus make less and less sense. As Charles argues: 

This is the law of unintended consequences at work: If an individual receives US$100 from the government, and at the same time the value of his portfolio/house falls by US$500, what is the individual likely to do? Spend the US$100 or save it to compensate for the capital loss he has just had to endure and perhaps reduce his consumption even further?The only way that one can expect Keynesian policies to break the "paradox of thrift" is to make the bet that people are foolish, and that they will disregard the deterioration in their balance sheets and simply look at the improvements in their income statements. This seems unlikely. Worse yet, even if individuals are foolish enough to disregard their balance sheets, banks surely won't; policies that push asset prices lower are bound to lead to further contractions in bank lending. This is why "stimulating consumption" in the middle of a balance sheet recession (as Japan has tried to do for two decades) is worse than useless, it is detrimental to a recovery.With fragile balance sheets the main issue in most markets today, the last thing OECD governments should want to do is to boost income statements at the expense of balance sheets. This probably explains why, the more the US administration talks about a second stimulus bill, the weaker US retail sales, US housing and the US$ are likely to be. It probably also helps explain why US retail investor confidence today stands at a record low.

This is the fundamental mistake that so many analysts and economists make about today's economic landscape. They assume that the recent recession and aftermath are like all past recessions since World War II. A little Keynesian stimulus and the consumer and business sectors will get back on track. But this is a very different environment. It's the end of the Debt Supercycle. It's Mohammed El-Erian's New Normal.

As we'll see in a few chapters, the periods following credit and financial crises are substantially different. They play out over years (if not decades) and are structural in nature and not merely cyclical recessions. And the policies needed by the government are different than in other cyclical recessions. We'll go into those later in the book, as they differ from country to country. But business as normal isn't the medicine we need, even though that's what many countries are going to attempt.Not Everyone Can Run a SurplusThe desire of every country is to somehow grow its way out of the current mess. And indeed that's the time-honored way for a country to heal itself. But let's look at yet another equation to show why that might not be possible this time. It's yet another case of people wanting to believe six impossible things before breakfast.Let's divide a country's economy into three sections: private, government, and exports. If you play with the variables a little bit you find that you get the following equation. Keep in mind that this is an accounting identity, not a theory. If it's wrong, then five centuries of double-entry bookkeeping must also be wrong.Domestic Private Sector Financial Balance + Governmental Fiscal Balance - the Current Account Balance (or Trade Deficit/Surplus) = 0By Domestic Private Sector Financial Balance we mean the net balance of businesses and consumers. Are they borrowing money or paying down debt? Government Fiscal Balance is the same: Is the government borrowing or paying down debt? And the Current Account Balance is the trade deficit or surplus.The implications are simple. The three items have to add up to zero. That means you cannot have surpluses in both the private and government sectors and run a trade deficit. You have to have a trade surplus.Let's make this simple. Let's say that the private sector runs a $100 surplus (they pay down debt), as does the government. Now, we subtract the trade balance. To make the equation come to zero there must be a $200 trade surplus:$100 (private debt reduction) + $100 (government debt reduction) - $200 (trade surplus) = 0.But what if the country wanted to run a $100 trade deficit? Then either private or public debt would have to increase by $100. The numbers have to add up to zero. One way for that to happen would be:$50 (private debt reduction) + (-$150) (government deficit) - (-$100) (trade deficit) = 0. (Note that we're adding a negative number and subtracting a negative number.)Bottom line: you can run a trade deficit, reduce government debt, and reduce private debt, but not all three at the same time. Choose two. Choose carefully.Were going to quote from a paper by Rob Parenteau, the editor of The Richebacher Letter, to help us understand why this simple equation is so important. Rob was writing about the problems in Europe, but the principles are the same everywhere (you can read the paper in two parts at nakedcapitalism.com): 

The question of fiscal sustainability looms large at the moment -- not just in the peripheral nations of the eurozone, but also in the UK, the US, and Japan. More restrictive fiscal paths are being proposed in order to avoid rapidly rising government debt-to-GDP ratios and the financing challenges they may entail, including the possibility of default for nations without sovereign currencies.However, most of the analysis and negotiation regarding the appropriate fiscal trajectory from here is occurring in something of a vacuum. The financial balance approach reveals that this way of proceeding may introduce new instabilities. Intended changes to the financial balance of one sector can only be accomplished if the remaining sectors also adjust in a complementary fashion. Pursuing fiscal sustainability along currently proposed lines is likely to increase the odds of destabilizing the private sectors in the eurozone and elsewhere -- unless an offsetting increase in current account balances can be accomplished in tandem....The underlying principle flows from the financial balance approach: the domestic private sector and the government sector cannot both deleverage at the same time unless a trade surplus can be achieved and sustained. Yet the whole world cannot run a trade surplus. More specific to the current predicament, we remain hard pressed to identify which nations or regions of the remainder of the world are prepared to become consistently larger net importers of Europe's tradable products. Countries currently running large trade surpluses view these as hard-won and well-deserved gains. They are unlikely to give up global market shares without a fight, especially since they are running export-led growth strategies. Then again, it is also said that necessity is the mother of all invention (and desperation its father?), so perhaps current-account-deficit nations will find the product innovations or the labor productivity gains that can lead to growing the market for their tradable products. In the meantime, for the sake of the citizens in the peripheral eurozone nations now facing fiscal retrenchment, pray there is life on Mars that exclusively consumes olives, red wine, and Guinness beer.

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