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Risk Over Reward

Thinking About Investing

True GDP
by Alpha and Vega, an Investor and a Trader
May 3rd, 2010

In this issue:
1) The Credit Card Analogy
2) What is GDP?
3) Why isn't Fiscal Stimulus Real Growth?
4) What is the US' True GDP?
5) Where is the Stimulus Going?

Dear Friends, Colleagues, and Investors,

Over the last two quarters, US real GDP grew at an annualized rate of 5.6%
and 3.2% respectively. Wow! Over the last 3 and half years, US real GDP grew
a total of about 1.5%. Not bad for the worst economy since the Great
Depression. Unfortunately, the US government had to spend an incredible $4.1
trillion to produce this $200 billion in growth. Without this new government
spending, real GDP would have shrunk 30% (if nothing else had changed).
How should we think about this fiscal stimulus? Is it more accurate to say that
GDP has grown 1.5% or shrunk 30%? I believe the latter is more accurate and
will demonstrate why.

The Credit Card Analogy

If I lose my job, I can sustain my lifestyle for a while, first with my savings and
then with credit cards. Despite having no income, I can continue going to the
movies and eating at fine restaurants. I can use one credit card to pay off
another, but over time the interest I’m paying on the credit cards will rise until
eventually I can’t make the payments. The US is currently in the situation of
using our credit to maintain the lifestyle to which we’ve become accustomed.
Optimists hope the economy will recover before we’re overwhelmed with our
interest payments, and that over time we can pay back the newly accumulated
debt. Regardless of whether we’re eventually able to pay the debt back, we
should recognize that the “GDP growth” spurred by debt is a mirage; it’s the
equivalent of getting a $1000 cash advance from a credit card and thinking
you’re a $1000 wealthier. I started with this analogy to explain how “true GDP”
could have shrunk by 30% without us feeling that much poorer; our new
borrowings are being spent to maintain unsustainable consumption levels.

What is GDP
“Real GDP growth” is defined as GDP growth minus inflation. GDP =
consumption + investment + governments spending + exports - imports. The
important thing to notice is that if the government increases spending by $1,
GDP automatically goes up by $1. So why doesn't the government just increase
spending by 10% every year and give us permanent 10%+ GDP growth? I'll
explore that question in the next section.
First I want to distinguish between “real gdp growth” and “true gdp growth.” I’ll
define the latter as real GDP growth minus fiscal stimulus. I’ll show why GDP
growth generated by stimulus isn’t real growth so much as a temporary loan that
the economy will eventually pay back with interest. Then I’ll look at growth in
the US and roughly estimate the “true GDP growth” number.

Why isn't Fiscal Stimulus Real Growth?

Unfortunately there’s no free lunch and stimulus produces all sorts of nasty
effects. The most obvious problem is that it increases government debt and
eventually investors will stop lending to an over indebted government. Every
major long-term economic study I could find suggests that $1 of government
spending in mature economies produces less than $1 of growth, probably much
less. Businesses thrive by borrowing $1, growing it to $1.20, paying the bank a
nickel in interest, and pocketing the extra 15 cents. If the government is
borrowing $1, turning it into 70 cents, and then owes investors $1 in principal
with 5 cents in interest, it will eventually go broke. This problem can take
decades to manifest, so let’s look at some of the more immediate ramifications.
The economist Hayek noted that most economic collapses are the result of a
misallocation of resources. The problem is that when a ton of people are
employed making buggy whips that no one wants, sooner or later they’ll be
unemployed and the economy will have little to show for the labor but
warehouses of dusty whips. Japan’s excess infrastructure spending in the 90s
is a real-world example. Capitalism works when bad businesses go broke and
incompetent employees change jobs or even careers. When we provide
massive stimulus to pay for projects that the market doesn’t value, not only are
we misallocating resources, we are also creating perverse incentives. For
example, the government guaranteed the debt of the country’s largest banks.
That gave investors an incentive to give those banks as much money as the
banks wanted. The banks knew they couldn’t fail with government backing, so
they have tremendous incentive to take excessive risk with the unlimited money
investors are giving them. In other words, $1 of government stimulus can
actually reduce future GDP by producing perverse incentives.

What is the US' True GDP Growth?

From January 2007 until today, US government debt increased by $4.1 trillion
During that time, real GDP increased by about $200 billion. This means that
“true GDP growth” over the period was about -30%. This sounds very extreme
which is why I started with the analogy. It doesn’t feel like GDP shrunk by 30%,
because we’re maintaining our consumption levels with new debt.

How is the Money Being Spent?

My argument is entirely dependent on the assumption that $1 of government
spending produces less than $1 of real productivity. It’s worth looking at the
actual spending to see if this is true. In developing countries, there is frequently
an opportunity to invest productively in the infrastructure of the country. For
example, China has spent a lot of money on roads, railways, and energy
infrastructure that will support future growth. Of the roughly $600 billion in
stimulus, about 65% was spent on infrastructure, and 20% was spent
specifically on long-term development projects like new education and energy
technology; a meager 10% was spent on transfer payments (e.g. unemployment
benefits). Alternatively, very little spending in the US has gone to productive
projects. The bulk of stimulus went to tax cuts, Medicaid, state fiscal relief, and
unemployment benefits. We can view the tax cuts as just more spending on our
core budget. Currently about 56% of the US budget goes to entitlements like
social security and Medicare and 23% to defense. Obviously, none of this
produces great future growth. A quick look at the remaining budget suggests
that only about 6% of the total is in any way devoted to growing productivity.

A final note – I’m not arguing against Keynes’ style fiscal stimulus; it may
prevent far worse economic outcomes. Heck, if I was out of a job and starving,
I’d probably use my credit card to buy food. We just need to recognize as
investors that growth in government spending is fundamentally different from
growth that comes from consumption and investment.

Your "debt-free" trader,


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