Tuesday, April 30, 2013

How Is GDP Financed?

It may seem strange to ask how GDP is financed.  GDP simply measures the total market value of final goods and services that an economy produces.  It is a way to measure national income, not a measure of assets on a national balance sheet. 

But the way GDP is paid for does matter.  If large quantities of borrowed money finance GDP, then GDP in future years may be less sustainable than GDP produced by organic growth (i.e., GDP derived from people and companies spending their earnings, rather than borrowings).  The pauper nations of the EU, mostly located on the southern rim, are good examples.  They borrowed heavily (or their banks borrowed heavily) to finance consumption.  For a while, their GDPs grew.  But debt, unfortunately, has to be repaid.  A nation's whose GDP is heavily dependent on borrowed money will eventually have to pay the piper.  If those payments are burdensome enough, the nation's GDP bubble will burst, and recession will follow.  That isn't hypothetical; look at Greece, Ireland, Cyprus and Spain.  Indeed, look at the EU as a whole, which is sinking into recession even as we blog.

In America, the picture ain't pretty.  Even though GDP is nominally growing, in the first quarter of this year at an annual rate of 2.5%, the question of sustainability looms.  The federal government is constraining its borrowing (partly because of sequestration and partly because of Social Security and income tax increases).  Thus, the federal budget wouldn't be a source of GDP growth. 

But the Federal Reserve's quantitative easing program is.  The Fed is pumping $85 billion a month into the economy through purchases of financial assets.  Over a full year, the QE program would pump $1 trillion into the economy.  That's equivalent to about 6% of America's $16 trillion GDP.  It wouldn't be accurate to say that $1 trillion spent on QE results in $1 trillion of GDP.  Much of the money printed by the Fed for QE is recycled back to the Federal Reserve System in the form of member bank deposits at Federal Reserve banks.  This process is a near wash (except that it gives the depositor-banks riskless profits).  But QE is boosting the economy.  Our stock market--bizarrely exuberant in the face of a tepid economy--needs its regular fix of QE to maintain and increase its high.  The real estate markets seem to be getting a boost from the Fed's purchases of mortgage-backed securities.  Increases in asset values such as these appear to be creating a wealth effect that boosts spending (mostly by the top 10%).  That is probably a primary source of GDP growth today. 

But QE is similar to borrowed money.  At some point, the Fed will start selling down its more than $3 trillion balance sheet.  This akin to debt repayment.  It will remove money from the economy.  When there is less money to spend, there may well be less economic growth.  The Fed is hoping that the economy will be organically growing briskly by the time it goes into QT (i.e., quantitative tightening).  But there's no way to know for sure that will be the case.  The Fed may have to shift to QT because of a rise in inflation, whether or not growth has revived.  Whatever the reason for QT, it will constrain growth.  In some circumstances, it could produce a recession. 

Like toothpaste and genies, QE on the loose isn't easily put back into the place where it came from.  There's no riskless way to execute QT.  It's possible that continuation of the Fed's QE program could stimulate the economy to resume vigorous growth.  But that's far from certain.  And every additional month of QE heightens the risks that our economy is becoming overleveraged.

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