How not to lose ground or how the developed world can dodge the sword of Damocles – Part I


First Part – The Difficulties

“Economic progress, in capital society, means turmoil”
Joseph A. Schumpeter

With genuine sorrow we observe the economic downward spiral of increasingly more European Union States and other developed economies. This article explores the causes and characteristics of the developed world’s grown structural difficulties and proposes steps that every economy must have to take in order to resolve it. Rather than to give recommendations how to alleviate symptoms of the world’s economic slowdown this article aims to define the vital steps towards a sustainable solution, point out the painful dilemmas, which will be faced by the developed world, and constitutes a sense of urgency to rapid action.

The combined debt of governments, nonfinancial companies, and private households in the core countries of the 18 OECD rose from 160% in 1980 to 321% in 2010, according to a study by the Bank of International Settlements (BIS). If that extra debt is invested and creates additional economic growth, there is nothing wrong with taking on debt. However, the vast majority in recent decades has been invested to pay the interest on previous debts, to speculate in stocks and real estate and to consume. Each additional dollar of debt today producing just 18 cents in new GDP compared with 59 cents in new GDP back in the 1960s.

Stephan G. Cecchetti, Madhusan S. Mohanty, and Fabrizio Zampolli, “The Real Effects of Debt” Bank of International Settlements (BIS) Working Paper No. 352, September 2011.

In the light of the above one would simply argue that to take on additional debt is nonsense and that we should deleverage. By now only Italy, Japan and the U.S. have taken steps to reduce their overall burden of debt. On top of it, deleveraging the private sector is mainly the result of defaults, not of actually paying back loans in terms of the U.S.

US Households Are Not Deleveraging – They are simply Defaulting in Bulk,” Zero Hedge, October 15, 2012.

Hidden unfunded liabilities of governments and companies especially in terms of age‐ or health‐care related spending. Life expectations have doubled and fertility rates have declined considerably, resulting in a negative trend in size of population disregarding immigration. In addition retirement age has been lowered significantly, meaning that in future less people have to come up for more and more pensioners. This growing welfare burden impose dramatic financial implications highlighted by another BIS study, even in a benign scenario (spending frozen at current levels of GDP and deficits reduced to precrisis levels) public debt would continue to grow at a significant rate.

Stephan G. Cecchetti, M.S. Mohanty, and Fabrizio Zampolli, “The Future of Public Debt: Prospects and Implications,” Bank for International Settlements (BIS) Working Paper No. 300, March 2010.

Furthermore underfunding of their pensions promises for private companies is an issue. Some companies’ unfunded liabilities are equivalent to more than 50 percent of their market capitalization. The unlikeliness of companies solving the problem with larger investment returns will eventually result in funding the gap out of current cash flow, cut their liabilities by offering diminishing lumpsum buyouts‐or particulately renege on their promises, as the public sector will unavoidably do.

GM Cutting Pension Obligations by $26 Billion on Buyouts”,, June 2, 2012.

Long‐term demographic trends and the tendency of governments to fund future growth non-sustainably with additional debt, which undoubtedly negatively affects the economy, if debt‐to‐GDP ratio is high, perpetuates the financial crisis to the disadvantage of future generations.

Moreover, over-sized public sectors are effecting economic growth negatively. According to a recent study, an increase in government size by 10% points is associated with lower growth rate of between 0,5% and 1%.

Andreas Berg and Magnus Henrekson, “Government Size and Growth: A Survey and Interpretations of the Evidence,” Journal of Economic Surveys, Social Science Research Network, January 2011.

Most European governments spending accounts for more than 40%, but in some cases such as France and Denmark governments spending is about 60% of GDP. Pompous public sectors amplify the impact of too much debt, creating an additional drag on future growth.

Indermit Gill and Martin Raiser,”Golden Growth: Restoring the Lustre of the European Economic Model,” World Bank, January 2012.

It might sound awkward these days with double‐digit unemployment rates in some European countries, but in future a critical problem will be labor scarcity. This is not only true for the Western world, but also for China and Russia, which overall population will shrink by 2020. Fewer people working generate less GDP, hamper growth and pay down existing debt. In addition slower productivity growth will affect the economy negatively. According to Robert Gordon a renowned growth researcher of Northwestern University, GDP growth per capita has been slowing down since the middle of the 20th century. By indicating that the rapid growth over the last 250 years might as well be a unique episode in human history.

Robert J. Gordon, “ Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds,” NBER Working Paper 18315, August 2012.

The Austrian Economist Joseph Schumpeter pointed out, that there are periods of rapid growth and that there are periods with slower growth and they do come in waves (based on Nikolai Kondratiev “The Major Economic Cycles”, 1925). Interrupted by financial crises and social turmoil before a new cycle of stronger growth could began. These long waves were associated with major advances in basic innovation, e.g. the steam engine or the automobile. It is a debatable point whether or not figments such as the iPad or facebook are likewise able to boost economic growth. What is more, the educational system in most developed countries is deteriorating. Maria Theresia reigned Austria (1740 ‐ 1780) during that time she introduced compulsory education, which in its essence hasn’t changed significantly and is comparable to most of the educational systems globally. Still education is heritable, meaning that children of highly educated parents usually attend University and that the vast majority from an uneducated background rarely exceeds the level of education their parents have. Meaning that young talents might get lost in the existing educational system and cannot contribute as much as they could, if skilled sufficiently. Times are changing and there is no need for children to be torn into mishmash, while sitting in school for 12 years with sometime not even been slightly challenged. Spending for Research & Development sometimes not even exceed 2% of countries GDP, bearing in mind that the production of innovative products has been one of the major sources of economic growth in the past decades for developed countries.

Meike Fries, “Bildung ist erblich

Another crucial point is the scarcity of resources, ending the area of fairly cheap resources. Not only the price of crude oil and precious metals, but also base metals and water will sooner or later exceed recent estimates.

Bottom line:

Owing to long‐term changes in developed‐world demographics unfunded liabilities will be impossible to repay and this will exacerbate the already developed world’s Ponzi scheme which is called forth by record‐high levels of public and private debts. Who will pay for it and who may benefit? All stakeholders will have to contribute their portion. The Rich will have to pay more taxes. Creditors will have to accept losses. Employees and worker will have to work longer and will have to investment more money in their retirement arrangements. Government spending has to be reduced in some areas and increased in more future orientated areas of social investment. Governments will have to get scaled‐down in order to be more efficient. As globalization entangled economies of different development levels, the emerging economies will have to contribute to the solution by consuming more and exporting less. Intense political controversy and critical tradeoffs will have to be managed countrywide and transnational.

Daniel Shelter with contributions from Ralf Berger, Jendrik Odewald, and Dirk Schilder: Collateral Damage: “Ending the Era of Ponzi Finance ‐ Ten Steps Developed Economies Must Take”. January 2013.

This article was based on a recent BCG study.

The solution is coming up soon and will be described in the following article.

Photo by Tonythemisfit

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