Did we grow our way out of WWII debt?

 

We are facing a major debt crisis in the US, yet the alarm bells don’t seem to matter. The argument is that we run the economy hot, and stronger growth will get the debt issue under control, or at least allow us to see a decline in the debt-to-GDP ratio. 

The argument for growing our way out of the debt crisis rests on the view that we have seen high debt before and solved it through growth. The WWII debt was huge, but the debt-to-GDP ratio declined during the post-WWII expansion. The COVID debt expansion was like a world war, yet we can solve the problem through strong post-COVID expansion. 

In an interesting paper, “Did the United States Really Grwo out of Its World War II Debt”, we find that this argument may be wrong. Debt/GDP would have declined much less if not for the policies of the pre-Accord peg (financial repression) and the distortion of real rates from surprise inflation. 

The debt/GDP ratio fell from 106 to 23 percent in actual history, but if not for the rate distortions, it would have declined only to 74 percent.

This is an interesting application of counterfactual analysis, yet it is a sobering thought that solving the debt/GDP problem will have to come through surprise inflation and financial repression.

From theory to reality - the ineffectiveness of socialism

 

Chantrill's four laws on the ineffectiveness of socialism. 

1. Socialism cannot work because of prices for multiple goods (Mises)
2. Administrative government cannot work because of the Knowledge Problem (Hayek)
3. Regulation does not work because of “regulatory capture” (Stigler).
4. Government programs cannot work because you can never reform them (Chantrill).

There is the positive economics of what we would like the economy and the normative of what it actually is. Reality often gets in the way of theory.  All things are flawed, and systems are broken. Economies are often inefficient due to structural issues rooted in human behavior. Our job in finance and economics is to determine how to navigate an inefficient system to move capital and resources to the places where they will have the greatest impact.

Earnings sustainability and equity returns

Nothing lasts forever. Many believe that trends are sustainable over the long term, but that is not the case, so today’s trend or growth rate may not tell us what will happen tomorrow. Too often, analysis compares two variables with the same timeframe when it is important to look to the future. In the case of long-term earnings growth, strong earnings today are not linked with strong forward performance. The chart above shows long-term earnings growth and compares it with forward earnings. There is a strong negative relationship. We should see forward earnings versus forward returns, and current earnings growth versus current returns, to close the loop on different combinations.

The end result is the same. Stock returns are tied to forward expectations, not what has happened currently or in the past.

Kahneman's solution to system1 thinking

 

Daniel Kahnemena came up with the idea that people either use system 1 or system 2 decision-making. In system 1, the brain makes impulsive decisions with little analytical thought, leading to behavioral mistakes. In the case of system 2 thinking, the brain slows down and uses analytics and logic to mkae decisions. There is nothing wrong with system 1 thinking when appropriate, and using system 2 for all thinking may be exhausting. Nevertheless, to combat the problems of system 1 thinking, Kahmean uses the SODAS problem-solving framework.

The SODAS acronym stands for situation, options, disadvantages, advantages, and solution. To bypass the automatic System 1 mind, the decision-maker should first define the exact problem faced, then review or brainstorm possible options to handle the situation. Third, the decision-maker should list the disadvantages and then the advantages for each available option. Finally, the decision-maker should select the best solution after the review. The SODAS method. It’s not the first, nor the last, method for making better decisions. It is simple and direct, and anyone can try it.