Lessons From Japan: Spending Your Way Out Of A Recession Doesn't Always Work

It may the understatement of the year to say that the tragedies in Japan had enormous human consequences as the devastation to coastal towns and the loss of life was staggering.

The good news, if there is any to be found, is that Japan had an elaborate emergency system in place to prepare the public for the earthquake and warn of the tsunami. These early warning systems gave people precious time to prepare and take action. However, from an economic perspective, Japan, like the United States, was ill-prepared for another shock to the system.

Many analysts have tried to look at the bright side of the earthquake/tsunami/nuclear disaster by suggesting that the rebuilding required may finally push the Japanese economy out of its 20+ year recession. Those seeing the glass as half-full from an economic standpoint argue that if ever there was a time to toss fiscal responsibility aside and implement a plan to “spend, spend, spend,” it would be now.

The Japanese government has, in fact, pledged to do just that. The central bank has made it clear that they are prepared to do whatever it takes to ensure there is adequate cash in the system to fund the rebuilding program.

However, the primary issue is the Japanese have a bit of a debt problem to begin with. John Hilsenrath at the WSJ tells us that Japanese government debt is more than 200% of the country’s GDP. This level is among the highest in the world and has recently prompted S&P to downgrade Japan’s sovereign debt rating. This may result in much higher borrowing costs for the government and ultimately reduce the effectiveness of the rebuilding program.

Here at home, the situation regarding government debt is not as bad, but is similar in the United States. In order to get the economy growing fast enough to reach “escape velocity” (the growth rate required in order to escape the grips of recession), the Fed has pulled out all the stops. And so far at least, it looks like the plan is working (2010 Q4 GDP was +3.1%, Q3: +2.6%, Q2: +1.7%).

The concept of spending your way out of a recession is hardly new and has been successful in the United States in the past. And with the U.S. being the best house on the global economic block, we have historically been able to print/borrow money at will in order to get the economy moving in the right direction whenever things got tough. But with debt having become a four-letter word thanks to the European PIGI’S crisis, the political will as well as the public’s acceptance of the idea of adding more debt is fading fast.

One way to look at the situation is from the perspective of how a family household would act during a time of financial difficulty. The Credit Crisis caused the income stream to the U.S. to fall, which is akin to the family breadwinner being forced to take a pay-cut. But since we expect things to rebound and ultimately improve, we have decided to use our credit cards to pay for our living expenses until the rebound comes and our “salary” is restored.

But with our credit cards quickly reaching their limits and the fact that the chances of getting another card are slim, the U.S. is betting on two things: (1) That the economy will rebound and create jobs again. And (2) that nothing bad is going to happen again in the interim.

The argument against all the doom-and-gloomers out there who contend that the U.S. is in deep doo-doo (yes, that is an official economic term at our firm) because of its massive debt is the point that our income is also massive – and can easily expand. Unless, of course, something bad happens again.

Statistics from the Federal Reserve show that the publicly held debt of the U.S. is only 63% of the nation’s GDP. And as Ben Bernanke says, nations with a debt-to-GDP ratio of between 60% and 70% are “pretty comfortable,” but those with debt ratios exceeding 100% would be “certainly very concerning.”

However, “publically held debt” doesn’t include all of the debts the U.S. currently has. In fact, the gross debt of the United States is currently 94.4% of GDP. In simple terms, this means that the amount we owe is only a smidge under our annual income. As such, this still does not appear to be a dire situation. After all, our income CAN (and likely will) rise. Therefore, if our income goes up and debt levels stay the same, the situation should improve.

The only problem here is the old saw that there are three kinds of lies: Lies, damned lies, and statistics. You see, even the “Gross Federal Debt” of the United States does not include things like the debt of our State and Local Governments, which the U.S. is ultimately responsible for. And speaking of things the government is responsible for, the debt of the GSE’s (Government Sponsored Enterprises such as Fannie Mae and Freddie Mac) is also conveniently withheld from the formula.

If one adds up the Gross Federal debt, the State and Local Government debt, and the debts of Fannie, Freddie, and Sallie, Ned Davis Research tell us that the U.S.’s Debt-to-GDP ratio soars to 158.4%. Thus, we owe more than 1.5 years worth of income. And if this ratio continues to climb, S&P has warned that our ‘AAA’ credit rating could be at risk.

The point of this missive is not to create fear about our debt. As a country, we decided to spend our way out of the Credit Crisis. Thus, it doesn’t make a lot of sense to now panic about debt levels when we only halfway through the plan – especially when it appears that the plan is working. (Could the plan be working better? Absolutely. But, we do have to recognise that GDP IS improving at the present time.)

No, the point this morning is that running high debt levels also carries a higher degree of risk. The bottom line is that if everything goes smoothly, the economic plan to spend our way out of recession should work fine. But since our credit cards are quickly becoming maxed out, things could get ugly if something bad happens to the U.S. the way it did to Japan. Thus, it would make sense to put some money aside for a rainy day. Because if the disaster in Japan taught us anything it is that rainy days DO happen.

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