Publish in



Please download to get full document.

View again

of 4
All materials on our website are shared by users. If you have any questions about copyright issues, please report us to resolve them. We are always happy to assist you.
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 ab
  Risk Over Reward   Thinking About Investing True GDP by Alpha and Vega, an Investor and a Trader May 3rd, 2010In this issue: 1) The Credit Card Analogy2) 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 $4.1trillion 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 andthen with credit cards. Despite having no income, I can continue going to themovies 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 untileventually 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 accumulateddebt. 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 theequivalent of getting a $1000 cash advance from a credit card and thinkingyou’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 newborrowings 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. Theimportant 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 increasespending by 10% every year and give us permanent 10%+ GDP growth? I'llexplore that question in the next section.First I want to distinguish between “real gdp growth” and “true gdp growth.” I’lldefine the latter as real GDP growth minus fiscal stimulus. I’ll show why GDPgrowth generated by stimulus isn’t real growth so much as a temporary loan thatthe economy will eventually pay back with interest. Then I’ll look at growth inthe 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 nastyeffects. The most obvious problem is that it increases government debt andeventually investors will stop lending to an over indebted government. Everymajor long-term economic study I could find suggests that $1 of governmentspending in mature economies produces less than $1 of growth, probably muchless. Businesses thrive by borrowing $1, growing it to $1.20, paying the bank anickel in interest, and pocketing the extra 15 cents. If the government isborrowing $1, turning it into 70 cents, and then owes investors $1 in principalwith 5 cents in interest, it will eventually go broke. This problem can takedecades 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 amisallocation of resources. The problem is that when a ton of people areemployed making buggy whips that no one wants, sooner or later they’ll beunemployed and the economy will have little to show for the labor butwarehouses of dusty whips. Japan’s excess infrastructure spending in the 90sis a real-world example. Capitalism works when bad businesses go broke andincompetent employees change jobs or even careers. When we providemassive stimulus to pay for projects that the market doesn’t value, not only arewe 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 thebanks wanted. The banks knew they couldn’t fail with government backing, so  they have tremendous incentive to take excessive risk with the unlimited moneyinvestors are giving them. In other words, $1 of government stimulus canactually 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 trilliondollars.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 extremewhich 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 governmentspending produces less than $1 of real productivity. It’s worth looking at theactual spending to see if this is true. In developing countries, there is frequentlyan opportunity to invest productively in the infrastructure of the country. For example, China has spent a lot of money on roads, railways, and energyinfrastructure that will support future growth. Of the roughly $600 billion instimulus, about 65% was spent on infrastructure, and 20% was spentspecifically on long-term development projects like new education and energytechnology; a meager 10% was spent on transfer payments (e.g. unemploymentbenefits). Alternatively, very little spending in the US has gone to productiveprojects. The bulk of stimulus went to tax cuts, Medicaid, state fiscal relief, andunemployment 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 likesocial security and Medicare and 23% to defense. Obviously, none of thisproduces 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 mayprevent 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 asinvestors that growth in government spending is fundamentally different fromgrowth that comes from consumption and investment.Your debt-free trader,Vega Risk over Reward: A conversation about intelligent investing – we discuss the nature of riskand uncertainty, macroeconomics, security valuation, and how to think about markets andinvest profitably - our online posts at: to the newsletter at:
We Need Your Support
Thank you for visiting our website and your interest in our free products and services. We are nonprofit website to share and download documents. To the running of this website, we need your help to support us.

Thanks to everyone for your continued support.

No, Thanks