The world is flirting with deflation. How GDP growth, debt, population changes and exchange rates will determine whether a Great Depression like deflation is coming.
In this episode, you’ll learn:
- What is gross domestic product or GDP.
- What causes GDP to grow over time.
- What would cause a nation to reduce its output.
- How debt influences both GDP growth and the rate of inflation or deflation.
- How GDP is calculated.
- Which countries are deleveraging and which are increasing debt levels.
- What have been global population growth trends.
- What have been recent inflation and deflation trends.
- How currencies exchange rates impact the rate of inflation and deflation.
Show Notes
Real GDP growth by continent and decade.
World Population Growth Statistics
U.S. Consumer Price Index release
Become a Better Investor With Our Investing Checklist
Become a Better Investor With Our Investing Checklist
Master successful investing with our Checklist and get expert weekly insights to help you build your wealth with confidence.
Summary Article
How Debt and Deflation Impact the Economy
In the musical the Sound of Music, Maria teaches Captain Von Trapp’s children how to sing with these words,
“Let’s start at the very beginning,
A very good place to start,
When you read you begin with A B C,
When you sing you begin with Do Re Me.”
I think it is helpful to take the same approach with the economy. Hence, I’ve modified the lyrics a bit.
“Let’s start at the very beginning,
A very good place to start,
When you read you begin with A B C,
With economics you begin with GDP.”
What Is GDP
GDP stands for gross domestic product. It measures a nation’s output in terms of goods and services.
It is the value of all the goods and services produced by a country during a given period, including the value of cars manufactured, food harvested, houses built, students taught at school, meals served at restaurants, and the hundreds of thousands of other items manufactured and services provided in a given country.
Importantly, GDP doesn’t measure how many things are produced, but the value produced in terms of dollars or another currency.
Producing one high dollar volume item can have the same GDP impact as producing ten low dollar value items.
What Drives GDP Growth
What causes economic output or GDP to grow over time?
Let’s answer that by looking at a simple example.
If you ran a bakery and got up early each day to bake loaves of bread to sell what would it take to increase production from 20 loaves to 25, assuming you were already working your hardest?
You could employ a helper or you could increase your efficiency by investing in time-saving equipment, such as a bigger oven or mixer, or by finding a way to work smarter, perhaps by improving your dough rolling technique.
In other words, bakery output increases if the population of bakers increases or if baker productivity increases due to technology improvements or improved baking techniques.
The same principle applies to the overall economy. A nation’s output increases over the long-term due to both worker population growth and increased productivity as each worker is able to produce more output because of improved technology or technique.
Given world population has grown over time and workers are becoming more productive, the global economy has grown 52 out of the past 53 years. The only exception was during the global recession of 2008.
Recessions
A recession is when a nation’s output shrinks. Less goods and services are produced usually because the number of workers declines as unemployment increases.
Why would a nation decrease its output? For the same reason a baker might bake fewer loaves a bread. She doesn’t think she will be able to sell them.
Of course, instead of baking fewer loaves, the baker could bake the same amount but lower the prices at which she sells them, reducing her profit.
In this example, the dollar value of the baker’s output shrinks even though number of loaves produced stays the same. Her contribution to her nation’s GDP is reduced.
If other producers and retailers also reduce their prices, the nation could experience deflation, an extended period of falling prices.
The opposite of deflation is inflation, an extended period of rising prices.
The Powerful Influence of Debt
There is a force in the economy that influences GDP growth and the rate of inflation or deflation.
It is debt.
The baker could borrow money to buy a bigger oven to boost her productivity. If she doesn’t borrow the money, she will have to delay the oven purchase until she saves enough of her profits.
Borrowing money allows us to accelerate our future purchases into the present.
When a nation’s businesses and households increase their debt levels, it increases both purchasing power and the supply of money in an economy.
That increased purchasing power due to debt encourages businesses to increase their output of goods and services.
Higher debt levels lead to higher GDP growth, at least for a time. At some point, though, the debt needs to be paid back.
When the level of debt gets excessive, the increased purchasing power and new money supply can outstrip a nation’s ability to produce new goods and services to meet the heightened demand. Prices rise. Inflation ensues.
Conversely, if a nation’s businesses and household decide to focus on paying down debt, a period of deleveraging commences. This reduces demand for goods and services, which causes businesses to either decrease their output or slow the pace of output growth.
Deleveraging
The U.S. private sector has been deleveraging since the start of the Great Recession. Private non-financial debt as a percent of GDP peaked at just under 170% in 2008. It has fallen to 144% of GDP as of December 31, 2014.
This deleveraging is one reason the pace of the current economic recovery has been below normal.
Fortunately, continued population growth and increased productivity has allowed the U.S. economy to continue to grow despite the deleveraging headwind.
Ideally, the deleveraging will continue as excessive debt can hinder economic growth.
Data from the Federal Reserve and Department of Commerce compiled by Ned Davis Research shows when private domestic non-financial debt as a percent of GDP has been below 98%, U.S. nominal GDP growth averaged 7.7% annually.
When private domestic non-financial debt as a percent of GDP has been above 135% as it is today, U.S. nominal GDP growth averaged 3.9% for year.
Let the deleveraging continue.
