SEXAUER, STEPHEN June 1310

Productivity and Growth versus

Debt-to-GDP1

1

Based on a forthcoming essay by Stephen Sexauer (Allianz Global Investors) and Bart van Ark (The Conference Board) – this presentation represents the authors’ personal views and do not necessarily represent the views of their respective organizations.

Stephen Sexauer Chief Investment Officer Allianz Global Investors Solutions Global Interdependence Institute Prague, June 2010

The Global Fiscal Mess: How to get out?

Two Factors to Rule Them All • P for productivity-driven GDP growth • λ for how fast government spending grows

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Stephen Sexauer June 2010

The Mess As seen through Greece, Spain, and the US Estimated 2010 Debt-to-GDP 120% 100% 80% 60% 40% 20% 0% Greece

Spain

United States

Estimated 2010 Fiscal Deficit % GDP Greece

Spain

United States

0% -2% -4% -6% -8% -10% -12% -14%

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Stephen Sexauer June 2010

The Options 1. Reduce the growth rate of government spending 2. Raise revenue (taxes) 3. Do both

The Questions 1. Can this be done--before the bond markets close, triggering debt default, currency debasement, or worse?

2. Specifically, how?

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Stephen Sexauer June 2010

Specifically, How? No country can grow itself easily out of a debt crisis: resolutions to debt-crises are extraordinarily complex, and require a mix of sound economic policy and restoration of confidence.

To resolve a debt-crisis, there are two policy principles that dominate all others: 1) Drive GDP growth by productivity 2) Reduce the growth in government spending significantly below the growth in GDP It sounds simple, although it is not simple to do it. But it doesn’t sound as drastic as the draconian measures to slash and burn as some suggest: • Is there a theoretical case for this? YES • Is productivity-driven growth in combination with a falling debt-to-GDP a realistic expectation? YES • Is there any empirical or anecdotal evidence? YES

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Stephen Sexauer June 2010

Some Evidence: Canada 1995 to 2006 There is an all-important observation here: everything grew.

Canada Debt-to-GDP 80% 70% 60% 50% 40% 30% 20% 10% 0%

Canada Budget Brief 1995…"Government must get its own house in order" . (page 3)

1995

1996

1997

1998

1999

2000

2001

P-λ debt-to-GDP

2002

2003

2004

2005

2006

Actual debt-to-GDP

Actual Data 1995 to 2006 g r e λ β N I P Pcb

5.4% = nominal GDP growth 4.9% = revenue growth = (N + I + P)β 3.2% = expense growth = (N + I)λ 0.78 = ratio government growth to (N + I) 0.90 = ratio revenue growth to GDP (N + I +P) 2.0% 2.1% 1.4% 1.3%

= employment growth = inflation (GDP deflator) = productivity (GDP - N - I) = productivity, conference board estimate

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Stephen Sexauer June 2010

A Simple Rule and a Model: P-λ A simple but robust model of a very complex problem: Definitions: • GDP growth = Working population growth + Inflation + Productivity growth = N+I+P • Government revenue growth = (N+I+P)β, β is the policy choice on revenue growth.

• Government spending growth = (N+I)λ, λ is the policy choice on spending growth. In a debt crisis, the default value for λ is 1.0.

The two dominant long-term policy goals: • Government spending grows at population plus inflation (λ=1). This will keep real per person consumption of government constant. It is a “no one worse off” policy.

• Government revenue growth = (N+I+P)β, with the long-term target for β=1.

Implications for the medium-term: • Productivity is the difference between revenues and spending. Hence, productivity growth is the annual flow of GDP available to reduce debt or to invest to create productivity-driven growth.

• If (N+I+P)β > (N+I)λ, then debt-to-GDP will fall, with the rate of decrease dominated by P and λ.

• There is a critical level of lambda (λc) where spending exceeds both revenue and GDP growth. This policy is unsustainable.

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Stephen Sexauer June 2010

More Evidence: the United States The Gramm-Rudman-Hollings-Reagan-Bush(41)-Clinton years, and then…

US Debt-to-GDP Actual versus a Gramm-Rudman-Hollings lambda 1985 to 2009 and Forecast

70% 60% 50% 40% 30%

Actual debt-to-GDP

P-λ debt-to-GDP

8

20

07 20

05 20

03 20

01 20

99 19

19

97

95 19

93 19

91 19

87

89 19

19

85

0%

19

10%

US debt-to-gdp Gramm-Rudman-Hollings lambda = .90

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Actual and forecast debt-to-GDP

20%

Forecast

Stephen Sexauer June 2010

A Well-Run Government Has as Infinite Life A well-run government can grow out of a debt-to-GDP crisis, even one as severe as Greece currently faces.

Greece A(2009)

Years to debt-to-GDP of:

debt-to-GDP: 115% revenue-to-GDP: 37% outlays-to-GDP: 50%

50%

25%

Greece Productivity

Greece Productivity

1%

2%

3%

1%

2%

3%

λ λ λ

1.0 0.9 0.8

β β β

1.0 1.0 1.0

45 37 32

25 23 21

18 17 16

48 40 34

27 25 23

20 19 17

λ λ λ

1.0 0.9 0.8

β β β

1.1 1.1 1.1

35 30 27

21 20 18

16 15 14

37 32 29

23 21 20

17 16 16

λ

λc

β

1.1

91

72

59

95

76

63

* Note: λc equates spending growth to GDP growth; hence all debt reduction is from higher revenues (taxes) growing at 1.1 * GDP.

History: Greece from 1995 to 2006--the same years as Canada’s successful episode. g r e λ β N I P Pcb

6.9% =nominal GDP growth 7.6% =revenue growth = (N + I + P)β 6.4% =expense growth = (N + I)λ 1.58 = ratio government growth to (N + I) 1.10 = ratio revenue growth to GDP (N + I +P) 1.0% 3.0% 2.9% 2.8%

= employment growth = inflation (GDP deflator) = productivity (GDP - N - I) = productivity, conference board estimate

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Stephen Sexauer June 2010

Spain Possible Future(s): Spain A(2009)

Years to debt-to-GDP of:

debt-to-GDP: 53% revenue-to-GDP: 35% outlays-to-GDP: 46%

50%

25%

Spain Productivity

Spain Productivity

λ λ λ

1.0 0.9 0.8

β β β

1.0 1.0 1.0

1% 38 31 26

2% 20 17 15

3% 13 12 11

1% 42 34 29

2% 23 20 18

3% 16 15 14

λ λ λ

1.0 0.9 0.8

β β β

1.1 1.1 1.1

29 24 21

16 15 13

11 10 9

32 27 24

19 17 16

14 13 12

λ

λc

β

1.1

91

72

59

95

76

63

* Note: λc equates spending growth to GDP growth; hence all debt reduction is from higher revenues (taxes) growing at 1.1 * GDP.

History: Spain from 1995 to 2006--the same years as Canada’s successful episode. g r e λ β N I P Pcb

7.2% =nominal GDP growth 7.8% =revenue growth = (N + I + P)β 5.8% =expense growth = (N + I)λ 0.83 = ratio government growth to (N + I) 1.08 = ratio revenue growth to GDP (N + I +P) 3.6% 3.4% 0.2% 0.1%

= employment growth = inflation (GDP deflator) = productivity (GDP - N - I) = productivity, conference board estimate

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Stephen Sexauer June 2010

The United States Possible Future(s):

US A(2009) debt-to-GDP: 53% revenue-to-GDP: 15% outlays-to-GDP: 25%

Years to debt-to-GDP of:

50% US Productivity 0.01 0.02 0.03 61 31 20 49 28 19 42 25 17

25% US Productivity 0.01 0.02 0.03 67 37 25 55 33 23 47 30 22

λ λ λ

1.0 0.9 0.8

β β β

1.0 1.0 1.0

λ λ λ

1.0 0.9 0.8

β β β

1.1 1.1 1.1

47 40 35

26 24 22

18 17 15

52 44 39

31 28 26

22 20 19

λ*

λc

β

1.1

136

102

85

145

112

95

λ

1

β**

1.0

39

19

12

46

15

17

** Beginning revenue-to GDP =

17.8%

The 1990 to 2008 US average.

History: The US from 1995 to 2006--the same years as Canada’s successful episode. g r e λ β N I P Pcb

5.5% =nominal GDP growth 5.4% =revenue growth = (N + I + P)β 5.2% =expense growth = (N + I)λ 1.46 = ratio government growth to (N + I) 0.97 = ratio revenue growth to GDP (N + I +P) 1.4% 2.2% 1.9% 2.0%

= employment growth = inflation (GDP deflator) = productivity (GDP - N - I) = productivity, conference board estimate

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Stephen Sexauer June 2010

The power of productivity. The importance of λ. A virtuous feedback loop.

P for Productivity Productivity is the dominant long-term factor. Productivity is the difference between government revenue growth and a baseline-government outlay growth, making it the ultimate force that reduces debt-to-GDP. And, of crucial importance, productivity is the most important factor for economic growth and prosperity. Policies that resolve a debt-to-GDP crisis are the same policies that create a growing economy.

λ for policy choices When λ = 1, real government spending per person stays constant—government grows and no one is on average worse off. The annual flow of productivity-driven GDP above N+I can be allocated to debt reduction, or to invest to increase productivity. These are all good choices. And, the choices are not “draconian.”

A virtuous feedback loop With a P-λ policy both the country and its creditors can see there is a plan to reduce debt-to-GDP to sustainable levels.

Both can see the progress in easy-to-measure variables. And both can see if the results are within the acceptable range.

If so, then it is a mathematical certainty that the lenders can be paid back.

This is crucial. Most sovereign-debt crises “arrive” suddenly, when the bond markets close to the borrower--when other people’s money can no longer be used to cover a fiscal deficit or maturing debt. Therefore, a process that resolves the crisis, where year-by-year progress is made and observed, debt markets stay open, spreads narrow, and borrowing costs drop, will eventually lead to government debt being refinanced or repaid.

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Stephen Sexauer June 2010

No Growth, No Escape from a Debt-to-GDP Crisis The power of counter-intuitive compounding: How is it that Canada’s debt-to-GDP fell 45% in 11 years when revenues grew only 2.2% faster than outlays?

Answer: Three levels—debt, outlays, and revenue—growing at different rates all divided by a growing GDP.

In a debt crisis, what policies are associated with growth and falling debt-to-GDP2 ?

Fiscal adjustment: When Debt-to-GDP Falls OECD countries, 1970 to 2007: 107 episodes of falling debt-to-GDP Economy Expands

Economy Shrinks

Average GDP increase above G-7

1.40%

-0.17%

Change in government revenue Income taxes Business taxes Indirect taxes

0.34% -0.27% 0.66% 0.01%

1.21% 0.48% 0.35% 0.21%

Change in government spending (primary)

-2.19%

-0.64%

Change in Debt-to-GDP

-5.76%

0.37%

Implication: Tax Less, Grow More 2

Alesina, Alberto and Silvia Ardagna, Large Changes in Fiscal Policy: Taxes versus Spending. August, 2009.

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Stephen Sexauer June 2010

Conclusions • There are two dominant factors to successfully resolve a debt-to-GDP crisis: o Productivity-driven GDP growth o Increasing GDP faster than increasing government spending.

• Productivity-driven growth dominates all else: “…growth depends on investment in human and physical capital and the production of new knowledge…”3

• A well-run government has an infinite life. But, time runs out when the debt markets close.

3

Gary Becker and Kevin Murphy, Do not let the cure destroy capitalism. Financial Times, 19 March 2009

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Stephen Sexauer June 2010

Appendix Debt-to-GDP is a cumulative stock (debt) divided by an annual flow (GDP). The stock of debt also has annual flows: outlays less revenues. The three key flows are typically different (g, r, and e, defined below). The interplay of these three different growth rates, combined with initial levels of debt-toGDP, revenue-to-GDP and outlay-to-GDP combine for the country-specific path and rate of debt-to-GDP reduction.

I. P- λ debt-to-GDP model. Growth rates: g = GDP growth = N+I+P r = revenue growth = (N+I+P)β e = outlay growth = (N+I)λ N = working population growth I = inflation P = productivity λ = actual outlay growth / (N+I) II. Debtt = Debtt-1 + Outlayst - Revenuest Dt = Dt-1 + Ot - Ft D1 = D0 + O1 - F1 D2 = D0 + O1 - F1+ O2 - F2 ….

Dt = Do + [Oo * Σ (1+eλ)n ] – [Ro * Σ (1+gβ)n] III. Debt-to-GDP GDPt = GDPo * (1+g)n Debtt / GDPt Dt / GDPt = Do / [GDPo * (1+g)t]

+

[Oo * Σ (1+eλ)t ] / [GDPo * (1+g)t] – [Ro * Σ (1+gβ)t] / [GDPo * (1+g)t]

IV. Key implications: a. For revenue growth = (N+I+P)β, if β > 1.0, then one day government will be the economy. Long-term β must be < 1. b. For outlay growth = (N+I)λ, if λ = 1.0, then real government growth will be constant per person. c. For outlay growth = (N+I)λ, there is a critical λc where (N+I) λ > g. This is an unsustainable policy. Long-term (N+I)λ must be < g. d. As long as there is growth and λ < λc, the crisis will resolve.

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Stephen Sexauer June 2010

V. P-λ model: a. Government revenue grow at N+I+P (nominal GDP) b. Government outlays grow at (N+I)λ c. When λ=1, productivity (P) is the difference between revenues and outlays.

VI. Growth Definitions a. GDP growth = N (population) + I (inflation) + P (productivity) b. Government revenue growth = GDP growth = (N + I +P)β, c. Government spending growth = (N+I)λ, λ is the policy choice on spending growth. d. If (N+I+P)β > (N+I)λ, then debt-to-GDP will fall, with the rate of decrease dominated by P and λ.

For a limited period, β can be > 1. Long-term, β must be < 1.0, otherwise government grows to be the economy.

The total model is five variables: N,I, β, P and λ. The core of the model is two variables: P for productivity and λ for the policy choice around constant real government spending growth per person. The P-λ model collapses the extraordinarily complicated into five key variables, and within these five, two dominant ones--P and λ.

Reducing debt-to-GDP requires feasible and sustainable actions that grow the denominator (GDP) and keep debt from growing faster than GDP. Working population (N) grows slowly. Inflation (I), while subject to volatile and deleterious episodes, also tends to move slowly. Government revenue betas are stable over time, and they are close to one. If addition, a revenue only solution cannot grow revenue faster than GDP for the extended period required resolve a debt-to-GDP crisis because government becomes GDP. (See Panel 4). Hence, the two dominant policy variables are P and λ.

These observations and principals allow the model to be simplified: 1. GDP growth = N (population) + I (inflation) + P (productivity) 2. Government revenue growth = GDP growth = (N + I +P)β 3. Government spending growth = (N+I)λ, λ is the policy choice on spending growth. The default is λ =1.

Revenue grows at GDP, and hence β=1. (For finite periods, β can less than one or more than one.)

Government spending grows at N+I to keep real per person consumption of government constant. Hence, λ=1. The model explicitly allows for a policy choice of λ of less than one or more than one. However, in the long-term λ must be less than the critical level (λc) where government spending grows faster than GDP. This policy is not sustainable.

When λ =1, government spending grows at N+I while government revenue grows at N+I+P. The difference is P, productivity. If this annual productivitydriven output is used to pay down debt, then the stock of debt will fall at the same time GDP is growing. Debt-to-GDP will fall, possibly quite rapidly depending on λ. Under the two policies of productivity-driven GDP growth and growing government slower than GDP, the crisis resolves.

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Panel 1A

Actual and P-λ model* debt-to-GDP Canada

Actual Data 1995 to 2006 g r e

Canada Debt-to-GDP 80% 70% 60% 50% 40% 30% 20% 10% 0%

λ β

Canada Budget Brief 1995…"Government must get its own house in order" . (page 3) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P-λ debt-to-GDP

Spain

Actual debt-to-GDP

Pcb g r e

Spain Debt-to-GDP lambda = 0.83

80%

N I P

5.4% = nominal GDP growth 4.9% = revenue growth = (N + I + P)β 3.2% = expense growth = (N + I)λ 0.78 = ratio government growth to (N + I) 0.90 = ratio revenue growth to GDP (N + I +P) 2.0% 2.1% 1.4% 1.3%

= employment growth = inflation (GDP deflator) = productivity (GDP - N - I) = productivity, conference board estimate

7.2% = nominal GDP growth 7.8% = revenue growth = (N + I + P)β 5.8% = expense growth = (N + I)λ

60%

λ β

40%

0.83 = ratio government growth to (N + I) 1.08 = ratio revenue growth to GDP (N + I +P)

20% 0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P-λ debt-to-GDP

Actual debt-to-GDP

N I P Pcb

17

3.6% 3.4% 0.2% 0.1%

= employment growth = inflation (GDP deflator) = productivity (GDP - N - I) = productivity, conference board estimate

Stephen Sexauer June 2010

Panel 1B Actual and P-λ model* debt-to-GDP United States

Actual Data 1995 to 2006 g r e

US Debt-to-GDP lambda = 1.46 60% 50% 40% 30% 20% 10% 0%

λ β

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P-λ debt-to-GDP

Greece

Actual debt-to-GDP

N I P Pcb g r e

Greece Debt-to-GDP lambda = 1.58 120%

5.5% = nominal GDP growth 5.4% = revenue growth = (N + I + P)β 5.2% = expense growth = (N + I)λ 1.46 = ratio government growth to (N + I) 0.97 = ratio revenue growth to GDP (N + I +P) 1.4% 2.2% 1.9% 2.0%

= employment growth = inflation (GDP deflator) = productivity (GDP - N - I) = productivity, conference board estimate

6.9% = nominal GDP growth 7.6% = revenue growth = (N + I + P)β 6.4% = expense growth = (N + I)λ

100% 80%

λ β

60% 40% 20%

N I P

0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P-λ debt-to-GDP

Actual debt-to-GDP

Pcb

1.58 = ratio government growth to (N + I) 1.10 = ratio revenue growth to GDP (N + I +P) 1.0% 3.0% 2.9% 2.8%

= employment growth = inflation (GDP deflator) = productivity (GDP - N - I) = productivity, conference board estimate

* The model uses only 5 varaibles to estimate debt outstanding to compute debt-to-GDP: N,I,P,β and λ. This is the blue line (with β=1). The green line uses actual debt.

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Stephen Sexauer June 2010

Panel 3A Historical Data 1995 to 2006 Actual lambdas Canada

Historical Period 1995 to 2006 Baseline Policy lambda = 1.0 = "no one worse off"

Canada Debt-to-GDP lambda = .078

Canada's lambda is the benchmark Canada Budget Brief 1995…"Government must get its own house in order" . (page 3)

19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07

80% 70% 60% 50% 40% 30% 20% 10% 0%

P-λ debt-to-GDP

Spain

Actual debt-to-GDP

Spain Debt-to-GDP lamda = 0.83

80%

Spain Debt-to-GDP with lambda = 1.0 1995 to 2006

80%

60%

60%

40%

40%

20%

20%

0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

P-λ debt-to-GDP

Actual debt-to-GDP

P-λ debt-to-GDP

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Actual debt-to-GDP

Stephen Sexauer June 2010

Panel 3B Historical Data 1995 to 2006 Actual lambdas United States

Historical Period 1995 to 2006 Baseline Policy lambda = 1.0 = "no one worse off"

US Debt-to-GDP lambda=1.46

US Debt-to-GDP with lambda = 1.0 1995 to 2006

60%

60%

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

0%

0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P-位 debt-to-GDP

Greece

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P-位 debt-to-GDP

Actual debt-to-GDP

Greece Debt-to-GDP lambda = 1.58 120%

120%

100%

100%

80%

80%

60%

60%

40%

40%

20%

20%

0%

Actual debt-to-GDP

Greece Debt-to-GDP with lambda = 1.0 1995 to 2006

0% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P-位 debt-to-GDP

Actual debt-to-GDP

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 P-位 debt-to-GDP

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Actual debt-to-GDP

Stephen Sexauer June 2010

Stephen Sexauer Allianz Global Investors Solutions: Chief Investment Officer Allianz Global Investors: Performance and Risk: Performance Portal and Risk-Return analysis for AGI WW equity portfolios (20072008) Allianz Global Investors-Nicholas Applegate Capital Management: Portfolio manager Large-cap Core and Large-cap Value (20032004) Morgan Stanley Asset Management (1989 – 2002) Portfolio manager Large-cap value; application of optimization techniques Risk structures for US Value and Growth portfolios Salomon Brothers: (1988-1989) Mr. Sexauer holds an MBA from the University of Chicago (economics and statistics) and a BS (economics) from the University of Illinois.

Economic data in this presentation are derived from internal research of the Conference Board Inc. and publicly available statistics published by the U.S. Federal Reserve, the Government of Canada, the U.S. Department of Commerce and the International Monetary Fund.

The information herein is provided for informational purposes only and should not be construed as a recommendation of any security, strategy or investment product, nor an offer or solicitation for the purchase or sale of any financial instrument. This material contains the current opinions of the author, which are subject to change without notice.

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