Luke Tilley, Chief Economist for Wilmington Trust Investment Advisors, Inc. View bio
The already-frightening trajectory for government debt around the world has been catapulted higher as a result of much-needed fiscal support. How concerned should we be as investors?
“A national debt, if it is not excessive, will be to us a national blessing.”ALEXANDER HAMILTON, 1781
“I go on the principle that a public debt is a curse.”JAMES MADISON, 1790
Despite being the two people most responsible for the creation and adoption of the U.S. Constitution, its author, Madison, and the nation’s first Treasury Secretary, Hamilton, held starkly different views on whether the new nation should take on debt. The debate rages on two and a half centuries later. Governments around the world tapped the debt markets quickly and forcefully in response to the COVID-19 pandemic, surely counting their ability to borrow as a blessing. Encouragingly, after a brief period of illiquidity and market dislocation in mid-March, financial markets absorbed the government issuance in stride. Governments, along with corporates that also issued record levels of debt, were able to borrow at extremely low rates. A blessing indeed.
The curse may arise as the bill comes due years from now, forcing governments to either tighten their belts (by raising taxes and cutting spending), or take the sneaky way out by monetizing the debt (essentially printing money to pay the tab) and “inflating it away,” with the cost of goods increased as a result. Tightening the belt is politically challenging and slows down the economy. Monetizing the debt may then seem appealing, but creates the risk of runaway inflation and high interest rates, a paradox of making the problem worse by trying to solve it. And there is the option of using a bit of both. In 2021, we do not expect a major push to get fiscal houses in order as economies will still be recovering and unemployment high.
Indeed, in 2021 there is a higher likelihood of more borrowing. As of this writing with just a few weeks left in 2020, the virus is spreading anew across Europe and resurging in the U.S., prompting fresh mitigation measures. Potent vaccines are on the way but are not going to be widely available until mid-2021. Before then, we expect more stimulus, especially in the U.S. The incoming Biden administration is advocating a large package, possibly as large as $3 trillion while Senate Republicans had introduced measures totaling $500 billion before the election. We expect a package of roughly $1 trillion in 1Q 2021, which will add even more to the national debt.
Kicking the can down the road?
In the longer term, we expect the U.S. and most developed nations to opt for a mix of belt-tightening and inflation, keeping long-term rates under control. Emerging markets economies are more likely to struggle. There is a risk to financial markets over the longer term of an upward trend in long-term interest rates following decades of a reliable downtrend in developed economies. The Federal Reserve is trying to engineer higher inflation than it has in the past but not let it get out of hand. Should it miscalculate and wait too long to raise rates, unexpectedly high inflation could lead to higher interest rates—thereby slowing growth—each of which would compound the challenge of debt.
The borrowed blessing
Governments responded to the pandemic much as the International Monetary Fund (IMF) recommended: that it “be swift, concerted, and commensurate with the severity of the health crisis.”1 Nearly all of the world’s developed economies and large emerging markets economies delivered a fiscal response greater than 10% of annual gross domestic product (GDP), unparalleled in history, reports the IMF. In aggregate, the IMF recorded nearly $8 trillion globally split between $3.3 trillion of tax cuts or direct government spending and $4.5 trillion of liquidity injections, loans, and loan guarantees.
Country fiscal measures in response to COVID-19
Percentage of GDP
Loans, equity, and guaranteesAdditional spending and foregone revenue
Source: International Monetary Fund.
The largest overall responses relative to economic size were implemented by Germany, Italy, and Japan, each of which surpassed 35% in its initial response. Much of those were in the form of loans and liquidity injections. The highest tax cuts and direct spending came from the United States, followed by Japan and Germany, the IMF also reports. The swift response paid dividends in terms of short-term economic recovery. After many early forecasts predicted a dismal, multi-year effort to recover pre-COVID GDP levels, stimulus provided an upside surprise through the summer and heading into the fall. The IMF expects global GDP to return to pre-COVID levels at the end of 2020, thanks to a resilient China. Emerging economies excluding China are forecast by the IMF to recover by mid-2021 while developed economies as a whole are not expected to fully recover until early 2022.2 We are cautious about the recovery path in late 2020 and early 2021 due to the uncertainty of a second wave of infections as well as the unknown extent of permanent economic scarring. As we look further out, the debt-financed stimulus will likely have serious long-term consequences.
The curse of the bill coming due
The immediate ramifications of the heavy borrowing are quite clear. A country’s indebtedness is best represented by its debt as a share of GDP, akin to a household’s debt-to-income ratio. At the close of 2019, the overall world ratio was 83%. The IMF expects it to be 102% by the end of 2020, up about 19% from a year ago. The impact is higher for advanced economies, up 26% from 2019 and less so for emerging markets, where the ratio is expected to rise by 11%.
It’s important to note that, for the most part, the fiscal actions taken by most countries are one-off actions as opposed to permanent structural changes to taxation and spending policies. Accordingly, the impact on long-run debt levels may only show a “step-up” effect, raising the overall level but not altering the long-run trajectory. While the Congressional Budget Office’s (CBO) updated long-term outlook for the U.S. federal budget reflects the sizeable jump in debt for the fiscal year just recently concluded, it assumes a longer-term trajectory that is roughly parallel to pre-COVID expectations—ending with debt at 195% of GDP in year 2050 compared to a projection of 180% before the pandemic.
It is cold comfort to find that dramatic fiscal efforts have not done too much damage to an already-terrible fiscal outlook. And the CBO’s baseline projections assume that laws such as the sunsetting of temporary tax cuts will remain in place, which may not be realistic. It’s more likely to be the case that none of the underlying assumptions about future deficits, interest rates, and economic growth will hold. Such is the nature of forecasting. The general contours of the projections are unarguable though: the U.S. is on an unsustainable debt path and the COVID pandemic has worsened it.
Because of the inherent nature of debt and the rising costs of interest payments, the trajectory will not change. In the early stages of the projection, interest payments as a share of GDP are expected to remain low, below 2%. But with a structural deficit and no plan to reduce it, interest costs will accumulate and grow to 3% of GDP in the early 2030s and to 8% by 2050, according to the CBO. If realized, that increase in debt service costs will crowd out government spending on other programs in the same way that a household that doesn’t have a plan to pay down a credit card balance over time will eventually need to cut spending drastically to deal with mounting debt.
What can be done?
For any government the path for its debt share of GDP is characterized by the equation below. Each year the debt will increase by the amount of any subsequent fiscal deficit and by the net cost of financing existing debt. While the equation is straightforward, solving a looming debt problem is complex.
Fiscal deficit: The most obvious opportunity to reduce debt is to run a fiscal surplus. That is challenging politically, but also weighs on economic growth and reduces tax revenues. In the aftermath of the global financial crisis of 2008–2009, the U.S. cut federal spending, which dragged on growth for four consecutive years from 2011 to 2014, hampering the early years of the recovery.3
Interest on debt: When interest rates rise, the cost of the country’s debt increases directly due to the financing costs. There is a secondary impact because higher interest rates drag on economic growth as financing terms for businesses and consumers curtail their investment.
Economic growth rate: Real growth comes from new businesses, jobs, workers, and productivity. These are all derived from innovation, investment, and education. For this equation, the economic growth rate is the real growth rate plus inflation, which is the nominal growth rate.
Inflation: Rising prices are a tempting lever for governments to pull, as inflation pushes up the nominal rate of economic growth thereby increasing tax revenue and cheapening the value of the old debt issued in previous years. But bond market investors who see this coming will demand higher interest rates for newly issued debt, pushing up financing costs and then also cutting into economic growth.
Try it yourself
Move the sliders to see the impact of inflation on the debt-to-GDP ratio.
Source for historical data: Congressional Budget Office. Projections: Wilmington Trust Investment Advisors, Inc.
Inflation is the most tempting solution for governments but also the most complex. Governments sometimes try to use higher inflation to “inflate the debt away” because higher inflation translates to higher nominal economic growth.
Don’t worry, we’ll make more: Modern Monetary Theory
One item we should address is Modern Monetary Theory (MMT), a new school of thought on economics and government debt that has gained popularity in recent years and essentially argues that governments, especially the U.S., should not worry about deficits and debt. MMT economists lack any specific model, but the logic is most easily stated like so: A government that borrows in its own currency should not concern itself with debt levels, as it can always print more of its own currency and therefore cannot be forced into default. The resulting policy recommendation is to borrow without concern, especially in today’s environment with low interest rates.
We are very dubious of this line of thinking, because it ignores the simple fact that debt levels have a feedback loop into inflation and interest rates. It ignores that printing money with abandon will push inflation higher, and it ignores that fixed income investors would most likely eschew debt from a country that is plainly committed to devaluing its currency and hence the value of the debt, pushing interest rates higher. Simply put from the U.S. perspective: Interest rates are low because fixed income investors around the world trust that the U.S. is not on a path to entertain such a policy. If it tried to abuse the privilege of low rates, we believe that privilege would disappear.
Paying for the pandemic will be challenging for several reasons new to this cycle:
In our view, the risk of higher inflation and escalating debt trajectories are relatively greater than in the previous recovery a decade ago. While both back then and now low interest rates from central banks are a commonality, one difference is this time the Fed has said it will keep them lower for longer in an effort to encourage higher inflation. Another difference is we now have big fiscal stimulus (direct-to-consumer assistance through bolstered unemployment insurance as well as stimulus payments). Together, those differences make the current situation starkly different. They create conditions that could (as the Fed intends) push inflation, and therefore long-term interest rates, higher and faster than in previous recoveries—and could also make it very difficult to manage government debt. Additionally, fixed income investments could be at risk of repricing later in the economic and market cycles, while equities could ride the inflation wave higher as central banks hold back on interest rate hikes. But all of this could occur in an environment of deteriorating government debt situations which could threaten both major asset classes, making real assets more attractive. Each country and region will require close monitoring as each will respond in its own way. In short, paying for the pandemic will likely have long-term consequences on all asset classes for years to come.
- “Fiscal Monitor: Policies to Support People During the COVID-19 Pandemic.” International Monetary Fund. April 2020, https://www.imf.org/en/Publications/FM/Issues/2020/04/06/fiscal-monitor-april-2020
- “World Economic Outlook Update: A crisis like no other, an uncertain recovery.” International Monetary Fund. June 2020, https://www.imf.org/en/Publications/WEO/Issues/2020/06/24/WEOUpdateJune2020
- Bureau of Economic Analysis. National Income and Product Accounts, https://apps.bea.gov/iTable/index_nipa.cfm
- Stephen Cecchetti, Mohanty S. Madhusudan, Fabrizio Zampolli, “The Real Effects of Debt.” Bank for International Settlements. Working Paper No. 352. 2011, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1946170
- Balázs Égert, “The 90% Public Debt Threshold: The Rise & Fall of a Sylised Fact.” William Davidson Institute. Working Paper No. 1048. 2013 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2304242
- Turner, David, and Spinelli, Francesca. “Interest-rate-growth differentials and government debt dynamics.” OECD Journal: Economic Studies, Volume 2012. 2013, pages 103-122
- Jonathan H. Wright, “Term Premia and Inflation Uncertainty: Empirical Evidence from an International Panel Dataset,” American Economic Review , Volume 101. June 2011, pages 1514-1534
Attention municipalities: Agencies and investors are carefully judging you on your overall financial health. Hear what Wilmington Trust’s Head of Municipal Fixed Income Dan Scholl has to say on this and the anticipated market trajectory.
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