Last week we had a series of meetings with some of our longest standing clients and learned about what’s keeping them up at night. As a second wave of COVID-19 infections takes hold around the world, many questioned if there’s any more firing power left, following the bazooka of fiscal and monetary measures that occurred during the spring. In this report, we tackle this and other pressing client questions.
Q: How can unemployment and consumer spending both be so high?
- Unprecedented spending by the U.S. government to ease the pandemic burden on households was a supersized application of Keynesian Economics 101. When the economy contracts, the government fills the void. In the second quarter, a 33% annualized dive in nominal GDP and a 13% average unemployment rate, was met with a 44% jump in personal disposable income. This marked a complete departure from past experiences (Chart 1).
- Economic growth and income paths usually follow each other, with government automatic stabilizers only partially filling the gaps. The divergence this time came from a 75% increase in government transfer payments, equivalent to US$2.4 trillion over the April to June period. This was the main factor allowing consumer spending to defy recession dynamics.
Q: What’s the bill adding up to?
- Naturally, higher government support means higher debt. Since March, marketable debt in the U.S. has grown by over US$3 trillion. The IMF has the Federal government’s net debt-to-GDP ratio (net of cash and equivalents) reaching 107% by 2021 (Chart 2).1 This is rare, but not the first time that debt levels have reached such high levels. In the 1940s, government spending to support the war effort caused the debt-to-GDP ratio to double from 42% to 106% over four years. Over the subsequent three decades, that ratio declined, with government spending as a share of real GDP dropping from a peak of 85% in 1944, to 26% in 1947. However, repeating this outcome is highly unlikely.
- The U.S., along with other countries, is likely to maintain a structurally higher debt ratio over the long run. Before the pandemic, spending as a share of GDP was already just 19%. With little fat to trim on non-discretionary spending, the options for a quick resolution are more limited.
Q: Who’s paying for this? Me? My kids? My kids’ kids?
- There is a long list of options on the table for addressing high government debt. Higher taxes (on capital gains, income, sales, and wealth) are a hot topic of conversation at our virtual cocktail parties. So too are future spending cuts. Neither path would be well received by everyone.
- This is where central banks can help to ease the burden. Over the last few months, we witnessed just how much support they can provide. For the U.S. government, the Federal Reserve’s quick actions not only eased financial market dislocation, but it made the cost of debt cheaper. It did this through a series of programs, coupled with cutting its policy rate to the zero lower bound and using forward guidance to push market expectations to be flat on the policy rate for the next decade. The average interest rate on U.S. government debt is now just 1.68%, while the average on newly issued debt is well below 1%. By keeping rates low, the average rate the government pays on all of its debt will decline over time.
- There’s one important caveat here. This narrative will hold for as long as interest rates stay low. If rates rise, it would make a compelling case to reduce debt burdens actively and more aggressively. Clearly, the most desirable path before aggressive taxes or spending cuts is to try to ‘grow’ out of it. If GDP growth is greater than the interest rate on debt, it is reasonable that the economy can in fact reduce the debt burden over time. As the economic recovery gains time, receding support payments are filled by tax payments.