Fiscal responses by governments around the world during the pandemic were unprecedented. Many governments put forward anywhere between 20% and 30% of gross domestic product in spending to mitigate the impact of economic shutdowns.
Policymakers, firm managers and investors should anticipate a significant fiscal narrowing for both public and private actors.
Now, after months of elevated inflation and surging interest rates, a different price and rate environment is emerging.
Policymakers, firm managers and investors should anticipate a significant fiscal narrowing for both public and private actors in the post-pandemic period.
An International Monetary Fund analysis in March of government spending during the health crisis found that “the power and agility of fiscal policy were far beyond what was previously thought possible. Governments channeled cash directly to households and businesses to save jobs and livelihoods.”
These actions demonstrated the special role of governments when things go bad, the analysis said.
“But now, the bill is coming due,” the analysis added. “Governments face the tricky task of reducing unprecedented debt to more sustainable levels while ensuring continued support for health systems and the most vulnerable.”
In some respects, central banks’ efforts to restore price stability will result not only in narrowing fiscal space but will constrain the ability of governments to use inflation as a way to offset the impact of large fiscal imbalances.
There is little argument that government spending on vaccines and continued income streams during the pandemic saved the global economy from collapse.
Data from the IMF shows the jump in emergency government spending in 2020 being financed by debt. This came as revenue plunged during the economic shutdown.
Though the debt relative to GDP in most countries is expected to moderate over the next five years, debt in the United States is expected to increase because of slowing economic activity. And China’s debt accumulation is expected to accelerate, reaching 100% of GDP by 2027.
So has spending go too far? Are we now paying for it with rising inflation and interest rates that will crimp consumer spending and push the global economy into recession? Has public debt risen to heights that would crowd out private investment and limit growth?
In an IMF discussion on public debt, the economist Olivier Blanchard rejects simple fiscal rules and says policymakers must consider the interplay of the outlook for interest rates, economic growth and political stability.
In emerging markets, he notes the complications of debt denominated in foreign currencies, which was evident in previous financial crises.
Ricardo Reis, an economics professor at the London School of Economics, warns that price stability matters more than ever if debts are to stay sustainable.
The expansion of public debt over the past 20 years was made possible by the decline in inflation and interest rates, he said. That debt will be sustainable as long as it keeps its ability to attract investors.
But as prices accelerate around the world, will we see a run of sovereign debt crises?
Emmanuel Saez, an economics professor at the University of California-Berkeley, points out that government spending among advanced economies has pivoted from national security basics to providing a social safety net, with public education necessary for economic advancement.
Although spending among emerging economies is increasing, he says that it has been insufficient, as we’ve demonstrated in the comparison of gross income per capita.
Finally, we would add to the discussion that the ability to issue debt is an important indicator of the health of the economy.
Japan’s debt has exceeded 100% of GDP for decades, so there must be a willing audience for that debt. Foreign purchases of U.S. debt subsided during the pandemic as investors sought the safety of cash.
Within those purchases is the implicit guarantee of repayment now threatened by the debate over lifting the U.S. debt ceiling. Forfeiture would worsen the rise in interest rates and deter private investment, hurting growth.
How much public debt is too much?
The rule of thumb was always that countries with debt-to-GDP ratios of 100% or more were in danger of default. It was a convenient milestone.
The U.S. reached 100% in 2012, and Japan long before that, but neither one is at the breaking point. So there must be something else that determines when a country has become so profligate that investors lose confidence.
We attribute Japan’s ability to increase debt to its population of savers encouraged by culture and demographics. At worst, the public was willing to finance bridges to nowhere. At best, there was the acceptance of progressive tax policy to finance that debt.
As for the United States, whose taxes have arguably become more regressive with each tax cut, there is the dominance of the dollar, which benefits all taxpayers.
In recent decades, the safety of that debt has attracted so-called hot money by the relatively higher rates of return of dollar-based assets in a world of extremely low interest rates.
Among the economies with debt-to-GDP ratios of less than 100%, is the prime example of the role of the bond market as the hall monitor for unfunded, ideologically driven spending, with the United Kingdom and its aborted tax cuts being the most recent example.
Previous debt crises have occurred in Mexico, Latin America and Asia, all to various degrees of damage to financing the world’s economy.
Should El Salvador’s experiment with cryptocurrencies backfire, it would be hard to envision the damage spreading beyond its immediate investment and trading partners.
If confidence in Greece’s ability to repay its loans were to collapse, common sense would suggest a solution exists within the whole of the European community, no matter the eventual cost.
The increase in corporate debt
While government debt among advanced economies is regarded as an investment in the potential growth of an economy, a 2019 study by the IMF found fault in the increase in pre-pandemic corporate debt.
According to the study, the low rate of interest in the U.K., United States, Germany and Japan encouraged businesses to increase their borrowing, often to finance payouts to shareholders rather than investment.
They point out that 40% of the corporate debt—some 15 trillion pounds—would be impossible to service if there were a downturn half as serious as that of a decade ago.
But in the past year, surveys conducted by RSM and by regional Federal Reserve banks show increased investment in productivity among U.S. corporations.
This investment was ostensibly prompted by the pandemic, most likely in response to the shortage of labor, rising labor costs and the need to countering supply chain inadequacies.
Regardless of the intentions, the corporate bond market is pricing in an increased risk of an economic slowdown. The interest rate spread between investment-grade U.S. corporate debt and risk-free 10-year Treasury bonds has increased to levels consistent with the global manufacturing recession caused by the 2018-20 trade war and prior episodes of economic stress.
The widening of the corporate interest rate spread confirms the increased level of distress in the bond market, with diminished levels of the willingness to borrow and to lend, which translates into diminished economic activity.
The dominance of the dollar
The dollar became the store of value among the world’s currencies in the realignment of global finances at the end of World War II, officially taking over the role held by the British pound.
More than 60% of foreign exchange reserve holdings are in dollars, with the euro gaining traction since its creation in 1999, particularly because of increased trade with emerging markets in eastern Europe and Africa.
And with most commodities priced in dollars, the transaction demand for dollars remains a dominant force in determining its value.
The free-floating dollar
No currency regime has ever lasted forever, the most recent example being the demise of the dollar’s peg to gold in 1973.
The result since then has been a roller-coaster ride for both the dollar and other currencies. The dollar’s value rose to unearthly heights in 1985 after the Federal Reserve under its chairman at the time, Paul Volcker, increased the monetary policy rate to 20% to end the oil-shock inflation of that era.
The next spike occurred during the surge of demand for dollar-based tech investments from 1995 until 2001. And recently, the dollar has spiked when investors surged into the higher returns of dollar-based assets when it became apparent that the Fed would respond to soaring inflation.
The dollar and interest rate differentials
The Fed’s response to this latest energy crisis has been to increase the federal funds rate from zero to 4%, with another full percentage point or more expected. For now, long-term U.S. interest rates are increasing step for step with expectations of inflation.
The European Central Bank was late off the mark, holding its policy rate at zero until July before increasing it to only 2%. That gives investors the easy choice of investing in U.S. Treasury bonds yielding 4% bolstered by the currency return of a stronger dollar. Japan has not and will probably not increase its policy rate, in an attempt to end deflation and foster growth.
For as long as Europe bears the brunt of Russia’s war against Ukraine and the West, we expect U.S. securities to remain more attractive and safer than the debt of other advanced economies.
The Treasury bond market
The U.S. bond market is the dominant force in world finances. The dollar is the vehicle of global trade, with exporters parking the proceeds from sales into U.S. money market securities.
And because of the U.S. commitment to its framework of laws and its regulation of the financial system and to the depth and breadth of its securities, the U.S. bond market is unlikely to lose that status anytime soon.
U.S. federal debt doubled from 40% of GDP in 2006 going into the Great Recession to 80% of GDP before the pandemic. Add another 40% onto that during the health crisis and the U.S. debt at 120% has reached unthinkable heights reserved for Japan and less prosperous economies.
But interest rates were in decline as a result of a number of factors, not only the squashing of inflation by central bankers but also, more significantly, the decline in energy prices. That led to a decline in net interest payments on government debt.
By the beginning of December, U.S. long-term interest rates had reached 4%, with expectations of inflation remaining higher than the Fed’s 2% target and for interest rates to adjust to more normal levels in the range of 4% to 5%.
The U.S. budget
The last time the United States ran a budget surplus was in 2001, and that was given away instead of invested or saved for a rainy day. Expenditures overwhelmed revenue during the recovery from the Great Recession and then again from 2017 to 2020, that most recent episode being the result of unfunded tax cuts and the drop in revenue because of the trade war.
During the pandemic, expenditures rocketed as government programs subsidized income. Those expenditures have since retreated as those subsidy programs ended.
Infrastructure spending is scheduled to begin in earnest now that the midterm elections are over, bringing with it expectations of expanded economic activity.
There is little concern that the U.S. economy will falter because net tax revenue would be insufficient to cover its debt payments. But there are threats from those in Congress who would run the risk of default as a method of shrinking the federal government.
We think that is a nonstarter with respect to putting the federal deficit on a path toward sustainability. Given that there is not a sizable constituency in Washington or financial capitals around the world to do that means we are lapsing back into the status quo that uses the global fixed income market to impose discipline upon government spending.
That returns us to the concept of government spending paving the way for economic progress and prosperity, with the bond markets providing the guardrails to ensure sane practices.
Financial conditions
Monetary policy is transmitted to the economy through financial conditions. In this latest episode of accelerating inflation, central banks have tightened financial conditions through increases in their policy rates. The increased cost of capital will eventually crimp investment demand by businesses and decrease consumer spending by raising the cost of credit.
At the beginning of December, U.S. financial conditions were 1.6 standard deviations below normal (defined as zero value of the RSM US Financial Conditions Index). The markets are volatile, which suggests instability, while interest rates have increased to reflect the increased risk of holding debt during periods of uncertainty.
Financial conditions have reached similar levels of tightness in other advanced economies, with diminished willingness to borrow or to lend. That reluctance to assume risk will result in slowdowns, while damaging potential long-term growth.
