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How Will We Pay for All This Stimulus?

By Richard "Crit" Thomas, CFA, CAIA
In the News Economy & Markets
Business office building in London, England

When I talk with financial professionals one of the most frequent questions I get relates to all of this monetary and fiscal stimulus and how will we pay for it all after the COVID-19 crisis abates.

What Comes After COVID-19?

Many observers suggest that we will just inflate our way out of this debt problem, like we did after World War II. Theoretically, inflation reduces the debt burden in two ways, it erodes the value of debt while at the same time tax revenues increase. Inflation did shoot up after WWII as demand outstripped supply. A lot of manufacturing capacity was diverted to the wartime effort reducing the supply of consumer goods. When the soldiers came home consumer demand increased, yet there was limited capacity to meet it. With demand exceeding supply, prices rose. This COVID-19 crisis has also taken out a lot of supply through bankruptcies and business closures. When the crisis subsides we could see a similar supply/demand imbalance, but I don’t believe it will be sustained for long, nor would it be welcome.

Inflation is Not the Answer

The ratio of U.S. debt-to-GDP peaked in 1946 at 120% and then began to rapidly decline. Just six years later in 1952 the debt-to-GDP ratio fell to just 70%. Over that period inflation did help boost GDP, but it wasn’t the only driver as inflation adjusted GDP grew 3.8% annualized and debt outstanding fell 0.7% annualized.  So even without inflation the debt burden would have shrank. But our current situation looks different. The latest Congressional Budget Office (CBO) forecast has U.S. debt outstanding increasing at a ~6% annual rate over the next 10 years, due mainly to rising entitlement obligations. Given demographics and past trends in productivity our real GDP growth potential is around 2% annualized.  All else equal, that would suggest that inflation would need to grow over 4% annually to begin to reduce the debt-to-GDP ratio. But this ignores the fact that most of our entitlements are tied to inflation either directly (COLA, i.e., cost of living adjustment) or indirectly (medical inflation). These inflation adjustments did not exist in the 1940s and 1950s, nor did entitlements represent a significant portion of our budget then. This idea that we are going to just inflate our way out of our debt burden doesn’t appear fully baked.

U.S. Debt Outstanding (the war years)

Source: Federal Reserve Bank of St. Louis

Blood from a Turnip

So what will the government do? It’s not going to be easy. I believe we will continue to kick the can down the road, though some belt tightening is probable after this current crisis is over. Should President Trump remain in office the belt tightening is likely to come from reduced spending. Typically budget cutters look first at discretionary spending. In 2019 mandatory spending and net interest paid represented 90% of income (tax revenues). According to the CBO those programs will represent 100% of income by the end of this decade. I forgot to mention, this is really depressing. After meeting mandatory obligations only 26% of the discretionary spending budget was covered by income in 2019, the remainder was borrowed (budget deficit). It’s entitlements that need to be cut. President Trump may take another shot at healthcare reform, though it will be difficult to get any major legislation through this polarized Congress. Should Joe Biden be elected he is likely to try to raise income through higher taxes, though the objective would be to fund more spending programs. Honestly the high debt level and growing deficit is just going to make life difficult for any administration.

Can’t the Federal Reserve (Fed) Just Monetize Our Debt?

A central bank can monetize debt. In theory a central bank could create money, buy government debt with it, and then write off the debt. So the debt just disappears. That sounds amazing, and a whole lot like quantitative easing (QE). It is not. The Fed does not buy directly from the Treasury, they buy Treasury securities through the secondary market (typically from a bank). By its charter the Fed cannot buy debt directly from the government, this is barred under the Federal Reserve Act and it supports the independence of the Fed. Under QE, the Fed creates money to buy government debt from a bank and in so doing creates a liability to that bank in the form of a reserve deposit. As such the Fed can’t just write the debt off as it would negatively impact the banks’ balance sheet. To monetize our debt the Fed would have to lose its independence.

The Ties that Bind

It is true that as the Fed holds a larger and larger portion of the government’s debt load, the two entities become more inextricably tied. This introduces the risk that the Fed’s independence becomes compromised. This risk bears watching. The Fed’s independence has been challenged from both the left and the right. Moreover, a number of recent Fed governor nominees have been fairly unconventional with strong political views. Certainly when one is deeply indebted, the ability to take control of the money printing press would look enticing. Yet any hint that the Fed may lose its independence would be devastating for the dollar and financial markets. I believe politicians understand this, but I may be naïve in my view.

So Where Does That Leave Us? 

I don’t believe inflation is the answer. After we put this COVID-19 crisis behind us the budget deficit will continue to grow due to increased entitlement spending (aging demographics) and higher net interest (higher level of debt). Both of these outlays are tied to inflation. We’d just be shooting ourselves in the foot. If it is not inflation, then that leaves austerity. Ultimately politicians will be forced to address entitlements, but it will take time – maybe closer to the end of this decade. The solution will include some combination of higher taxes and reduced entitlements, though I expect that it will come in small increments. In other words, it is unlikely to be a near-term issue and, when it happens, it will likely come in small doses.

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crit thomas global market strategist

Richard "Crit" Thomas, CFA, CAIA

Global Market Strategist
Crit is responsible for examining and evaluating economic conditions, generating insights and providing a sharpened perspective on investment strategies for enriched portfolio construction.

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