Does the surge in government borrowing matter?

Signs that the US recovery might be stalling in the face of a second wave of Covid-19 cases look set to draw a predictable response from Congress. Lawmakers are putting together another rescue package, the fifth since the crisis began, which is expected to top $1 trillion.

Spending packages approved by Congress this year already total some $2.5 trillion and although not all will be spent, the budget deficit looks set to rise to $3.5 trillion (17% of GDP) this year.  

The US is not alone. UK borrowing is expected to rise to £350bn this fiscal year, the highest nominal amount since the Second World War. And deficits are surging across the world, with the IMF estimating that some $9 trillion has been put forward in fiscal support and that public debt will exceed WW2 levels for the G20 at 142% of GDP in 2020.

Within the total, IMF projections show US debt rising from 109% of GDP in 2019 to 141% of GDP this year. For the eurozone, the figures are a more palatable 84% to 105% of GDP; however, these include Italy where debt is expected to exceed 166% GDP in 2020. It is Germany, of course, which is keeping the average down and the figures do not include the costs of the new €750bn European recovery fund, worth 5.4% of GDP for EU27 (the 27 member states remaining after the UK’s exit from the EU).

Make no mistake, these policies are a vital lifeline to people and businesses during the downturn in providing a bridge across the pandemic. They are necessary for the economy to remain intact and able to deliver the recovery when the threat of Covid-19 recedes. Nonetheless, they also raise questions about the long-term costs of record debt levels and the impact on the economy and investment landscape.

Are we entering a new era for debt?

Looking at the total debt picture for the US, it looks like we are moving into a new phase where total debt to GDP takes another significant step higher. If we combine debt from government, households and business we can see three distinct periods (chart 1).

• Mid 1950s to 1980. The first of these three periods saw total debt to GDP running at around 130%, during which government debt levels fell whilst corporate borrowing rose as a share of national income.
• 1980 to 2000. The second phase saw an acceleration in borrowing. The recession of the early 1980s, followed by the de-regulation of lending to the private sector, saw debt step up to 185% of GDP, driven by all three sectors, particularly households.  
• 2000 to 2020. Debt accelerated again in the first decade of the century driven by mortgage lending to households. This was followed by the sub-prime crisis and another leg up to 250% of GDP. Between 2010 and the end of 2019, corporate debt rose, but the main driver was an increase in government debt levels. Notably, the household sector de-leveraged during this period, such that overall debt remained steady.

The next phase: what are the implications of higher government debt?

We are now in another acceleration phase and the likelihood that the US is heading for debt levels around 300% of GDP, driven by the surge in government borrowing.

One thing is clear: different sectors can leverage and de-leverage, but the overall level of debt keeps rising. How concerned should we be about this and what are the implications?

If the economy bounces back, then tax revenues will rise and outlays fall, thus helping to bring the deficit and debt down. This is the hope, but as the challenge of operating a business and the impact on confidence from Covid-19 become apparent, it looks less likely.

Long run scarring effects mean that there will be some permanent damage to the economy with adverse consequences for government finances. This comes on top of the extra demands on government for increased healthcare spending and infrastructure as a result of the Covid crisis -  a factor we discussed in our recent update of the Inescapable Truths.

If the economy is not going to return to its previous path the question is how sustainable will the rise in borrowing be? Will governments be forced to take action to bring deficits down?

The role of the bond markets

In the past, the bond markets were seen as the check on government borrowing by pushing up yields on any sign of increased enthusiasm for looser fiscal policy, prompting governments to rein in their plans. Today the bond market “vigilantes” are a distant memory and there has been little or no adverse reaction in government yields to the rise in borrowing.

This may well be due to the weakness of economic activity which has driven down inflation expectations and sent investors into safe assets such as government paper. Such an effect would be expected to reverse as the economy recovers. However, it could also reflect the power of central bank policy, with rate cuts, forward guidance and asset purchases driving down the cost of borrowing along the yield curve, signalling that interest rates will remain very low for many years.

Although their asset purchase programmes are in the secondary market, central banks are significant buyers of bonds and research suggests they have a marked influence on the level of yields.

The chart below shows the 10-year government bond yield in the US and the UK is at its lowest level in 120 years. In Japan and Germany the position is more extreme: 10-year yields are negative and investors have to pay for the right to lend to these governments.

Three potential problems

Why worry? After all, from an interest rate perspective there seems to be little cost from the surge in borrowing. Helped by the action of central banks, governments are providing necessary support to the economy with interest rates at record lows.

However, looking further out we see three potential problems if high debt levels persist:

1. Central bank independence undermined

The first is the potential threat to central bank independence. Economic recovery will bring a need for tighter monetary policy to safeguard against inflation, which will push rates higher and increase borrowing costs. Such a move will not be popular with highly indebted governments who are likely to pressurise central banks to keep policy easy. The risk is that we see inflation pick up as the central bank is compromised in its objectives. President Trump did not hold back his displeasure at Fed tightening in 2018 and central banks generally could find it difficult to disentangle themselves from their role in helping to fund fiscal policy.

2. Savers repressed.

The second, is financial repression. Investors have had to cope with low interest rates ever since the financial crisis in 2008, but the latest cut in interest rates means the challenge of meeting savings targets and generating an income in retirement are even greater.

In some respects this is an objective of monetary policy: investors are being forced to take on more risk and in the process will put more savings into parts of the economy which will generate growth rather than safe assets such as government bonds.

Alternatively, investors will have to simply put more money aside to meet their goals which will reduce demand and growth in the economy – sometimes known as the “paradox of thrift”. Either way, it means that savers have been subject to financial repression as savings returns have been reduced and the cost of a pension or other savings plan has been significantly increased.

3. Drag on future growth

The third, and probably the most significant concern, is the potential drag on future growth. As Japan and Italy have demonstrated, high levels public debt are associated with weak growth. Although there is a debate about the direction of causation, there are clear headwinds on activity from high debt burdens.

The effects of high debt burdens

Increased financing risks

High debt limits the ability of an economy to use fiscal policy as a tool to stimulate the cycle. To retain the confidence of lenders, borrowers need to demonstrate that their finances are on a sustainable path and consequently find they have little room for manoeuvre on fiscal spending. Many have to periodically tighten fiscal policy through public spending cuts or tax increases. The recent experience of Japan is a case in point where the economy went into recession after the increase in consumption tax as the government tried (yet again) to address its long run finances.  

Japan is actually one of the less vulnerable countries in this respect as financing problems are more likely in those economies which – unlike Japan – rely heavily on external funding and/or are seen as a credit risk. Many emerging market countries fall into this category, but also developed economies such as Italy which do not control their own currency.

Whilst investors in the current environment are searching for yield and willing to take risk, there is always the danger of a “sudden stop” in financing which can bring a currency collapse and/or a broader financial crisis. Growth is then impacted through a sharp tightening of monetary and fiscal policy with recession inevitably following.

The role of the dollar

The threat from higher debt can be seen in the context of the competition for funds. Arguably the US is vulnerable in this respect by running significant budget and balance of payment deficits – the so called twin deficits.

The economy is dependent on foreign investors or “the kindness of strangers”.

As the last Governor of the Bank of England, Mark Carney noted, the UK is in a similar position. The difference with the US is that unlike the UK and others, it has the “exorbitant privilege” of the dollar, the global funding currency, so can sustain significant imbalances for longer than other less “privileged” countries.

The dollar still dominates global foreign exchange reserves, trade invoicing and lending outside the US, for example

Rather than a collapse in the dollar, the greater danger here is that the massive increase in US government borrowing will absorb a significant proportion of the world’s savings, creating scarcity elsewhere.

The most vulnerable in this scenario would be the emerging markets and other areas which rely on dollar funding. Many of these economies have, of course, already faced some of the most difficult problems associated with the impact and aftermath of Covid-19 as they have simply been unable to provide the healthcare or financial support necessary to protect the population. 

International organisations such as the IMF and World Bank are likely to play a greater role in ensuring that these countries remain adequately funded in the future.

Crowding out

The potential strain created by the US budget deficit is a form of international crowding out, where one borrower absorbs the pool of savings.

At the national level the concern is the same, with investment likely to suffer as the government crowds out the private sector. The risk is that weak private investment hits productivity and future growth. This has been a traditional argument against high levels of government spending and borrowing and was popularised by the Reagan and Thatcher administrations of the 1980s.  

However, the evidence for this is quite limited, as increases in government and corporate debt have often gone hand in hand (see the chart above). The picture today is also complicated, as the mechanism for crowding out is higher interest rates which, as we have argued, are being repressed by central banks and QE.

Nonetheless, higher government debt increases the likelihood of higher taxes, from which the corporate sector will not be exempt. Presidential candidate Joe Biden has already made it clear that he will reverse some of the Trump cuts in corporate taxation.

Private investment and productivity may also be hit by the potential return of “big government” where the government finds itself taking ownership of many key businesses but struggling as a result of support plans during Covid-19.

Conclusions

Government borrowing is rising rapidly and is likely to stay high given long-term scarring effects on the economy from Covid-19. Even with a recovery, it is likely that governments will withdraw slowly from their increased role in the economy and some may find they hold liabilities for some time after the pandemic has faded.

The weakness of economic activity has depressed private investment and allowed the rise in government budget deficits to be financed at historically low interest rates. An outcome facilitated by central banks through ultra loose monetary policy.

However, whilst such policy is needed at present and stimulus should remain in place well into next year, high government debt levels will create tensions further out.

Financial repression is putting pressure on savers who face an escalating cost of retirement.

Economic recovery will put pressure on central banks to raise interest rates creating a clash with governments who will face significantly higher borrowing costs. Central banks may find their independence challenged as a result.

There is also the danger that with many countries competing for funds we see a squeeze on those who depend on external financing or have lower credit ratings. In particular, US government borrowing can create a scarcity of funding in more vulnerable economies resulting in retrenchment and recession as they struggle for capital. The impact will be felt by those who have already been most affected by Covid-19.

Fiscal policy may be today’s saviour but will create significant challenges in the future.