In a rare show of bipartisan politics, both this administration and the previous one seem to say “no”. With a compliant Federal Reserve Bank, it appears there is no limit to the spending funded by borrowing more. I suppose it is true to say, “as long as there are no consequences and plenty of liquidity globally to lend the U.S. government money, why should there be any issues?” The problem with this conclusion is that life is rarely that simple. This is likely to be especially the case as most of the world’s democracies are in a similar position – some far worse. So, let’s examine the extent of the problem for the U.S.
Total government debt (the national debt) is currently more than 120 percent the size of the U.S. economy as measured by Gross Domestic Product (GDP). This level is higher than at any time outside wartime, and a far cry from the low level achieved during the Nixon Presidency of just 31 percent of GDP. As the administration is projected to continue to outspend its receipts for years to come, the Congressional Budget Office has predicted the level could be twice the size of the economy by 2050! The other side of this statistic is the cost of servicing the debt. Paradoxically, despite the sharp rise in the size of the debt, interest payments are actually falling. Interest rates are, of course, at record lows.
The dilemma for future administrations may be linked to the rising cost of debt servicing (paying back the debt with interest) if interest rates were to increase significantly. Very quickly, the cost of servicing this debt may become the single largest expense for the government. At which point, it may become progressively more difficult to maintain current social programs and military spending. Alternatively, a future administration may decide to raise taxes significantly across the economy to increase its income in an attempt to pay down the debt. The problem with this route, as other countries have found to their cost, is that the resulting reduction in consumer spending for an economy, with 68 percent of our economy linked to the consumer, may result in a recession and hence falling tax receipts.
There are, however, two other options:
- Generate more economic growth and full employment in order to increase tax receipts. This route appears to be the stance taken by both the previous and current administrations, although many in the Democratic legislature are also seeking to increase taxes. Clearly, taxes are likely to increase over time, but the debate will inevitably switch to how much and what the economic consequences will be. There are, as some economists have argued, two types of spending: handouts, which the current administration believe will help those in need while recognizing the difficulty in targeting the appropriate areas of need, and spending on infrastructure, which is being currently debated. Both areas will boost demand in the economy and hence risk inflation as there are palpably huge constraints in the supply of goods at the present time. Infrastructure spending, if completed properly, should aid economic productivity, and help long term growth. This, in turn, can counter inflation and reduce the level of debt through higher tax receipts.
- Inflation is the ‘friend of the indebted’ as we argued in last month’s article. In theory, as inflation increases, the level of tax receipts will rise and if spending is controlled, so, too will the size of the debt decrease. Indeed, inflation reduces the real size of the debt compared to GDP. The problem is that higher inflation has other economic consequences. Consumer purchasing power can become less if wages do not keep up with the trend in prices. To control costs, companies may attempt to reduce employment. The Federal Reserve Bank may increase interest rates and tighten all its policies in order to control inflation.
Currently, however, the chair of the Federal Reserve Bank and the Treasury Secretary appear prepared to take a chance on inflation, believing any short-term spike will prove transitory.
That there are inflationary pressures in the economy right now is difficult to dispute. Many metals, oil, and food items were already significantly higher than a year previous in February – before prices collapsed in the wake of the pandemic induced lockdowns. Interestingly, the recovery in all these prices appear to stem from the Federal Reserve Bank’s announcement of monetary stimulus at the end of March 2020. Just look at Iron Ore and Tin prices:
The other aspect raising prices is the high level of demand caused by the stimulus coupled with a lack of supply caused by a year fighting COVID. The number of manufacturers reporting the inability to access supplies promptly has risen to all-time highs. Similarly, the number of companies reporting higher raw material and other input prices has risen dramatically:
In the chart above, we see an interesting change in the correlation of these two lines. They were relatively close until 1990 and less connected since then. 1990, of course, marked the ending of communism in Eastern Europe and an opening up of new productive capacity. By the end of the decade, massive investment was pouring into an opening Chinese economy, which for the last twenty years has increased global manufacturing capacity significantly. The only way to keep the prices-paid line from being reflected as a sharp rise in overall inflation as measured by the Consumer Prices Index (CPI), the world needs to unearth more productive capacity. Technology is clearly a factor driving more productivity, but the open-ended question at this time is whether it will be enough.
It is probably not too surprising that in this environment Fixed Income assets such as bonds, are under pressure. Yields have increased significantly and prices, the inverse of yields, have fallen. Conversely, equity prices and commodities have increased as has that most speculative of all ‘investments’ – Bitcoin:
Trevor Forbes’s articles and contributions to The Berkshire Edge should not be construed as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice for compensation. As an author with specific expertise, his contributions reflect his personal views and do not represent Renaissance Investment Group LLC.
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