By David Nelson, CFA CMT
US Debt as a % of GDP hit a peak at the height of World War II. In the face of its greatest challenge, America was willing to spend whatever it took to survive.
During the Financial Crisis on the heels of a housing bubble and toxic securities in deposit institutions debt as a percentage of GDP exploded higher. Once again America was willing to spend whatever it took to survive. Here we are 3/4 of a century after the end of the last World War and we are poised to breach that milestone sometime next year.
President Biden has just signed a $1.9 Trillion Covid relief bill on the heels of three others not to mention a Fed balance sheet that added another $3 Trillion last year. Already talk in Washington centers on a follow-on package. If we attach the phrase “Covid Response” to every piece of legislation America once again will spend whatever it takes to survive.
In a war, whether you’re fighting off bullets or a virus, anything goes but at some point after the crisis, there’s usually a conversation about how to return to fiscal and monetary health. Maybe not anymore.
The New Math
Throughout my financial career I was taught that high debt offers leverage and used responsibly can increase returns. However, push the leverage too far and you can bring down a company and sometimes even a nation.
Today there are an increasing number of economists including some from the canyons of Wall Street that say this kind of thinking is old fashioned. It isn’t the level of debt that matters but the nominal interest expense or inflation adjusted the real interest expense.
Nominal Interest Expense as a percentage of GDP
Last week two economists from Goldman Sachs, Laura Nicolae and Ronnie Walker penned a research piece New Thinking on Fiscal Sustainability.
They lay out the case that when viewed through a different lens compared to the 80’s and early 90’s, the United States is in much better shape. Of course, today’s low yields look great especially when you consider 10-year yields in the early 80’s were 16%.
10-Year Yields since 1980
The note focuses repeatedly on a paper written by former chair of the Council of Economic Advisors under President Obama, Jason Furman, and former Secretary of Treasury under President Clinton, Larry Summers, A Reconsideration of Fiscal Policy in the Era of Low Interest Rates.
By examining their paper in a Goldman Sachs research piece, the theory moves from a being party driven left of center to a research note coming from a bulge bracket firm on Wall Street.
Both documents are music to the ears of the current administration. This kind of thinking almost demands continued fiscal spending using the current low rates to justify.
Selling the Message
It’s no secret there is an incestuous relationship between Goldman and the Government. Goldman is the farm system for future government officials. Just look at a few of the alumni.
Goldman Former Partners
- Gary Cohn – Former Director of National Economic Council
- Steve Mnuchin – Former Secretary of Treasury
- Hank Paulson – Former Secretary of Treasury
- Mario Draghi – Former President of ECB
- Gary Gensler – Biden Pick to Head the SEC
- William Dudley– Former President of the NY Fed
- Jim Hines – U.S. House of Representatives
My point is, get ready for an unprecedented push for continued fiscal and monetary stimulus beyond anything previously considered. Of course, this kind of thinking works right up until the time it doesn’t.
What seems to get little discussion is if we continue to go down this path what happens if your crystal ball or compass is just a little off?
Questions
What happens if we wake up one day and the inflation the Fed has been trying to produce for the last decade finally arrives? Brent crude is close to crossing above $70 a barrel and commodity prices are soaring.
What’s going to hold down the long end of the yield curve if bond traders decide 1.6% isn’t enough of a return to tie up capital for 10 years?
Yield Curve Control – is often mentioned as a tool to offset an unwanted increase in long rates. The Fed is already spending $120 Billion a month and with GDP expected to be North of 6%* this year it would take a massive multiple of that number to hold rates down if they start to move higher.
With 10-year rates doubling in just the last 6 months it begs the biggest question of them all:
WHAT’S THE BACKUP PLAN?
*Goldman Forecast for GDP in 2021 is 7%
