Debt and Deficits Are About to Matter Again for Investors
What matters more: debt or deficits? Debt service or debt load? Central bank asset purchases or balance sheet size? These questions have always occupied the minds of economists, investors and politicians. The financial crisis provided some of the answers. We learned that debt levels mattered when they crossed a critical threshold, triggering global crises and igniting systemic risk.
Carmen Reinhart and Kenneth Rogoff warned in their 2009 book “This Time is Different: Eight Centuries of Financial Folly” that a sluggish recovery would follow a debt-fueled recession. Their basic premise held then and is true today: Annual economic growth in the U.S. has been 1.8 percent since the publication of the paper that became the basis for the book.
But a funny thing happened on the way to the nirvana of post-crisis deleveraging. In February 2015, McKinsey & Co. threw cold water on this idealistic notion with a watershed report titled “Debt and (Not Much) Deleveraging.” How on earth had the world tacked on $57 trillion of incremental debt in the seven years after the eruption of the crisis we feared would end the world? Had we not learned our lesson?
And yet, no crisis has erupted in the two years since the McKinsey report. Has the pendulum swung clear back to the debt doesn’t matter at all extreme? Chances are we’re about to find out. The era of zero interest rates, and negative rates overseas, has glossed over debt that’s built up since 2007.
Today’s Federal Reserve statement may provide clues as to how aggressive policy makers will be in both raising rates and potentially beginning to tighten monetary policy from another angle, by allowing the reinvestment of maturing securities to cease and begin shrinking the central bank’s balance sheet.
But then combine the dynamic of tightening financial conditions with the Congressional Budget Office’s year-old calculations that the deficit, which had fallen from 10 percent of gross domestic product to 2.2 percent in the 2015 fiscal year, would more than double to 4.9 percent by 2026. The CBO projects debt held by the public will swell to 86 percent, twice the historic average and the highest since 1947.
In terms of borrowing costs, the CBO assumes that the rate on three-month Treasury bills rises to 2.8 percent by 2026 from its current level of 0.5 percent, while that of 10-year Treasuries increases to 3.6 percent from about 2.5 percent now. Just think of what that would do to Uncle Sam’s interest expense, not only on an absolute basis but also as a percentage of total federal outlays with the national debt at the cusp of crossing the $20 trillion line. That’s on top of the $18.2 trillion in household debt.
So, add rising deficits and higher rates together with a shrinking balance sheet that will slash Fed remittances back to the Treasury. Then factor in Trump’s proposed tax cuts, and just for proper measure, the looming reality that an aging population presents to entitlement spending. What do you get? Even worse debt-to-GDP levels than what the CBO assumes.
Moody’s Investors Service and Fitch Ratings, which didn’t follow Standard & Poor’s August 2011 move to strip U.S. of its AAA rating, are sounding very worried.
Artificially low interest rates have not only helped the government, they’ve also produced a generation of families who’ve become addicted to serial mortgage refinancing and fallen back in love with credit cards, all the better with which to aspire to appear to live the American Dream.
The irony is that he greatest proponents of the debt-service-is-the-only-thing-that-matters argument come from within the Fed. This deceptive mantra is drilled into newbies at the Fed in true Jim Jones Kool-Aid fashion. Think of it as the mirror image of a sudden freezing of liquidity in the financial markets. Debt service is inconsequential so long as it doesn’t exist.
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Danielle DiMartino Booth at Danielle@dimartinobooth.com
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