Debt, both public and commercial, is exploding in the United States and internationally.
Interest rates are kept low by central banks. The governments of the United States and southern Europe cannot afford higher national debt rates. Neither can the private financial system of the developed world.
One effect would be to decimate the share price of commercial banks by marking-to-market their bond portfolios. A rise in nominal interest rates would reveal a vulnerable system. Several large central banks around the world share the responsibility of keeping rates low and providing the liquidity needed to support deficit spending. The mortgage and commercial sectors are in constant need of support.
“Debt requires sustained zero interest rates; but followed by slow economic growth and modest inflation.
The pandemic simply exposed and exasperated this outdated dynamic, did not bring it about. The good news is that even in the face of sovereign and private debt, interest rates will remain low. The alternative is a generalized collapse scenario.
Still, be prepared for modest economic growth (longer term, two percent a year is the upper limit of optimism) because debt is holding it back. Inflation will remain subdued, with a few sectors as temporary exceptions. The velocity (the speed at which money circulates) is slowed down by excess debt because it decreases aggregate demand. In addition, debt reduces available bank financing.
Debt and deficits in Tns
Many summers ago, in 1984, I was shocked – as young people can be – when I was taught in college that America’s federal debt caused by overspending was unsustainable at 1, $ 6 billion, or about 39% of GDP. Fast forward 37 years, and now all the talk about the debt and the budget is in the trillions. As an example of what a trillion is: a trillion seconds ago we will return to the age of the woolly mammoth.
The US federal debt currently stands at about $ 28 trillion in national debt. Within five years, perhaps as early as 2025, this debt will have reached $ 35 to $ 40 billion according to several world-renowned economists.
With a nominal interest rate of 2.5%, the interest charge for the government could be around $ 1 billion per year. Interest on the US national debt stood at $ 0.4 billion in 2020, which represented about 7% of the federal budget. This year, the federal budget is spending $ 5.8 billion. Tax revenues are budgeted 40% less at $ 3.5 billion. It’s hard to see this large budget deficit eliminated in light of voter expectations and rising interest charges.
With the expected US public debt, the debt / GDP ratio could reach 180% in a few years. Some economists claim that a 100 percent ratio is the tipping point in the sense that interest charges can only be repaid by issuing more debt. In fact, a kind of government Ponzi scheme where debt service is paid by issuing even more new debt – because interest cannot be covered by tax revenue minus government spending.
Although there is a theoretical possibility that the federal debt could be reduced relative to the size of the economy through a period of high GDP growth and inflation. However, that might not happen because the higher nominal interest rates that were to follow such a growth scenario would sacrifice a lot of federal spending instead of the higher interest bill on the national debt. In addition, higher nominal rates of the Federal Reserve system (the Fed) can collapse all or part of the private sector financial system.
Another obstacle is that the services component has reached 45% of US GDP – and that there has been no inflation for the service sector in recent decades. The service sector has a high compensation share, leaving little room for improvement in productivity.
But let’s not undermine future fiscal and financial innovations such as creative accounting, moratoriums, new sources of government revenue and new sources of technological productivity. In addition, population growth is essential – a point not lost in the US immigration policies of the new Biden administration.
With a debt of 40 billion dollars, the American population (328 million) may wonder what happened to this money. In a few years, a family of four’s share of the national debt will be half a million dollars (which they “owe”) and they will have to pay their taxes. Admittedly, a brake on private consumption.
Consider the last economic crisis – 2007-8. This was in part caused by the conditions put in place by low rates with abundant liquidity as well as light regulation of rating agencies, mortgage companies and investment banks. The result was subprime mortgages, an asset and housing price bubble – and the collapse of the financial system.
Not that different from what we are faced with today. The irony is that what triggered the latest financial crisis were low interest rates when in the future it could be an increase. While the Great Recession was caused by US financial engineering in residential mortgage derivatives, the next crisis could be caused by non-transparent innovation in commercial real estate securities. Or just that rates go up and expose that some businesses can’t pay their rent – think retail stores, malls, empty offices, movie theaters, hotels, etc. Afterwards, homeowners and financial institutions can fall back like a tangled house of cards.
Federal Reserve Chairman Jerome Powell and his colleagues at international central banks have no choice but to keep rates low, suck up weak corporate papers and support mortgage institutions.
The Fed under quantitative easing programs has increased liquidity to $ 2 billion per year. This corresponds to the budget deficit. The sequence is this: the government spends (too much), issues treasury bills, notes and bonds which the Fed then buys.
The Fed has extended (say QE +) its buying mandate and core business to also buy mortgage bonds, commercial paper, high yield bonds and direct loans.
High yield bonds are commercial papers that include “junk bonds” (which is a near-equity security) issued by companies such as Ford and General Motors. As part of QE +, the Fed is also supporting industries such as airlines and cruise lines with direct loans.
Companies have used low interest rates and central bank liquidity to get into debt and many sectors are vulnerable.
The industrial sector the most supported by the Fed is the banking sector with financing rates at minus one percent interest per year. This means that when invested in T-paper with a return of 1.5% per annum, the carry trade is 2.5% per annum, a very favorable environment. If this negative funding rate turned positive, the entire financial system would experience a crisis from which it may not be able to recover.
Recently, the inflation monster has resurfaced to curb expansionary fiscal policies. The “post-pandemic” world is experiencing rising commodity prices. Could it be the fact that the suddenly higher global supply-supply balance has to adjust after a “quiet” period with little demand and therefore supply?
Wage inflation (total compensation) in the United States has been contained for decades. Wage and product inflation in the developed world will be brought under control by low-cost producers in emerging markets and home robotics.
However unlikely, a take-off in inflation would truncate the recovery. If prices rise faster than wages, real income and any expansion suffer.
The United States and therefore the global financial system is leaving no room for an increase in interest rates from the Fed, nor for an increase in market-induced credit spreads. Same story in Europe. So, expect rates to stay low and QE + to keep a hand under the real estate market and US businesses.
Rest of the developed world
In addition, the Bank of England has joined the trillion dollar debt party which cannot afford rising interest rates. The pandemic has added $ 1/2 trillion to Britain’s national debt. Over the next 12 months, double that figure to $ 1 trillion as the UK government has been borrowing £ 1.06 billion a day since the pandemic struck.
The European ECB has kept deposit rates negative for more than two years. While the ECB lacks transparency, it does not lack support for the commercial banking system. It is fair to assume that if base rates, sovereign and commercial rates as well as credit spreads increased, the European banking system would be under attack. Banks are subsidized with negative funding rates and can transact in long-term government bonds – and therefore are highly exposed. The first to disappear would be the share prices of the major banks in Germany, Spain, Italy and others.
For decades, Japan’s economy has been characterized by miniscule growth, low rates, and low inflation. Japan’s national debt has increased and its debt-to-GDP ratio currently stands at 256%.
Expect debt in the developed world to intuitively contravene interest rate controls. And – also counterintuitive – low interest rates will not stimulate growth and inflation. The high amounts of debt serve as an anchor.
Perhaps there is an innovative financial solution.
About the Author
Tor Svensson is the founder and president of Capital Finance International (CFI.co), which supports the UN SDGs. Tor is a senior advisor to an NGO recognized by the UN.