It is hard to believe that the COVID environment has been with us for over twelve months, a fact many would like to forget. There is a fact that will be less transitory in nature because of the COVID environment: the mounting debt across developed and emerging countries globally. The resurgence of this topic following 2020 is not without reason: in the United States, the outstanding publicly held Federal Debt exploded to 100% of the United States annual Gross Domestic Product (GDP), the highest the ratio has been since the end of World War II (roughly $21.5 trillion dollars).
Although annual deficits had been running higher than usual heading into 2020, the sharp increase was largely due to the significant fiscal response to the COVID pandemic. The response was swift and large in magnitude- effectively larger than the response to the Global Financial Crisis, in a fraction of the time. The strong response from policy makers was one of the key reasons we had a powerful economic and financial market recovery, but it did come at a significant cost from debt perspective.
Now that the economy and financial markets have nearly recovered, market participants are turning their attention to the newly increased debt burden, and the potential impact on inflation and interest rate dynamics. While it is understandable to be concerned, there are two key considerations when discussing the fiscal health of the United States: the US Dollars role as the reserve currency of the world, and the low level of interest rates globally.
These two factors are the key reasons why the United States should not be viewed through a “household balance sheet” lens. As reserve currency holder, which is effectively the main currency held in reserves and used for global transactions, we are able to in essence “print” money. This means in practice there is consistent technical and fundamental demand for our debt, which funds our ability to execute programs such as the CARES Act. Lower interest rates also have the obvious benefit of reducing the cost to pay interest on the existing debt. Despite the debt/GDP ratio being twice as high as it was in 1996, the annual debt service cost as a percentage of GDP was lower in 2020.
These factors, combined with the emergence of economic theories such as Modern Monetary Theory, have paved the way for the change in perception around debt growth. There still will be questions about the long-term burden of the debt, and market participants are looking at the post-World War II playbook for clues. This playbook, the last and only time the debt/GDP ratio has been higher, involved various financial repression policies. Stated simply, this refers to policies to keep interest rates (artificially) low, allowing an economy to growth through its debt burden (less desirable outcome would be to purely inflate through nominal debt). This took various forms during and after World War II in the United States, including Treasury yields effectively being fixed below free market rates.
While there are considerations regarding the amount of public debt outstanding, they are in our opinion very long-term. The fiscal and monetary policies of 2020 have set-up the US economy for potentially its highest GDP growth rate in +25 years, and helped financial markets recover to all-time highs. The US Dollar’s position as reserve currency, and generationally low interest rates, combined with strong economic growth, make Federal Debt situation very manageable in the near-term.