There are two methods by which a country may achieve an annual spending budget. First funds can be raised through taxation of citizens and businesses. The second is to borrow. Historically a prudent monetary policy would not utilize the second option unless there is an emergency, like war or economic recessions.
Yet we find ourselves today with a budget deficit approaching $1 trillion here in the U.S. and a national debt ballooning to almost $23 trillion. The Treasury Department has been keeping records for the last 230 years and shows that we have amassed $11.4 trillion in debt since 2009. Think about that. We have added as much debt in the past 10 years as we did in the previous 220 years!
By comparing what a country owes with what it produces, the debt-to-GDP ratio should reliably indicate a country’s ability to pay back its debts. In the third quarter of 2019, the U.S. debt-to-GDP ratio was 106%, approaching levels not seen since World War II.
Countries like Japan and Greece may have less overall debt when compared to the U.S., but look much worse when you realize Japan’s debt is 234% of its GDP, followed by Greece at 182%. Debt for the world’s largest economy, China, is currently 54% of its GDP, a significant increase from 2014 when the national debt was at 41.5% of GDP. China’s national debt is currently over $5 trillion.
Unemployment is low, interest rates are low and inflation seems muted. This seems like an unusual environment for debt levels to be at such high levels. But there is an old theory gaining new life among economist: Modern Monetary Theory or MMT. Leaning heavily on work done over 90 years ago by famed economist John Maynard Keynes, the theory argues that carrying large deficits and debt levels isn’t as bad as once believed. If the U.S. dollar is the world’s leading currency, it can simply print its way to bridging the gap between taxes and spending.
For the theory to work the growth being driven by government spending must outpace the interest paid on debt. Therefore, it is not about minimizing spending, but rather maximizing the benefits of that spending to further drive economic growth.
We’ve seen similar stories before. Economists and others that attempt to predict the unknown tend to analyze the recent past to rationalize the ‘new normal’. This reminds us of the tech bubble in the late 1990’s/early 2000s. It was believed that investors had left the old way behind and were charting a new reality, whereby fundamentals matter little and castles in the sky reign supreme. We all know how the story ends, when things reach unusual extremes – – they don’t continue in perpetuity, but rather come crashing back down to earth.
Sovereign debt may continue down the same path for years to come, but we believe at some point there will be a catalyst that exposes the structural deficiency. A likely culprit is a pick-up in inflation beginning a domino effect of higher interest rates and an increase in the cost of debt. This means a larger chunk of the budget would go toward debt payments and less to funding high-growth initiatives.
Perhaps while things look strong, we ought to be adopting more sensible fiscal policy, if for no other reason than to create more levers to pull when the next recession arrives.
