In a rare bipartisan politics show, both this administration and the previous one seem to be saying ‘no’. With a compliant Federal Reserve Bank, there appears to be no limit to what spending is funded by borrowing more. I guess it’s true to say, “As long as there are no consequences and a lot of global liquidity to lend money to the US government, why would there be problems?” The problem with this conclusion is that life is seldom that simple. This is probably the case especially since most of the world’s democracies find themselves in a similar situation – some much worse. So let’s take a look at the scale of the problem for the United States.

Total public debt (the national debt) is currently over 120% of the size of the US economy as measured by gross domestic product (GDP). This level is higher than at any time outside the war, and a far cry from the low level reached during the Nixon presidency of only 31% of GDP. While the administration is expected to continue to exceed its revenue for years to come, the Congressional Budget Office has predicted that the level could be double the size of the economy by 2050! The other aspect of this statistic is the cost of servicing the debt. Paradoxically, despite the large increase in the amount of debt, interest payments are in fact declining. Interest rates are, of course, at record highs.

The dilemma for future administrations could relate to the rising cost of servicing the debt (debt repayment with interest) if interest rates were to rise significantly. Very quickly, the cost of servicing that debt can become the biggest expense for the government. At this point, it can become increasingly difficult to maintain current social programs and military spending. Alternatively, a future administration may decide to significantly increase taxes throughout the economy to increase its income in order to pay off debt. The problem with this route, as other countries have found at their cost, is that the resulting reduction in consumer spending for an economy, with 68% of our economy tied to the consumer, can lead to a recession and therefore a decline in tax revenues.

There are, however, two other options:

    • Generate more economic growth and full employment in order to increase tax revenues. This path appears to be the stance taken by both previous and current administrations, although many Democratic MPs are also looking to raise taxes. It is clear that taxes are likely to increase over time, but the debate will inevitably turn to the amount and the economic consequences. There are, as some economists have argued, two types of spending: grants, which the current administration believes will help those in need while recognizing the difficulty of targeting the appropriate areas of need, and spending infrastructure, which are currently under debate. Both areas will stimulate demand in the economy and hence the risk of inflation, as there are currently huge constraints in the supply of goods. Spending on infrastructure, if done correctly, should promote economic productivity and promote long-term growth. This, in turn, can counter inflation and reduce the level of debt through higher tax revenues.
    • Inflation is “the friend of the indebted” as we argued in last month’s article. In theory, as inflation rises, the level of tax revenue will increase and if spending is controlled, the amount of debt will also decrease. Indeed, inflation reduces the real size of debt relative to GDP. The problem is that higher inflation has other economic consequences. The purchasing power of consumers can decrease if wages do not follow the price trend. To control costs, companies can try to reduce employment. The Federal Reserve Bank can raise interest rates and tighten all of its policies to control inflation.

Currently, however, the President of the Federal Reserve Bank and the Secretary of the Treasury seem poised to take a chance on inflation, believing that any short-term spike will prove to be transitory.

It is difficult to dispute that there are currently inflationary pressures in the economy. Many metals, oil and food were already significantly higher than a year ago in February – before prices collapsed following the lockdowns induced by the pandemic. Interestingly, the rally in all of these prices seems to come from the Federal Reserve Bank’s announcement of a monetary stimulus at the end of March 2020. Just look at the prices for iron ore and tin:

Graphic courtesy of Factset

The other aspect of the price increase is the high level of demand caused by the stimulus, coupled with a lack of supply caused by a year of fighting COVID. The number of manufacturers reporting inability to access supplies quickly has reached all-time highs. Likewise, the number of companies reporting an increase in the prices of raw materials and other inputs has increased significantly:

Graph showing the relationship between manufacturing prices and the consumer price index from 1969 to 2020
Graphic courtesy of Factset

In the chart above, we see an interesting change in the correlation of these two lines. They were relatively close until 1990 and less connected since. 1990 of course marked the end of communism in Eastern Europe and the opening of new production capacity. By the end of the decade, massive investments were pouring into a booming Chinese economy, which over the past two decades has dramatically increased global manufacturing capacity. The only way to avoid the price paid line translating into a sharp rise in headline inflation as measured by the consumer price index (CPI), the world needs to unearth more production capacity. Technology is clearly a driver of increased productivity, but the question now open is whether it will suffice.

It is probably not too surprising that in this environment fixed income assets such as bonds are under pressure. Yields have increased significantly and prices, unlike yields, have fallen. Conversely, the prices of stocks and commodities rose, as did the most speculative of all “ investments ” – Bitcoin:

Graph showing the return on investment for different types of investments.
Graphic courtesy of Factset

Trevor Forbes’ articles and contributions to The Berkshire Edge should not be construed as a solicitation to transact or attempt to transact in securities, or as the provision of personalized investment advice for remuneration. As an author with specific expertise, his contributions reflect his personal opinions and do not represent Renaissance Investment Group LLC.

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