A Choice between Bad and Worse
Updated: Jul 19, 2020
Governments and central banks of many global economies around the world have been forced to address the consequences associated with COVID-19. As economies grind to a halt and unemployment surges to record levels, responsible governments are focused on reducing the (hopefully) temporary but harsh economic hardships being faced by the general population, especially those millions that have just lost their jobs. By doing so, governments hope to buy time as economies around the world shut down and people self-isolate, in hopes that COVID-19 will eventually run its course and peter out. By being proactive, the objective is to ensure that the incredible economic damage being unleased by the COVID-19 pandemic will not permenantly impair the global economy when things eventually normalise, as of course they will.
Governments are having to make a choice between bad and worse, because the unprecedented monetary and fiscal stimulus measures are not free. Central banks’ actions in major economies will prolong their ultra-accommodative policies dating back to the Great Recession, and government fiscal stimulus will add to many countries’ already extensive sovereign debt. Look at it this way - these policies are in some respects “mortgaging the future” because, at some point, market forces will hold governments accountable and will require them to reduce their debt or pay higher prices to borrow. Similarly, if central banks continue to keep interest rates at zero, this will eventually fuel even more asset bubbles, contributing further to wealth disparity and the underlying social unhappiness or even unrest such disparity might fuel. History – at least as far as developing countries - has shown that these sorts of things rarely end well. However, developed economies are not necessarily immune from a future debt crisis, so time will tell. In spite of these concerns, I believe that governments are making the right decisions now by taking unprecedented measures to eradicate the virus and blunt the adverse economic consequences to the extent possible. There are a variety of opinions on this, but the reality is that it is truly a choice between bad and worse. I want to provide some perspective in this post on the various stimulus measures that have, or are about to be, enacted in the U.S. The E.U., the U.K., China and many other countries or economic blocks affected by COVID-19 have all used monetary and fiscal tools to some extent to blunt the effect, but since the U.S. is the world’s largest economy and has been very proactive, I thought I would focus there to start with.
The Federal Reserve has taken a number of steps to provide additional monetary stimulus to the U.S. economy. Looking at interest rates first, the Federal Reserve has lowered the bank overnight borrowing rate (the Federal Funds rate) to effectively zero, starting with an unexpected off-the-run reduction of 50bps on March 3rd (from 1.50% to 1.00% lower bound), followed by an additional reduction of 100bps on March 15th (from 1.00% to 0% lower bound). The 150bps reduction in less than two weeks effectively lowers the cost on most borrowings, including the rates charged on mortgages, automobile loans, credit cards, student loans, etc. Concurrent with the second decrease in the Federal Funds rate on March 23rd, the Federal Reserve also announced a number of additional measures to support certain segments of the economy, and you can find the press release directly from the Federal Reserve detailing these steps here. Most interesting perhaps is that fact that the new round of quantitative easing (“QE”) is much more potent that prior rounds because this round has no dollar limit and the scope of assets that can be purchased is much broader than ever before, including things like investment grade rated US corporate bonds and term asset-backed securities. These, and other similar measures, are meant to keep interest rates at record lows across the curve and to facilitate liquidity in some less liquid markets that were becoming locked-up. The Federal Reserve is also providing support for mortgage-backed securities and municipalities and has taken various steps to ensure that contagion does not spill over into the bank market. Consumers and companies obviously benefit immensely from these measures. As far as fiscal policy, the about-to-be-approved plan in front of Congress is a $2 trillion stimulus package containing a variety of aid to individuals and businesses. One of the most startling features is that the bill provides direct payments to individuals of $1,200 to each American earning less than $75,000/year in gross income, reducing gradually to nil for those earning $99,000 or more. This is referred to as “helicopter money”, an amazingly broad (and costly) fiscal stimulus measure. The fiscal package contains a number of other provisions, including higher unemployment benefits and an extension of the time that such benefits are available. The package includes $500 bln in loans and loan guarantees to stressed companies (focus on small & medium-sized enterprises, or “SME’s”), states and municipalities, including $32 bln in loans for passenger airline and freight companies. The bill also contains provisions / aid for hospitals, those people that are independent contractors (i.e. “gig economy” workers), and protection against foreclosures and evictions, amongst many other provisions. It is unprecedented in terms of its size and scope.
There are many beneficiaries of the monetary and fiscal stimulus measures, including consumers generally, those workers that have just been laid off, many businesses facing a dramatic decline in revenues or even being forced to close (restaurants, retailers, and so on), many companies that depend on functioning capital markets for funding, hospitals, and so on. Some of the effects can be seen visibly and quickly, such as in the BBB corporate bond market. However, there are some constituents for which the aid is less clear, and I suspect this could eventually lead to another fiscal stimulus package. For example, I am not sure what these stimulus measures do for high yield issuers (unless they fit the SME category) or investors, or for the U.S. oil & gas industry which remains under severe stress because of the decline in oil prices. Moreover, once the market “normalises” and COVID-19 is in the rear view mirror, then the ongoing artificially low interest rates – should they persist - will continue to exacerbate wealth inequality by promoting asset bubbles in markets like the stock market. Perhaps the real losers at the end will be future generations that will be called on by the government to address record debt levels, most likely through a combination of austerity measures and much higher taxes.
Let me end this post by putting the US fiscal stimulus plan in context. Here are some facts you might wish to digest, and I have based these on the annual report from the U.S. Congressional Budget Office entitled “The Budget and Economic Outlook: 2020 to 2030”, which you can find here. At the end of 2019, U.S. total debt was $22.7 trillion of which $16.8 billion was held by the public (and the rest intra-governmental). As you might expect, from an absolute basis the U.S. has the largest debt in the world (as well as the largest economy, which you must keep in mind). Depending on which debt figure you choose, this means that Debt-to-GDP was 107% (total) or 79% (only public debt) in 2019. To put this in context, some other countries have the following Debt-to-GDP ratios (total debt so relative to the 107% for the U.S. in 2019): Japan, 238%; Italy, 133%; France, 99%; the U.K., 86%; Canada, 84%; Germany, 57%; and China 55% (source: World Population Review).
In the CBO budget for 2020, U.S. GDP was expected to increase 2.2% to $22.3 billion, and the deficit was projected to be a record $1 trillion based on revenues of $3.6 trillion and outlays of $4.6 trillion. U.S. debt was expected to increase to $23.8 trillion at the end of the year, resulting in the total debt remaining at 107% of GDP. The economic damage inflicted by COVID-19 will likely cause U.S. GDP to decrease by around 3.8% this year according to Goldman Sachs, or to $21.5 trillion. Based on a few assumptions and my simple math, what was already going to be a record deficit before COVID-19 of $1 trillion in the U.S. in 2020 will likely balloon to over $3 trillion, increasing U.S. debt by year end to nearly $26 trillion. Here’s the simple analysis.
One last interesting point is that interest on the U.S. federal debt currently accounts for around 1.7% of GDP and was in any event projected to increase to 2.6% of GDP by 2030. Although the cost of government borrowings has decreased significantly, it is hard to imagine a scenario in which such a significant amount of incremental debt will not raise the burden of interest going forward much more quickly than that projected by the CBO in its pre-coronavirus report.
The fiscal situation in the US is worsening, but the government made the decision - as did most - that it is better to blunt the economic effect of COVID-19 today even if these measures result in a larger “mortgage on the future”. I agree with this. Not acting would firstly be politically unacceptable. Secondly, whilst the cost of such stimulus measures is largely being ignored at the moment, I would venture to say that the long-term and permanent economic damage of not acting could lead to a prolonged depression because the downturn has been so harsh and unexpected. Opinions do vary on this though, and only time will tell how this story ends. It might in fact be decades from now before we can really look back and say.