May 18—$6.0 trillion. Roughly half of that was recently given out to ease Americans’ COVID-19-induced economic suffering—with nearly another $3 trillion now proposed. That’s atop a U.S. debt tab of over $20 trillion. Our CIO Tony Roth and Chief Economist Luke Tilley discuss why it matters, whether we should be worried, and the importance of having a plan.
Please listen to important disclosures at the end of the podcast.
Wilmington WealthWise with Tony Roth
Episode 9: U.S. Federal Debt—From Bubble to Balloon
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors, Inc.
Luke Tilley, Chief Economist, Wilmington Trust Investment Advisors, Inc.
Tony Roth: Welcome to Wilmington WealthWise, the podcast dedicated to financial literacy where we take complex ideas from the investment world and make them accessible to everyone. I’m your host, Tony Roth, chief investment officer of Wilmington Trust.
Joining me today is my colleague, our Chief Economist, Luke Tilley. Joining me today is my colleague, our Chief Economist Luke Tilley. Prior to joining Wilmington Trust five years ago, Luke was an officer and economic advisor with the Federal Reserve of Philadelphia. Earlier in his career, Luke was an economist for the U.S. Department of Housing and Urban Development. Luke, thank you for being here today.
Luke Tilley: Happy to be here.
Tony Roth: Today, Luke and I are going to discuss the long-term considerations of U.S. debt bubbles. The initial fiscal response to the COVID crisis was the release of $2.9 trillion stimulus and Washington is now debating additional stimulus, which, in our view, could range anywhere from another call it $2 to $5 trillion over the next 12 months. But what are the long-term implications for this and what should be done in the aftermath of the crisis to address the debt that we’ve taken on and how do we ensure that we’re not leaving our kids and future generations with a debt regret? So, let’s put this in context. Worldwide government response to COVID has been unprecedented in the speed and the scope and, to be sure, that’s a good thing. Countries have locked down their populations to try to limit the spread of the virus and it’s created, probably, the swiftest recession that we’ve ever seen. Let’s remember that we came into the year this year with a fairly positive outlook for GDP, and if we looked at the rate of our implied rate of growth based on our estimates for January and February, we were probably close to 2.5% for GDP this year, and now we’re going to see a drop in the first quarter due to the mitigations, due to the essentially forced closure of the economy of a pretty massive amount. I mean, Luke, what are you thinking at this point in terms of the drop in GPD annualized for the second quarter?
Luke Tilley: For the second quarter we are projecting a 40% annualized decline. So, it’s important to remember that GDP numbers are reported as annualized numbers. So, that sort of—it blows it up to annualize it. But still, we’re talking about roughly a 10% decline in our economy in a fairly short amount of time and that is just unfathomable when we think about numbers that we’re accustomed to seeing.
Tony Roth: And when we think about moving forward into the third quarter and fourth quarters, even if we have a somewhat successful reopening of states so that people go back to work to some degree, you’re still not going to see a normalization of consumer behavior. People clearly are still afraid to go out and they’re very constrained in their activities. So, when you think about the rest of the year, what do you think the third and fourth quarters might look like?
Luke Tilley: So, we’re on the pessimistic side of this. I think reopening the economy is not the same as restarting it and we think that there are significant challenges as you’ve talked about in some of the other podcast episodes with the science and people feeling comfortable. And then, just on the economic side, we don’t think that businesses are going to return to their normal behavior, staffing levels, or capex like they did before. And workers are going to be a little bit reluctant, too.
So, when we get to the end of the year, we’re thinking a decline in the economy of 5% or so in terms of real GDP for the year. Just to put that in context, that’s far worse than 2008 and 2009.
Tony Roth: So, as a response to all of this, the government has spent a tremendous amount of money and will continue to spend a lot of money. And the term that I like to use is cash transfers, because what that means is that the government is finding different programs or mechanisms to put cash from—move cash from the Treasury and put it into the hands of the unemployed, small businesses, and in certain cases in terms of the Main Street program. How much increase in government debt is really plausible or judicious or is there a limit to it? What do you think in terms of is debt inherently bad for the economy to take on? Should we be thinking about it through that lens and it should be minimized at all costs?
Luke Tilley: Right. So, I mean on the very general question of is in debt inherently bad, I’m going to say it depends. Right? This is the classic answer from economists. Because it really does depend. It depends on what the debt is used for and it depends on the size of it.
If you want to sort of use a more personal example, think about student debt versus gambling debt. If you have a student that’s taking on debt in order to increase their ability to earn in the future, that would be considered good debt. And countries do very similar things. My favorite example is the Eisenhower interstate system, first in 1956. It was going to be $26 billion was the initial price tag. For our GDP back then, it was about 6% of GDP. So, it was this huge cost. It ended up at even costing more, but you can see, you know, if you go back and go back to that debate, you just can’t imagine not having that now because of the growth that it promoted.
So, I think it’s an excellent example of good debt. And we talk about other types of good debt that we could be taking on right now. Infrastructure is one of the obvious ones. Talking about building wider nationwide broadband is something that gets talked about. So, those kinds of things can be good debt.
Tony Roth: So, it’s sort of like a company really, where the company can finance itself from debt or equity. Obviously, a country doesn’t really have equity. But a country can finance itself from taxing its citizens or a country can increase its debt and as long as its debt is not growing faster than the GDP, it would seem to be fairly sustainable subject to a course of the amount of debt service that the country has to bear. If you have too much debt out there, even if perhaps your debt is growing within the confines of how fast your GDP grows so you can grow your way out of it over a long period of time, if you get to a point where the debt service is so large, that can be a problem in and of itself.
Tilley: Right. Right. Exactly. And that’s an important point, the size and the ability to pay it back in terms of growth. If you go back to the student debt example, I’m saying that a student taking on debt is a good thing. But the size can be unbearable, too. You know, medical students graduate with hundreds of thousands of dollars of debt, but their income sort of justifies it.
You wouldn’t want to have somebody graduating with that much debt if they were, you know, like an English or a social work major, even an economics major for that matter, to be – that would just be too much, even though the type of debt is okay. But it comes back to exactly what you’re saying. Are you going to be able to pay it back over time?
Tony Roth: So really, it’s a question of scale. Right? Debt is okay. It makes sense to take it on, especially in these circumstances, as long as it doesn’t get too large. So, the question is, is it getting too large and how do we know when it’s getting too large?
And let me just, before you answer that, provide another framing of the same question, which is that there is a new term that has been introduced into our political landscape called modern monetary theory, MMT. We can essentially, we being the U.S. government, the Treasury, sell as much debt as it needs to in order to not even just in context of this crisis bring us out of this crisis, but in order to provide the support and benefits to the society that we think are desirable and that we shouldn’t even worry about the total amount of debt, because if we have more debt that needs to get served we can just issue more debt in order to pay the interest to service that debt. And someone will always buy it, because we’re the U.S. and that’s sort of the premise of modern monetary theory.
So, when you think about how much is enough and then you also think about this notion of modern monetary theory, what’s your reaction to that, that whole sort of new ecosystem of thinking?
Luke Tilley: I have a lot of issues with sort of that premise and the modern monetary theorists, because a lot of the things that do come out of that school of thought are true. The U.S. does have the reserve currency. It can borrow without any kind of limit it would seem.
But I think it’s sort of that static assumed nature that nothing’s ever going to change. You know, so the modern monetary theorists will say this is all fine and good and then their trigger or their sign that there’s something wrong is higher inflation. They say that as long as there is low inflation. And the problem is that economies are not static. Yes, we are the reserve currency. Yes, we are the world’s superpower. We can’t go with the assumption that that’s always going to be the case. If you sort of exploit that too much over time, then you will end up having people doubting whether you’re going to be able to pay back your debt. You will have investors driving your interest rates higher. That would lead to the inflation and that is where it becomes a challenge. And then, we basically have turned into some of those countries that have had debt problems over history.
Tony Roth: Maybe just remind us where we stood before COVID hit in terms of the size of the debt. And then, from there we’ll talk about, okay, from that baseline let’s layer in all this additional debt we’re taking on.
Luke Tilley: To set the baseline, the U.S. has run deficits and basically had growing debt for multiple decades now, a generation, with the exception of the late 1990s. And really, for the past 20 years or so we’ve been in a worsening debt situation. And then, when you throw in the tax law from late 2017 that went into effect in early 2018, corporate tax cuts, individual tax cuts, and definitely making the deficit wider. So, the Congressional Budget Office, which is sort of the arbiter and the best projector of these things, very nonpartisan arm of the government, was projecting trillion dollar deficits over the next 10 years and getting larger over that time, going from a trillion dollars this year on up to basically $1.5 trillion 10 years from now and just growing over time inexorably. They would never really be coming down. So, we were in a very bad situation as of January 1, in terms of our public finances and the size of the debt and the trajectory that we were looking at then.
Tony Roth: Now we have another $3 trillion that we’ve committed to, plus we have, whether it’s $1.5, whether it’s $3, if this scenario, I mean subpar GDP, significant unemployment, real impairment to small businesses continues into next year, which is our base case scenario, clearly we’re going to need some number of additional trillions of dollars of support, not just by the way for consumers and for small businesses, but probably for states and local governments as well.
So, we have $3. Let’s say we’re going to need another somewhere between $2 and $5 at a minimum over time. Where does that leave us and when do you think we get to a tipping point? And how important is it that interest rates are so low? Because I know that the Treasury Secretary Mr. Mnuchin, has said, hey, we can take this all on because rates are so low it’s going to be okay.
Luke Tilley: The situation has obviously changed quite a bit. And the CBO released, the Congressional Budget Office released their new projections as of late April, so with the first four stimulus packages, obviously not including anymore that are coming down the pike. And then, they have included that stimulus and then also a deterioration in the economy and their estimate was for the deficit this year to have gone from that original $1 trillion roughly up to $3.7 trillion. So, obviously a much, much bigger hit as you said in the opening, a much larger share of the economy, which is sort of unprecedented in the post-war era.
And so, if we get any more stimulus coming down the line, then we’ll have even more of that.
I will point out that a lot of this debt is dampening the depth of the recession. So, it would be a lot deeper without a lot of these cash transfers or the unemployment insurance component. And the idea there is that the government is trying to basically improve the overall debt situation, because if you don’t do this, the economy gets hit even harder; your revenues get hit even harder. So, in some ways enacting all of this legislation puts you in a better place, because you have a just somewhat stronger economy and you haven’t had your revenues hit as hard.
But the fact remains that we’re dealing with a much larger debt situation on the other side of this crisis than we had going in. It means that interest rates are likely to be higher. You know, the Federal Reserve is going to be trying to keep interest rates low. But all other things being equal, if we have a larger debt load out there, just like, you know, giving a loan to somebody who is a little bit more risky, you would charge them a higher interest rate and that’s certainly a possibility.
Tony Roth: I mean, Luke, you have four children and we always used to say before COVID that when we had a conversation around debt, we were sacrificing our children’s futures by basically bringing forward economic growth. Do you feel even more so? Even though it may be necessary and right that we do this, do you really get worried around the burden that your kids are going to have to deal with, our kids are going to have to deal with?
Luke Tilley: Yeah. I’m definitely more worried. So, I think the way I always said it pre-COVID, if somebody asked me are you worried about the debt and deficit situation, I would say in the next year not at all, over the next 10 years yes definitely, and for my kids absolutely. And I think that the only real change is that those statements have gotten even greater in magnitude, that the concerns are larger because it was going to be a daunting task to pay it back, not impossible.
Luke Tilley: Our problems are different. But we were sort of headed that direction, because Japan’s situation is mostly because of basically a decline in population and a decline in their labor force. And so, that takes away from their ability to grow their economy and their ability to pay their debt back. And as you said, between 200% and 250% of GDP, they’re sort of at the developed world’s highest. And there are others that are sort of in the neighborhood of us.
Italy is about 135% of GDP and they do have higher interest rates, but they haven’t gone over sort of like this tipping point like Argentina. The United Kingdom is in a similar situation to us. So, this is sort of a common story. The most important thing here is that Japan still does have low interest rates. People are willing to invest in their debt. And that comes back to the crux of it and it’s basically that people believe that they will be making payments on it, that they are good to make payments on it, and they’ll be able to do that. And this is going to lead into a discussion about the Fed is that they are not going to use sort of the printing presses to inflate away the debt. There’s public faith and investor faith that the debt is good, and people are going to get paid back for it.
Tony Roth: So, I like that you bring in the printing presses, because it’s a good segue to think about the relationship between the Treasury and the Fed. Already this year the Fed has increased its balance sheet by about $2.5 trillion. About $1.7 of that $2.5 is attributable to government bonds, U.S. government bonds that the Fed has purchased from the Treasury, essentially, or from the secondary market. So, now that we’re projecting that the Treasury will probably introduce another $3.5 trillion of bond issuance this year, well that has the impact of reversing a lot of the liquidity that the Fed has worked so hard to introduce into the system. So, we’ve all heard of quantitative easing, of course. So, quantitative easing means that the Fed is going out and buying government bonds and mortgages and those securities come out of the system in a sense to go on the Fed balance sheet and all that cash that was on the Fed balance sheet goes out into the system and that creates liquidity. It makes markets function better. It helps to push interest rates down.
But now that the Fed is going to go and throw another $3.5 trillion of assets into the pool, that sort of reverses that liquidity pump of the Fed. So, do you see that as problematic or do you see that the Fed will just jump in and buy all those securities so that it doesn’t impact the liquidity of markets, doesn’t pull out the cash that’s already out there? In which, that raises the other problem, sort of the Venezuela problem, where it’s just a round circle where we’re just printing money and buying our own money.
Luke Tilley: Yeah. So, there are two different worlds here that you’ve described and one of them is unambiguously bad. It’s the Venezuela. It’s the Argentina. It’s Zimbabwe famously did this several years ago. I actually have sitting right next to me here a couple of notes from the – from Zimbabwe that are the $1 trillion notes that they had to print, because their fiscal situation got so out of hand and their inflation got so high that they had to print these things.
And that situation is sort of when the Treasury and the Fed are one and the same. If the Treasury needs to issue debt because they are profligate and because they’re handing out subsidies and it’s unsustainable and then the central bank of the country turns around and buys all of it, that is just monetizing the debt and it debases the currency and that’s how you get to those downward spirals that is unambiguously the worst situation you can be in with a government issuing debt and the central bank just being a patsy and sort of – and buying all of it. And that is where you don’t want to be or else all bets are off.
The better situation, but it’s still going to create challenges, is exactly what you’re saying. The Fed is operating independently. They purchased a lot of Treasuries already this year, as you’ve said, $1.7 trillion. But, that’s to achieve their goals. As you said, they were returning liquidity to the markets. They wanted to make sure that the market is functioning. And they also have other goals in the past, you know, 10 years ago, creating a QE program that was to push down on lower long-term interest rates and trying to promote growth.
As long as those decisions are independent of just financing the government’s, Congress’, deficits, then that can be okay and it’s going to lead to some of the challenges that you’re talking about. And that’s where we are now. So, as you said, much higher deficits expected this year. We’ll have to see what’s coming with this next fiscal package. And the Fed is likely to buy more Treasury later on this year, either to try and help the economy or to return some of the liquidity to the market. But it’s probably not going to be enough and hopefully not enough to absorb all of the Treasury debt or else we would be in that, sort of that worst of all situations.
So, they’re not going to buy all of it. There needs to be somebody who’s going to buy that Treasury debt, still have the faith that they’re going to get paid back in order to finance all of this stimulus.
Tony Roth: And the Fed does not want an overly steep yield curve right now, in other words, doesn’t want rates to go too high, because it will cause impairment to borrowing.
A lot of the programs that the Fed has designed and launched and implemented are designed to try to cause banks to lend money at reasonable and low rates to customers, to businesses, to individuals. And if, in fact, the Treasury issues all these securities and there aren’t enough buyers out there, we’ll see rates move up pretty high. And so, the Fed may have to buy a lot of these Treasury securities in order to keep the, call it the 10-year rate below 1% or wherever it wants to see it. And as investors, we need to keep a very careful eye on that. What’s your reaction to that line of thought?
Luke Tilley: Yeah. So, that’s where you could characterize this as possibly the Fed getting backed into a corner if their mandate, and it is their mandate to keep interest rates sort of moderate and their stated goal is to keep interest rates low in a situation like this in order to promote growth. If the interest rates start moving up, then they are, for all intents and purposes, being backed into a corner that they’d be forced to make purchases of that debt in order to keep the interest rates low.
The Bank of Japan employs a strategy of this, the yield curve control, in trying to target the yield on the 10-year Treasury. That kind of a strategy could be extended to basically the entire yield curve, as you say, to any point along the maturity curve. Japan does it without having to buy too many. You know, they’re not financing the entire deficit of the government. But that would be a step towards, as I said, sort of backing the Fed into a corner and getting closer and closer to that subpar situation, suboptimal situation, where the Fed is financing all of the debt.
Tony Roth: It’s suboptimal, not because there’s some inherent limit to how big the Fed balance sheet could be, right? The Fed balance sheet could be as big as it wants to be. But it’s the circle that’s being created around the government financing itself by essentially selling debt to itself. That’s really the more concerning part. Do I have that right?
Luke Tilley: You’re exactly right that there’s no functional or legislated limit on the size of the Fed’s balance sheet. The reason it would be so bad is if the Fed was financing all of the government’s deficits. And then, importantly, if investors believe that that would go on and that that was sort of the new status quo, that devalues the currency, drives up inflation, high interest rate, all of those terrible things.
Tony Roth: So, Luke, I wanted to give you a chance to add any final thoughts if you have any.
Luke Tilley: Yeah. I think that it’s important to point out that as challenging as this situation is, we’re not in an impossible situation. We do have a large, strong economy. We are able to solve these problems. It doesn’t need to be that we balance the budget on a yearly basis or even that we eliminate all deficits.
Really, the goal would be to put the debt, the GDP ratio, on a downward trajectory so that you’re paying off some of the debt on that relative to your economy, the size of your economy, paying it down a little bit each year, that debt-to-GDP ratio. It’s not impossible, not even close to impossible. It does require some very hard decisions. But I think it’s very attainable and that’s what we should be shooting for when the, sort of the, crisis abates and we’re more on the path to recovery.
Tony Roth: Well, that’s great insight. Thank you so much, Luke. Let me summarize for everybody what I think the three main takeaways are from today’s conversation. The first one is that not getting into each element of the stimulus that has been provided by Congress and the president, it’s clear in our view that this debt was necessary at this point in order to dampen the depth of the recession. Without the stimulus, the economy really would’ve hit an even harder bump, if you will, maybe even an immediate depression. Although depressions are measured over a longer period of time, we would’ve been on that trajectory and we don’t think we’re necessarily on that trajectory at this point.
Second thing is that once we get past COVID and we have a vaccine, herd immunity, whatever it is, hopefully about a year from now or so, we’re going to have to be very careful as a society, as a government, in how we manage the debt that we have. It’s going to be a very large number, larger than we ever thought we would get to. We’re fortunate that we have a low rate environment and hopefully Secretary Mnuchin will be very successful in structuring the debt to be as long-dated as possible, which will give us a longer period of time to pay it off. But, we’re going to have to be very careful and responsible in managing how we pay off that debt and make sure that we don’t run large deficits, 3% to 4% of GDP, which is what we’ve been running over the last couple years. We’re going to really have discipline on the spending side.
And the third takeaway is that we’re going to need to be, as investors in the short term, very cognizant and attentive to the relationship between the amount of issuance of incremental US debt from the Treasury and the Federal Reserve and the Federal Reserve’s balance sheet. Because on the one hand we need to be able to see that there are enough buyers out there independent of the Fed that rates don’t go too high. If you don’t have enough buyers, rates are really going to move upwards and that’s going to be problematic, not just for bonds, but it’s also going to be, I think, very concerning to the equity market, because as the equity market sees not effective functioning in the bond market, the equity market is really going to come under pressure.
So, that’s something we have to look at very carefully. And then, we have to balance that and evaluate how much of these bonds are being purchased by the Fed, because if that number gets too high, in and of itself, it sort of starts to smack of the Fed targeting the yield curve, trying to artificially manage the yield curve, as well as the idea that there’s not real independent substance to the borrowing of the U.S. government in order to fund itself, but it’s really just selling debt to itself. So, we’re going to be monitoring those issues very, very carefully.
So, with that, I want to thank everybody for listening today. I want to remind everybody that you can always send your suggestions and feedback, as well as, again, suggestions for new ideas, new topics for podcasts to firstname.lastname@example.org. And lastly, I want to encourage everybody to please go to wilmingtontrust.com for a roundup of all of our blog ideas, podcasts, media content relating to coronavirus from a market, economic, and global health perspective. Thank you all so much and bye for now.
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