Does federal debt matter?
Bottom Line Amid the global coronavirus pandemic, the federal government has ripped a page from its Great Recession playbook, orchestrating an aggressive monetary and fiscal policy response. But the question on the minds of many investors is whether the Federal Reserve, Congress and the Trump Administration have collectively done too much to help stabilize and resuscitate the U.S. economy from its deepest recession in history? The bonus question is how are we going to pay for all this largesse? For some, the concept of Modern Monetary Theory (MMT) is an appealing option worth exploring.
What has Washington done so far?
- Fed’s all in Chair Jerome Powell cut interest rates by 150 basis points in two emergency meetings in March, lowering the upper band of the fed funds rate to 0.25%. The Fed lifted a $700 billion cap and pledged unlimited purchases of Treasuries, mortgage-back securities, investment-grade corporates and high-yield bonds. It also injected liquidity into the U.S. banking system, created a backstop for commercial paper and added additional lending facilities to support workers, businesses, and state and local governments. The Fed has inflated its balance sheet from $4 trillion at the beginning of this year to about $7.5 trillion, and it could approach $9-10 trillion by year-end.
- Phase 5 stimulus coming President Trump declared a national emergency, invoked the defense production act and reached across the aisle with Democrats to craft four phases of coronavirus spending (including the CARES Act) totaling nearly $3 trillion to date. The Democrat-controlled House passed the $3 trillion HEROES Act last month, but it is unlikely that Senate Republicans will pass this proposed Phase 5 spending plan before mid-July at the earliest (after the release of the June jobs report on July 2). It likely will have a price tag that’s half of what Speaker Nancy Pelosi has proposed.
What might the U.S. budget deficit and federal debt be at the end of 2020? President Bush left office at the end of 2008 with about $10 trillion in federal debt, President Obama doubled the debt to $20 trillion by 2016 and President Trump added $1 trillion in each of his first three years in office through year-end 2019, totaling $23 trillion. With Washington’s aforementioned emergency spending this year to combat the exogenous shock of the coronavirus, the federal debt could approach or exceed $30 trillion by year end 2020. The International Monetary Fund forecasts that the U.S. debt-to-GDP ratio will approximate 131% this year, compared with 109% in 2019.
Is MMT the answer? MMT is a macroeconomic theory in which sovereign currency-issuing governments (like the U.S.) with no monetary constraints could finance any budget deficit by simply printing more money. While the main criticism of MMT is that it could result in hyperinflation, advocates suggest that through higher interest rates and taxes, the government can effectively remove the excess liquidity to cool the economy and prevent an inflationary spike.
Political ramifications In recent years, MMT has gained significant political traction through progressive stalwarts such as Sen. Bernie Sanders (D-VT) and Rep. Alexandria Ocasio-Cortez (D-NY), who propose using MMT as a funding solution for some of their largest programs, such as Medicare for All and the Green New Deal. More centrist politicians, however, dismiss MMT as dangerous, pointing to the risk of having a federal government with an unlimited budget that never needs to be balanced. But as public support for social programs increases, the government needs to create a funding mechanism without pushing the U.S. economy into a deep recession.
Whither the Fed? While the Fed would not necessarily become obsolete under MMT, it would no longer be completely independent, as it would be working in conjunction with the Treasury Department to print money to fund a growing federal budget deficit. So if left unchecked by the Fed, MMT could potentially lead to higher inflation somewhere down the road or perhaps worsening economic outcomes.
Although MMT is a particularly attractive model for progressives, it would imply a shift in emphasis from sound economic policy to one that is more politically expedient. With large annual budget deficits and growing federal debt, people would become accustomed to a standard of living that we as a nation simply can’t afford. So if we take the power to print money away from the Fed and give it, in effect, to the politicians, it begs the obvious question: who can we trust more to keep a steady hand on the wheel–the Fed or our elected politicians?
'Japanization' of the U.S.? Japan, for example, has been practicing MMT for the past few years, and its debt-to-GDP ratio has soared to about 250%. But Japan’s experience with MMT has coincided with strong deflationary pressures in their economy, perhaps due to unfavorable demographics (an aging population combined with restrictive immigration policies and a lack of full economic equality for women). In addition, Japan has increased its value-added consumption tax (VAT) several times in recent years, pushing the Japanese economy into recession.
More traditional solutions As an alternative to MMT, the federal government might look to refinance its debt with historically low interest rates and attempt to grow the economy faster:
- Role of interest rates In May, the Treasury Dept. offered a 20-year bond for the first time since 1986, selling $20 billion at a yield of 1.20%. It also announced plans to issue $3 trillion during the second quarter alone to finance the government’s extraordinary coronavirus spending. Benchmark 10-year Treasuries were yielding 6% in 2000, 5% in 2007, 3% in 2018, and only 0.70% today. Much like refinancing a mortgage, taking advantage of the record decline in interest rates will dramatically reduce the federal government’s interest payments on its debt, making the borrowing much more affordable. Will there be demand among foreign investors? Down from a peak of $17 trillion last year, there is still more than $10 trillion in negative-yielding sovereign debt on the market, so 20-year Treasuries yielding 1.23% today remain a very attractive alternative to German bunds yielding a negative 42 basis points and Japanese JGB’s at breakeven. So given the higher positive Treasury yields, the U.S. should have no difficulty refinancing its debt if the dollar remains strong.
- Faster economic growth matters The rule of thumb is that more rapid GDP growth results in stronger revenue generation through tax receipts by the federal government, which it can theoretically use to fund current spending and repay some of the existing debt. U.S. GDP growth over the past three years has been running at a faster, above-trend pace, which has contributed to the slower pace of increase in the federal budget deficit. From 2009 through 2016, however, growth accelerated at roughly half speed, and the deficit grew more quickly. Although the U.S. economy is currently mired in its deepest recession in history, which the National Bureau of Economic Research recently dated as having started in February, it appears the economy troughed in April, with sharp sequential improvement over the past two months. We here at Federated Hermes think the recession ended in the second quarter and are forecasting powerful double-digit GDP increases in each of the third and fourth quarters of 2020. The Fed also is forecasting strong, above-trend, full-year GDP growth of 5% in 2021 and 3.5% in 2022.
Research assistance provided by Federated Hermes summer intern Sophia Tropaitis.