This week we visit the second of the 5D's, that is, debt and, in particular, the pivotal role it will play in investment markets going forward...
We begin with the statement that not all debts are created equal. And this isn't necessarily simply about distinguishing between household debt and public sector debt, but also the purpose for which the debt burden was increased.
Chalmers, our then newly minted treasurer, stated rather vehemently that "the debt burden left to us" was the highest since the aftermath of WWII". Aside from the shoddiness of the research undertaken in a clearly public statement, since Debt to GDP in 1950 was 88% under Menzies as opposed to the 54% it is today, it showcases a fundamental misunderstanding of the nature of debt in the broader economy. Looking more globally, we are constantly told that with Federal Debt in the US, standing at an astonishing 130% of GDP or $30.8 Tn USD or put another way $245,000 USD per taxpayer, it will never be paid back. Similarly, we hear pundits (who should know better) posit apocalyptic consequences, comparing governments to households. So let's begin with that and understand the likely way out of this situation, looking to history for some guidance.
First, it is neither relevant nor even valid to compare public debt to that of a household. For one thing, households cannot create their own money. So how does government debt actually impact the broader economy? Are we implying similar to that now infamous modern monetary crowd, that governments simply print their way out of this situation? Well, we can accept the latter if not for one simple metric - inflation. In the absence of inflation, one could easily make the case that the state doesn't have any incentive to not take on additional debt or indeed increase money supply indefinitely.
So then we come to the real issue: it is not the extent of global debt but rather a causal link between debt and inflation (debasement).
Back to Basics
(Credit to Prof. Steve Keen here who we don’t necessarily agree with in totality but in this instance certainly) Let's think for a moment about the overall banking system and money creation from a purely accounting perspective. In doing so, we use the balance sheet equation: Assets - Liabilities = Equity. From a bank's perspective, its assets are made up of loans, treasury bonds and reserves, whereas liabilities are deposits with equity being the gap between the two. In this instance, government expenditure increases the banks' liabilities in the form of deposits (i.e. increases private savings), whereas taxation does the opposite. Thus, we have a situation where government deficits increase money supply, whereas surpluses do the opposite. By the way, this viewpoint goes against the traditional economics you may be more familiar with, given Public Debt is supposed to crowd out the private sector.
The above mechanism may indicate why QE didn't have the desired effects, and why inflationary pressures were not evident. QE is an increase in the bank reserves of the financial system; thus an increase in assets and corresponding equity. It is not necessarily transferred into the real economy. Because we are specifically speaking of public sector debt, we shall look at the mechanism for why public debt is not your traditional debt. When the treasury issues debt, it does so with interest, but how do the banks buy these notes. Well, they do so with reserves (i.e. an asset swap effectively) which were in turn created by the deficit itself. Banks do so because unlike reserves, bonds earn interest and can be traded on the market.
The point is that it may in fact perversely be the case that public sector debt is a REQUIREMENT as opposed to a want for a well-functioning economy. In effect, every time a government runs a surplus, it does so at the cost of the household. Our contention is however not that we should continue to pile on public debt. The reason for this is the presence of inflation which leads central banks to increase interest rates. In particular, the below chart says it all:
The charts showcase how at current pace, the US debt servicing burden will be the single biggest source of expenditure for the Federal government as early as next year. If the hawks at the Fed have their way then this will vastly outstrip and hamstring any further growth. Since the headline Fed funds rate seems to be the only tool with which we seem to know how to use at this point in time, there is every likelihood that at least in the short run, we (or more specifically the US) may end up running roughshod over the economy.
So there we have it. It is our belief that higher levels of public debt have not in this case led to higher inflation (this time round it has been a result of the supply side). Rather, tackling inflation in the normal fashion could be harder and much more dangerous in the current economic environment because of the higher levels of debt.
Beyond the Basics; Debt and the Global Economy
The above is a brief overview of the implications for economies with a mature financial system and the ability to issue currencies at their own pace. The problem? Consider the Eurozone with nations such as Italy and Spain with disproportionate amounts of public sector debt that nonetheless do not have control over money creation nor their own rates.
Similarly, consider the 75 nations that are close to Sovereign Debt default since their debts are issued in USD. The Federal Reserve is central to the functioning of the global financial system. Thus a more "fiscally responsible" US intent on dealing with domestic inflation could effectively destabilise the rest of the world. Doesn't make sense? Consider the simple accounting scenario described above and consider a context in which the financial system's balance sheets in vastly different jurisdictions could have assets and liabilities in a currency unrelated to the nation they operate in, for example the Eurodollar markets (time deposits of USD outside of the US or global central banks requiring treasuries to facilitate their own trade).
A slowdown in US treasury issuance and a hawkish Fed have broader implications for most investors' emerging market allocations and global growth.
Way Out: The likely Eventuality
It was Churchill who once said that Americans will always do the right thing - after exhausting all other options", substitute Americans for central bankers and we posit that it makes a great deal more sense. What may be in store is perhaps nicely highlighted by a recent case before the British High Court. In this particular case, the pension schemes of BT, Ford and Marks and Spencer challenged the UK government over the legality of a planned change to the calculation of inflation.
The UK statistics authority wanted to reformulate the retail price index inflation measure from 2030 and replace it with CPIH (CPI + household expenses). In short, the government wished to use a better representation of inflation (which also happened to be the lower number). RPI in the UK stands at 12% vs. sub 10's for CPI.
Never fear, we have seen this done this before, with Clinton administration in the 1990's altering the way inflation was measured. Essentially by lowering the measured or publicly stated inflation number, we then allow central banks to run interest rates at lower levels. This creates the illusion of a positive real interest rate while still allowing the government to service their rather large public debt balance. In the US, it was done by keeping the REAL interest rates for government debt below 1% for two-thirds of the time between 1945-1980.
Side note on Government Debt
We recently came across an article in Bloomberg which showcased that the biggest ports in the US were also the least efficient for containers (i.e. Los Angles and Long Beach ranking below their esteemed counterparts in the Congo and Angola). Inefficient ports result in costs of using them being higher then they should be (supply side inflation). Imagine if the US government had used their "printed cash" to upgrade the port infrastructure (helping with supply side bottlenecks) rather then send out billions of dollars in stimulus cheques...
Markets & Commentary
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