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Economic Insights

History suggests that elevated levels of borrowing will not have a significant negative impact on inflation, the value of the U.S. dollar, and investor confidence in the world’s largest economy.

Read time: 3 minutes


In recent months, U.S. debt levels have surged as nearly $3 trillion in fiscal stimulus measures have been passed by Congress in response to the COVID-19 pandemic. This spending, combined with the rapid expansion of the U.S. Federal Reserve’s (Fed)  balance sheet, has alarmed many market watchers who worry about the consequences of this dramatic rise in both debt levels and the apparent printing of money by the Fed.

While there are certainly consequences associated with borrowing heavily today, we believe it is unlikely that these recent actions will trigger either a debt crisis or a currency devaluation. Rather, the U.S. dollar remains the world’s reserve currency and in high demand by global investors for its perceived stability. The expanding U.S. budget deficit is likely to have a negative effect on future growth, in our view; however, it does not pose an immediate threat to investor confidence in the world’s largest economy.

Debt Levels on the Rise
By the end of 2020, total outstanding U.S. debt is expected to exceed 130% of the nation’s annual gross domestic product (GDP), almost double its pre-2008 level of roughly 70%, based on IMF data. While much of this increase occurred between 2008 and 2010 from the combination of stimulus spending and a decrease in GDP, the debt has continued to rise steadily since the end of the global financial crisis (GFC). The recent stimulus packages, which represent almost 15% of GDP so far, have pushed U.S. debt ever higher, surpassing the average debt-to-GDP ratios of other developed economies (see Figure 1). Clearly, investor concerns are not without merit, as $3 trillion in spending in only two months is an enormous number. Yet context is important; national debt in excess of an entire year of GDP, while high, is hardly without precedent.


Figure 1. How Does U.S. Debt/GDP Ratio Stack Up Against Developed Economies?

Source: International Monetary Fund. Data as of April 30, 2020. Dotted lines indicate projected ratios.

 

Debt from developed economies around the world has been rising steadily for some time. Investors have not fled the euro, despite the fact that Europe has a more troubled financial system than the United States, and far lower economic growth. And despite mounting debt levels and aggressive policy from the European Central Bank (ECB), inflation has run persistently below ECB targets. Moreover, Japan—a case study in supersized sovereign debt—has had debt in excess of annual GDP for more than 20 years and a stagnant economy that has made it difficult for the nation to improve this relationship by growing its economic output. Yet despite some predictions that debt supply would overwhelm investor demand, resulting in sharply rising yields, or concerns that easy monetary policy from the Bank of Japan (BOJ) and loose fiscal policy would erode the value of the yen, we have seen neither come to pass. Instead, yields and inflation have hovered near zero for decades, and the yen historically has outperformed other currencies during “flight to quality” periods of market turmoil.

Early evidence in the United States suggests a similar faith in the country’s economic system; the U.S. dollar was in such demand globally in March and April—while the Fed and Congress were busy formulating stimulus and liquidity measures—that the Fed had to create special swap lines with other central banks to ensure there would be enough dollars to meet the needs of global investors.

Expanding Central Bank Balance Sheets
Of course, debt is not the only story. Heavy engagement in developed economies by the Fed and its counterparts in other nations has resulted in low or negative overnight interest rates (based on Bloomberg data) and the massive expansion of central bank balance sheets, as shown in Figure 2.

 

Figure 2. Central Banks Expand Balance Sheets in Response to the Pandemic
Total central bank assets as a percentage of local currency gross domestic product, 2006–2019


Source: Haver Analytics and yardeni.com. Data (annual) as of May 27, 2020. Fed=U.S. Federal Reserve. ECB=European Central Bank. BOJ=Bank of Japan. PBOC=People’s Bank of China.

 

To some observers, quantitative easing, in which central banks purchase securities and hold them on their balance sheets, may seem little different from a government buying its own debt and thus “printing” money. The Fed’s balance sheet has grown by trillions, as have the balance sheets of the ECB and BOJ. But this balance sheet expansion is not the same as the government printing money. It is merely one, very visible, vehicle with which central banks influence the amount of cash in the system, when it would otherwise be tied up on bank balance sheets. That is, it allows the Fed to adjust the available cash in the financial system at any point in time, without increasing wealth or debt.

While this distinction may seem small, it is also critical. We have empirical evidence from multiple countries now that quantitative easing has not increased inflation in any economies that have used it thus far, despite early concerns that it might create upward pressure on prices or devalue the underlying currencies.

Summing Up
The United States is not Japan, nor is it Europe. In our view, the United States is far better positioned to weather this shock from the COVID-19 disruption than many other advanced economies, coming into the pandemic with a low rate of unemployment, healthy economic growth, and a robust financial system. The massive increase in deficit spending raises legitimate concerns about future growth, as more economic activity is siphoned off to pay debts from prior years. There is always a price to pay. But in our view, there is no reason to believe aggressive monetary and fiscal stimulus threaten to undermine the U.S. dollar’s standing as the world’s reserve currency—and the underlying financial strength of the most powerful nation in the world.

 

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