Wealth Management: Market Perspective – The bill

09/06/2020

Kevin Gardiner, Global Investment Strategist, Wealth Management

If stock prices agree that the long-term damage done to quoted businesses may not be as large as feared in March, what can we say about the wider economic impact?

There will be all sorts of indirect as well as direct economic effects of the disruption. Identifying them all, and their consequences, is impossible. How to gauge the lost human capital and opportunities from closing schools and universities? Can we quantify the increase in inequality?

But is the impact best thought of as a “cost” at all?

Incomes, output and expenditures (GDP)

Total incomes (GDP) have fallen sharply. We might compare its path with the trend it might otherwise have followed, but that assumes we know what the alternative path would have been, and we don't. A simpler estimate of the impact is the cumulative shortfall from the starting point. The sort of fall in global GDP estimated by the International Monetary Fund, with the starting point being regained sometime next year, might suggest a cumulative loss of GDP that is a multiple of the loss sustained in the Global Financial Crisis (GFC).

But has this been avoidable? What were the alternatives? Would GDP have followed its “trend” path anyway? A counter-factual world with higher fatalities and health services pushed beyond breaking point would also have seen big damage - certainly in human terms, and likely economically too. Sometimes there are only bad outcomes to choose between.

Balance sheets

Capital markets show the evolving value of businesses that have issued securities. With a lag,we will be able to see how household borrowing has risen. Data for private businesses and much real estate are patchy - and late. We can only guess there will be big and permanent losses.

Government liabilities are very visible, and rising quickly with those support packages. The scale of the debt overhang will depend on how much of the contingent support is taken up. Plausible estimates of government debt to GDP ratios after this year's surge are shown in ﬁgure 4.Remember, debt is rising as GDP is falling - a double whammy for the ratios.

They are rising faster than in the GFC, and to higher levels. However, the wide range of ratios across countries, and history in the UK, suggests it is far from clear at what level they begin to cause problems. There is as yet no sign that the prospective borrowing is unsettling lenders. The yields on high-quality government bonds have been at or close to all-time nominal lows, and in real terms are ﬁrmly negative in most places.

Arguably, the creation of national debts, funding infrastructure and fostering liquid capital markets, was one of the key drivers of economic development.

None of this stops people worrying about it. Debt can be a crushing burden for individuals and businesses. And clearly, there are limits even to public borrowing. The US government can borrow as much as it wants in its own currency, but Venezuela's can't borrow in any currency at any price.

The debate is one of the ﬁercest in ﬁnance.Again, we suggest keeping the dramatic assertions at arm's length. The world cannot be insolvent, though it can be illiquid. We cannot “borrow from future generations”.

Taxes may rise - current effective rates are not high. But they may not have to (and surely not soon - what would be the point?). Borrowing charges are low, and resumed growth will cut deﬁcits: big tax increases and spending cuts are economically and politically a last resort.

And again, what were the alternatives? If government borrowing hadn't risen, the damage to longer-term GDP and private balance sheets would likely have been bigger.

Borrow or print?

So entrenched is the distrust of borrowing that many economists - and central bankers, who should know better - are suggesting a riskier alternative, namely: the printing of money.

What's so alarming about monetary ﬁnancing?Aren't banknotes just another negative real yield government liability, albeit a perpetual one?

They are. But deﬁcits funded by bonds sold to the public are redirecting spending power that already exists. When governments print money,they create new spending power. And if they do so very publicly - not just via quantitative easing,but by boosting procurement and other spending and using newly minted cash to pay for it - then people may start to ask questions.

Most obviously, if there is all that extra money around, how can it be worth as much? And if it's going to lose its value, shouldn't we use it pretty quickly?

Monetary credibility and inﬂation risk

There is little inﬂation currently (ﬁgure 5), and with demand weak, little expectation of any (ﬁgure 6). US core consumer prices had a record fall in April. Even before the crisis, it was being widely suggested that a little bit more of it would be a good thing, and would help get rid of that (allegedly) unmanageable debt burden.

Now, as noted, government and central bank support has surged, and may not be taken off the table until well after the economic rebound is visible. If so, boosted public demand may be supplemented by reviving private demand,leaving aggregate supply trailing in its wake. We might yet face a classic demand-pull inﬂation -particularly if much of that demand is backed by printing. Cue those sceptical questions.

The proponents of “modern monetary theory” will be right - up to a point. We do not know when that point will be, but we can guess it will arrive sooner than the point when governments lose their ability to borrow. It took a long time to restore monetary credibility after the 1970s, but it may not take long to lose it again. When interest rates are so low,and savings plentiful, why take the risk?

Much is being made today - understandably - of the EU's potential “Hamiltonian moment”. But Germany in particular is very aware that Hamilton's key insight was mutual borrowing, not printing.

We doubt inﬂation can be ﬁne-tuned. Using it to tackle debt is like setting ﬁre to your house to tackle a damp problem. The bill we worry most about facing, then, is an intangible one: the risk of lost monetary credibility, and a longer-term revival in inﬂation.