Fallout from stimulus and money printing. The next chapter in the crisis?

The Fed is printing money and debt is skyrocketing to fund stimulus programs and support the economy.  Should we be worried?  Will the dollar lose its status?  We don’t know what the limits are to these programs or what will happen but we sure look like we are going to test those limits.

These policies of stimulus, interest rates, quantitative easing (QE), and bond buying, are all related to modern monetary theory (MMT).  These policies have evolved over the years and can be categorized in two ways, Monetary and Fiscal.

• Monetary Policy is controlled by the Federal Reserve Board (Fed) to manage money supply (i.e. interest rate cuts, QE, asset purchases).
• Fiscal Policy is Federal spending and tax policies as dictated by legislation passed by the Congress and signed by the President (stimulus packages, stimulus checks, government spending, tax cuts).

The Federal government used deficit spending (funded by increasing debt) in the post WW2 era to add fiscal stimulus whenever the economy slowed, hit recessionary conditions, or experienced an exogenous shock.  The roots of these policies can be found in Keynesian Economics and the governments greater role in the economy during WW2. 

The Federal Reserve's monetary tool of choice to stimulate the economy historically was cutting interest rates.  However once The Federal Reserve hit zero interest rates (called ZIRP) during the 2008-9 financial crisis they began adding to their toolbox.  Fed policies evolved by adding tools such as "asset purchases" and other "loan facilities".   As the lender of last resort they implicitly or explicitly "guarantee" debts and reduce fear during difficult times. 

The bond purchases and money lending are done with the newly created money (aka "printing money" whether paper or digital).  Other policies like interest rate cuts and reserve requirements create "looser" monetary.  Therefore these policies result in money creation.  The newly created money is then worked into the economy. 

Fed creates new money > Fed uses money to by bonds or lend >  New money enters the economy

These tools evolved even further during the pandemic by adding different types of bonds they can buy.  Traditionally they would limit their purchases to government bonds but now they purchase corporate bonds.  Perhaps the most controversial is their buying bonds of "fallen angels" that are below investment grade (aka junk bonds).  Most recently they have bought out right junk bonds by way of buying Exchange Traded Funds (ETF's) that contain these junk bonds in addition to fallen angels.

In my observations, fiscal stimulus, and thus adding debt, became an expectation over time.  The only questions being "when" and " how much" the stimulus packages would be.  For the Fed it was when and how much rates would be cut.   However the stimulus, (debt and money creation) has had a diminishing return over time.  Hence the need for these new and even experimental tools to get the desired effect of boosting the economy .

But do these tools and policies have limits?  On the surface it seems logical that continually adding debt would eventually lead to disaster.  That’s what would happen in our personal households or businesses.  Imagine if you ran up your credit card bill that you could no longer repay.  Or took out a mortgage, then lost your job, and could no longer afford the payments.  Your household would have to pay the piper. 

However, the Government is not limited by the same constraints as a household or business.  They have the ability to always collect taxes and can't "lose their job" and hence lose their income.  In theory they can print more money to pay back debt.  As long as it remains manageable.  They must be able to pay interest and investors by way of the market (made up of institutions, sovereign, individuals, etc.) must remain confident in the scheme and continue to invest.  

These policies could also bring other unwanted side effects.  Printing too much money would seemingly lead to inflation and other negative outcomes (the dollar becoming worth less, or worthless, and could lose the status as the world's reserve currency).  But the jury is out as it appears unclear if or when this might occur. 

How can we tell?  Do we have anything to base these judgements upon?  We can look at other developed countries who have gone down this path, have debts similar to ours, and see how they are doing. 

A good, or at least easy, way to measure a country's debt is a ratio of how much debt they have compared to their Gross Domestic Product (GDP).  GDP is a measure of a country's economy.  This would be similar to measuring your total debt to your income with GDP being income in this case.  A large debt may be manageable if your income is high enough to make the payments over time.  However if the debt is too high relative to your income that debts becomes unmanageable (or worse you are insolvent). 

If we look at a list of developed countries' debt to GDP ratio you would find Japan at ~200% generally tops this list, meaning their debt is 200% of their GDP or 2x.  Many other countries, mostly in Europe, fall somewhere between 100-140% of debt to GDP.  For example at the end of 2019 Japan was estimated at 198%, Italy at 131%, Portugal at 123%, and the United States at 91%.  Many of the countries with higher debt to GDP ratios are plagued with sluggish and stagnating economies.  You could glean from this analysis that possibly somewhere between 100-200% of Debt to GDP we could start facing serious headwinds due to the debt load. 

So where are we now?  Well it’s a moving target and a lot has changed since those 2019 figures.  The last official measure of GDP ending March 31st was 21.54tril.  Using the blue chip consensus estimates for the current quarter would put us at 14tril.  We should recover, perhaps even significantly from the current quarter but I will use these two data points as a range, valuing our GDP between 14 - 21.54tril.

Our most recent debt stands at ~26tril.  That would put us in a range of somewhere between 121 - 186% of Debt to GDP.

2019 Debt to GDP Ratios

Japan - 198%

Italy - 131%

US - 91%

US Current Debt to GDP

Low Estimate 121%

High Estimate 186%

However its not as simple as a ratio.  Many other factors such as demographics, economic characteristics, culture, and government surely influences the ability to manage debt and keep investors confidence.   A growing economy perhaps helps the most.  The US has historically enjoyed a vibrant economy that adapts, innovates, and bounces back.

Are we just like Europe or Japan, I would argue no.  Culturally they are different, Japan has a higher savings rate and almost all have different cultures and aging populations.  Furthermore the US and the dollar enjoys the special status of the world's reserve currency.  Does that mean we have no limits to debt?  I don’t think so.  But if we have a debt capacity larger than Europe and Japan, and I believe we do, then we have room for this experiment to continue.  If we are just like Japan and Europe than depending on where we land after this crisis in terms of GDP then we could be starting to hit the ceiling of what MMT can do for us.

The concern here is just the same as any other country.  Stagnation.  In other words the Feds run out of "ammo" and cannot cut rates, buy bonds, create stimulus or use other tools that stimulate the economy.  This syndrome is also known as "pushing on a string" when no matter how much debt or money is thrown at the problem it does not revive the economy and does not reach "escape velocity". 

But "if the house is on fire, put out fire, and worry about water damage later".  The argument is made that our economic house is on fire and we should use all means necessary to put out the fire and worry about the fallout later.   If we don't lose our innovation and characteristics then I like our chances even better and see no reason why we bounce back as always.

In sum, yes we should be concerned about these policies, certainly keep an eye on it, and maybe even hedge a little. But don’t go all in on any premise that we are certain to face doom because of any actions taken by the Feds.  The most likely outcome based on history is that we recover and the economy and markets continue to grow and reach new highs.  Historically speaking, the stock market generally has a 100% success rate at recovering.  Therefore, abandoning your long term investment plan by preparing for an unlikely doom scenario could very likely hurt your longer term results. 

^{The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment.  The material presented is provided for informational purposes only.}