How the US Debt Burden Will Be Managed

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Global debt is skyrocketing. US public debt is skyrocketing. And, today, this burden of debt will have to be dealt with.

The question is, “How long?”

As I said yesterday, the ability to cope with the debt burden will depend on how quickly the US economy recovers from the economic recession it currently finds itself in.

Investors have been discouraged in recent days as the Federal Reserve, in his latest predictionssuggest that the U.S. economy will shrink 6.5% in 2020 and expand 5.0% in 2021.

This means that in the fourth quarter of 2021, the US economy will be smaller than it was in the fourth quarter of 2019. Economic growth like this will not help to deleverage the US government.

Since the Federal Reserve released its forecast at 2:00 p.m. Wednesday, June 10, any remaining optimism in the stock market appears to have been deflated. The S&P 500 stock index closed last Friday at 3,041, down from its Tuesday close of 3,207. On Monday morning, the S&P index opened around 2,975.

The Federal Reserve is doing what it can

The Federal Reserve system appears to be doing all it can to provide liquidity to the banking system and financial markets, but that can only go so far as to mitigate economic decline. And these liquidity measures can go no further to bring the US economy back to where it was.

The government’s fiscal policy also helps to minimize the decline and then stimulate a recovery. But, in the process, a lot of debt is created and much of the debt is monetized as the Fed steps up its debt purchases.

Most economists support what the Federal Reserve is doing to support the banking system and financial markets. For example, Raghuram Rajan, professor of economics at the University of Chicago and former head of India’s central bank, voiced support for the Fed in an interview for Bloomberg TV.

Harvard economist Kenneth Rogoff, who has written extensively on the financial crisis, has also publicly stated that he supports the actions taken by the Federal Reserve. Mr Rogoff, in an interview with Goldman Sachshas “no problem with policymakers” taking these steps “if it means we’ll get through this in one piece.”

While rising debt wasn’t a free lunch, that doesn’t mean we shouldn’t buy lunch for everyone right now. We should be”.

No free lunch

The International Monetary Fund projects that US public debt will reach 131% of annual economic output this year, up from 109% in 2019. That’s a higher debt burden than after World War II. And huge debts, if not overcome by increasing economic growth, can, in turn, further stunt the growth of an economy. There is plenty of historical evidence for this. One of the reasons for this is that savings increase during these times, which lowers interest rates, which encourages borrowing and only increases the debt burden.

Paul Hannon, writing in the FinancialTimes, proposes four ways to get out of this debt situation in the long term: first, very rapid economic growth; second by high rates of inflation; third, through austerity; and fourth by what is called financial repression.

The first of these seem out of reach, given the Federal Reserve forecasts presented above. The second and third, no one really wants. That leaves the fourth method, again not painless.

What is meant by financial repression?

Mr. Hannon describes financial repression as the policy of supporting government bond prices, which would keep interest rates low. The government would take further action in the United States and elsewhere to limit interest rates paid on banks, making alternatives to government bonds less attractive to investors. He cites the years after World War II, when the Federal Reserve and the US Treasury Department was a time when these joint operations were set up.

According to a 2015 article by economists Carmen Reinhart and M. Belen Sbrancia, financial repression caused the average interest bill of 12 governments to drop from 1% of gross domestic product to 5% during the years 1945 to 1980.

The system “was instrumental in reducing or liquidating the massive stocks of debt accumulated during World War II,” they wrote.

For many, this is a better way to reduce a country’s debt-to-income ratio than the path to inflation or the path to austerity.

“Financial repression is not without cost and risk,” adds Hannon. But, the approach has a long history. For example, this abolition of interest rates hit savers. In addition, some analysts fear that the Federal Reserve will lose its independence from working so closely with the Treasury Department.

The future

Ultimately, investors need to consider the future they face.

Currently, the Federal Reserve and the Treasury Department are trying to limit the recession. There seems to be general agreement that it needs to be done…there is no alternative.

But what the Fed and the Treasury Department are doing only leads to further dislocations, adding to the dislocations that have been created over the past decade or more. These conditions are the result of “credit inflation” which has existed for more than fifty years. We are paying for excessive debt production in this modern era.

Carmen Reinhart, quoted above, who has just been named World Bank Chief Economist on May 20, states that “It’s a war. In a war, you care about winning the war, then you care about paying for it”.

But it’s not too early for investors to start thinking about the future they will invest in.

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