- Market Commentary
- By Jack Ablin
- April 29, 2020
The Implications of Our COVID-19 Debt Burden
COVID-19 virus lockdowns have thrown the global economy into a tailspin, and governments worldwide are bracing for a depression-level downturn. In the US, 30 per cent of the economy is shut down, 30 per cent is fully operational and 40 per cent is suffering some degree of impact. Economists estimate that the US unemployment rate could hit 30 per cent, eclipsing the 24.9 per cent peak reached at the height of the Great Depression. The US economy is projected to contract this quarter by an annualized rate of 26 per cent, its worst quarterly showing in over a generation. Central banks, parliaments and the US Congress have responded with a double-barreled dose of monetary and fiscal support to bridge the void left by social distancing. To date, Congress and the Federal Reserve have dispensed dollars to the tune of nearly 40 per cent of GDP. The IMF predicts developed-market government debt will balloon $6 trillion to $66 trillion this year, amounting to 122 per cent of GDP and budget deficits towering toward 11 per cent of GDP.
Congressional largesse, including the CARES Act and the Payroll Protection Program, has received bipartisan support because the economic shutdown was mandated and because most of the stimulus is designed to help individuals and small businesses, not “too big to fail” banks. Conservatives and progressives agree that the record spending is both necessary and inevitable as we face one of the biggest global threats in nearly 100 years. If ever there were a time to bring forward future spending, it’s now. According to estimates by the Committee for a Responsible Federal Budget (CRFB), under current stimulus announced to date, the federal budget deficit will expand to $3.8 trillion this year, enveloping 18.7 per cent of GDP, and $2.1 trillion next year, or 9.7 per cent of GDP. By comparison, the previous deficit, created in response to the financial crisis in 2009, never breached 10 per cent of GDP. The CRFB also projects that federal debt held by the public will exceed the size of the economy by the end of this year; by 2023 it will eclipse the record set after World War II. Notwithstanding emergency stimulus, government spending has been growing as a share of the economy in recent years as overall economic growth has slowed.
Once the pandemic runs its course and economies begin to emerge from the lockdowns, policymakers will be forced to grapple with how to get out from under their respective debt burdens. Printing money is certainly an option, at least for those countries with the wherewithal to do so. The United States and Japan are luckier in that regard and will have an easier time repaying their debts than countries that do not have the luxury of owning the keys to a monetary printing press. A sizable share of sovereign debt defaults historically could be blamed on foreign currency-related liabilities. Italy is a stark example: its gross government debt amounts to about 140 per cent of GDP and is projected to rise to 160 per cent this year. Its debt is denominated in euros, a currency it does not control, and one-third of it is owed to foreign creditors.
Historically, policymakers have chosen different strategies in tackling high debt levels, although their playbooks revolve around similar themes. After World War II countries shrank their debts over the course of decades through a combination of taxes on income and capital and financial repression, a policy of holding interest rates below the inflation rate, which helps erode debt levels in real terms. At its wartime peak, America’s public debt was 112 per cent of GDP and Britain’s was 259 per cent. Seventy years later, the US debt-to-GDP ratio had slid to 26 per cent and Britain’s to 43 per cent. Nowadays, interest rates are low, so debt service has not been a big budget item for most governments. As of last year, the US government devoted 8.4 per cent of its budget to interest payments. Bigger balances in recent years have more than offset lower rates. That figure was 5.3 per cent as recently as 2009.
Financial repression has been effective and is a reliable method of growing out of debt by ensuring nominal growth – real economic growth adjusted for inflation – remains consistently above the interest rate on government debt. A high tolerance for inflation, combined with an ability to prevent interest rates from keeping pace, allows debt to shrink over time. Between 1968 and 1980 inflation rates stayed consistently above benchmark interest rates, so it was not a coincidence that US debt as a share of GDP shrank from 32 per cent to 25 per cent. Personal income tax rates were another important factor. In 1946, in the aftermath of World War II, when federal debt reached nearly 120 per cent of GDP, the highest marginal personal income tax rate was over 90 per cent. It wasn’t until 1965, when the debt shrank to 45 per cent of GDP, that the highest marginal personal income tax rate fell to 70 per cent.
Britain in the 1910s, for example, chose a regressive policy to reduce their World War I debt load, using a combination of higher taxes and inflation. Wages did not keep pace with inflation, however, in effect shifting income from the working class to their employers. The global financial crisis ballooned developed-economy debt by about one-third. In the aftermath, many countries chose to cut public spending. European countries opted for austerity. Between 2010 and 2019, the US and Europe reduced their public spending-to-GDP ratio by 3.5 percentage points, according to The Economist. Britain’s spending slid by 6 percentage points while taxes rose between 1 and 2 percentage points of GDP.
This time around, lawmakers have a menu of strategies for shrinking the debt while distributing the pain. Three primary strategies could be deployed by sovereign policymakers to dispense with their debts over time:
- Pay down debt on the back of higher taxation and lower spending. This strategy would undoubtedly be derided by virtually all constituents.
- Pay less than they owe by defaulting, restructuring, or insidiously through inflation. Default is not a sustainable strategy, however. History has shown that creditors will not let issuers who default come back to the debt markets.
- Continue rolling the debt over, hoping it will shrink over time through a combination of growth, inflation and relatively low interest rates. We expect US lawmakers to pursue this approach, which is the most politically palatable solution.
Higher inflation helps countries like the US shrink its national debt in real terms by allowing the government to pay it back in cheaper dollars. Inflation, however, results in regressive redistribution, since assets, like real estate and financial securities, rise in tandem with inflation, while wage gains tend to trail prices. Retirees, savers, and those on a fixed income would also bear the brunt of financial repression should rates stay below the inflation rate. At the same time, an inflation strategy would also benefit highly indebted companies and individuals, diminishing the real value of their liabilities although raising the prospect of moral hazard. Over the last 50 years, the US 10-year Treasury yield spent about half of the time below the inflation rate.
Inflation, however, would complicate Federal Reserve strategy. The trillions of dollars of additional money supply it created from quantitative easing ends up in the banking system as reserves on which the Fed pays interest. Raising rates to combat an inflation threat would not only cost the Treasury more to refinance its debt, it would also cost the Fed more in interest on deposits. A less independent Federal Reserve might be tempted to drag their feet hiking rates, running the risk of higher-than-desired inflation. The threat of inflation is far from everyone’s mind right now: in fact, the bond market’s implied annualized inflation rate is 1.1 per cent for the next 10 years. However, the prospect of boosting demand with government-sponsored spending support, with limited supplies due to supply-chain disruptions, could put upward pressure on prices. Tariffs imposed on imported goods, another tool to limit supply, could compound an already out of whack supply-demand imbalance.
We expect, over the next several years, the desire to reduce US debt levels and federal budget gaps will press policymakers to rely on a combination of taxes on income, wealth and capital, spending cuts and financial repression to address the imbalances. Higher taxes, like what occurred in the wake of World War II, could be targeted to reduce income inequality. While a 90 per cent marginal tax rate is off the table, we must plan for higher marginal tax rates. Taxes on capital gains will likely rise as well, although lawmakers are cognizant that capital investing is the lifeblood of America. Wealth taxes, like those on property at the state and local levels, and on inheritance through the estate tax, are back in play.
On the spending side, entitlements like Social Security and Medicare, which were already under duress going into 2020, represent additional, unwelcome budgetary pressure points. Medicare Part A faces insolvency in 2026, according to estimates prepared by Medicare Trustees – and that was before the economic and health consequences of COVID-19 were taken into consideration. According to their report, our nation’s health care benefit must undergo a combination of premium increases and benefit cuts to remain solvent. Social Security, which has a slightly longer runway, would require either immediately raising payroll taxes by one-quarter, or 3.1 percentage points, reducing all benefits by 19 per cent, reducing new benefits by 23 per cent, or some combination of the three, to keep our nation’s retirement benefit solvent through most Americans’ lifetimes, based on the results of a Social Security Trustees report.
Myriad investment and planning implications arise from the new mix of policies we expect to face over the next several years. Trends in larger government, which will undoubtedly continue, can no longer be financed exclusively with deficits and expanding debt. We expect equity investing, through public markets, private equity and real estate, to remain the most effective way to preserve and grow capital in the coming years, particularly in an environment in which inflation rates exceed interest rates. We expect bond investing will come under pressure as lenders find themselves on the opposite side of the table from indebted lawmakers. This means that shorter-dated maturities, like floating rate lending and particularly in tax-free municipal bonds, represent the best way to navigate financial repression and higher personal income tax rates in the years ahead.
Investors also should consider converting at least a portion of their traditional IRAs to Roth IRAs as another hedge against future higher marginal tax rates. The shift requires paying ordinary income tax on the conversion amount, but the resulting portfolio accumulates tax free, required minimum distributions would be eliminated and future withdrawals could be made tax free. Our Cresset team is prepared to model your individual situation and make specific, customized recommendations for you.
Realizing capital gains this year or next, particularly on long-term, closely held assets like businesses or real estate, could be a useful way of avoiding a costlier capital gains tax rate in the future. Qualified Opportunity Zone legislation, part of the 2018 Tax Reform Act, enables investors with realized capital gains to defer paying taxes on those gains until 2026 while deploying them into projects which are in effect tax free. Cresset has nationally recognized opportunity zone expertise. Please do not hesitate to reach out to us to help you craft a strategy.
State and local governments are under pressure and raising property tax rates is one lever local lawmakers could use to extract more revenue from their wealthiest residents. We understand there are many factors to consider when deciding between renting and owning, but from a tax standpoint, renting rather than owning in cities with high and potentially higher property taxes, could be a smart strategy. One offset could be a rollback in State and Local Tax (SALT) deduction restrictions, which are currently capped at $10,000. Comprehensive estate planning is a smart, time-tested strategy that easily pays for itself. Financial planning and estate planning are part of the comprehensive solution Cresset offers its clients. Please reach out to us. Unprecedented markets, economies, budgets and other circumstances will undoubtedly result in new, different and more complex challenges as we navigate the imbalances in the coming years. It will be interesting.