Will High Government Debt Lead us to Economic Ruin?

Since 2008, many governments around the world have racked up huge debts in trying to prop up their economy.  This has been particularly bad in the US since 2016 as the annual deficits have increased to over 1 Trillion dollars a year, even before the coronavirus hit. It is entirely possible that the US federal government deficit could top $2 Trillion dollars in 2020.  The US Debt to GDP ratio now stands at over 110% and that is increasing rapidly right now as the debt goes up and the GDP is likely shrinking due to the recession caused by coronavirus.  

As much of the world's economy is tied to the US economy and is largely dependent on it, this large government debt is certainly a cause for concern.  However, does a large US government debt mean that the US economy is destined for economic ruin?  The answer is: probably not, and here's why.

The US Government Has Options to Pay Off Their Debt First off, the US government debt is growing too fast and it is a problem.  But not in the traditional sense that the US Government will simply be unable to pay their bills.  Sovereign governments have more options available to them then the typical person or company who borrows money.  The US government's options are:

They could sell assets. Just like you or I, the US has assets they could sell in order to pay down their debt. This includes millions of acres of land in the US.  Some of these pieces of land are very hard to value and so are not included in the government's balance sheet assets, but nevertheless are valuable. For example, what is the Washington Monument or Lincoln Memorial worth?  Or what is Yellowstone National Park worth?  So while the government does have a lot of debt, they also have a large asset base.

Taxing authority. The government in the US has huge taxing authority which they can, and do utilize all the time.  This could include additional sales taxes or estate taxes which could generate trillions of dollars of revenue for them if implemented.  A 5% Good and Services Tax in the US like we have in Canada would go a long way to fixing their normal year deficits (not including the special provisions this year for coronavirus).

The government can issue treasury loans which are directly bought by the Federal Reserve. The two bodies of government would have to work together and agree on this, but essentially by doing so they create an unlimited amount of funding for the US government which is only restricted by the Fed's ability to print money.  Now of course this will have side effects in terms of higher inflation that I will talk about below.  Nevertheless, this is a legitimate tool the government can use to ensure it pays its bills.

Large Government Debt Does Not Necessarily Lead to Economic Stagnation

Large government debt does not necessarily mean the economy will be unable to grow or even grow rapidly.  Few people understand this, but historically speaking, the point at which the US Government was the most indebted relative to the size of its GDP was immediately after World War II.  You can see this in the chart below.  The cost of the war had obviously driven the US Government into massive debt.  

Despite this, the period from 1945-1970 was probably the most prosperous stretch of economic expansion in the 20th century in the US.  As a result, the debt to GDP ratio went into a long period of decline from the 1940s to the 1970s.  That was even as government spending increased with additional programs like social security and others. There was of course a number of different circumstances and factors why the economy did well during the period from 1945-1970, and these factors may not repeat themselves in the future.  

But it is important to realize that just because the government is in debt, that doesn't mean the US economy is necessarily in trouble. Source: https://www.statista.com/chart/19131/federal-debt-held-by-the-public-as-a-percentage-of-gdp/

Austerity Rarely Works

If we look historically, fiscal austerity by governments doesn't really work very well. Often the austerity leads to economic contraction which makes it even harder for the government to repay the debt because their tax revenues fall faster than their debt payments.  It would take a very long time for the US government to repay its debt, and it would be quite painful for the US economy. It would also provide dubious benefits given that the Government can pretty much finance as much debt as it wants right now at close to 0% interest.

Usually when governments try austerity, it is either because it is imposed on them (like Greece), or because they have a deep rooted fear of a repeat of hyperinflation (like Germany).  Hyperinflation is the equivalent of bankruptcy for a national government.  Effectively it's a default because the government is forced to print money to pay its debt payments which have grown too large. Now you don't need to have a hyperinflation to devalue your currency over time.  Running the economy at a higher inflation rate can be a way for a government to avoid paying back its debt in a round about way. It is also often more politically feasible then massive cuts to government spending.  This is bad for savers but good for borrowers. Because the government is a huge borrower, you can see why higher inflation can be appealing for them.

The Real Concern

So while I think it is very unlikely that the US government will ever repay its debt, I do think the US government will try to inflate away the value of its debt. So as investors we do need to be prepared to invest in a higher inflation environment, because I think there is a high probability it is coming. That doesn't mean we will definitely have a hyperinflation in the US, because monetary policymakers understand hyperinflations pretty well nowadays and can likely prevent them.  

However, I do think we could easily see a sustained period of higher inflation (5% annually or higher) again if we're not careful. I think that this is the real risk of letting the government debt get too high. If inflation started to rise to even 5% annually, interest rates would have to rise to match and that could be very painful for the economy. In addition, pretty much all of the fixed income in the world would have massive losses if inflation increased to 5%.  Even equities would be dramatically repriced.  They would be worth a lot less in a world where goods and services cost a lot more.  That would be a big problem.

How to be Prepared

So what do we do to about these things?  Well one of the reasons that we try and limit the amount of fixed income we invest in is because I think a high inflation environment like the one I described above is very possible, if not probable.  We can't predict when or if that will even happen, but we can prepare for it happening by limiting fixed income to the amount we need. Traditionally people who were worried about inflation invested in hard assets like Gold or Real Estate.  Nowadays you of course have cryptocurrency people who think it's the new digital gold.

I personally like real estate as an investment where it can be gotten for the right price.  I don't like gold or crypto as much because as these are non producing assets that don't pay dividends and don't produce anything of value. As such in order to make a return you must find someone in the future to pay more for it then you did. An investment in a capital light high cashflow business is probably the best hedge against inflation.  

That's why Warren Buffett has always liked See's Candies so much.  The candy business doesn't require a lot of capital and it generates very high profits consistently. Because it requires little capital it isn't impacted by inflation much. The price of its chocolates will simply rise with the cost of inflation and since they don't have to re-invest much into the business, the higher inflation won't impact their costs too much.

Most of the equities that we own are inflation resistant like See's Candies to one degree or another.  That doesn't mean they wouldn't be temporarily impacted by a spike in inflation. What it does mean is that they likely won't have a long term impairment of the value of their business caused by high inflation.

Making Our Investment Decisions

While the US government debt is a problem, it's a problem which will probably manifest itself in higher inflation.  There's obviously no way to time when inflation will run higher, so that's why we don't make investment decisions around it.  We design portfolios to be as inflation resistant as possible within a client's goals and risk tolerances, and in doing so we're always prepared for a higher inflation environment.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.