The Growing National Debt
The Implications for Economic Growth, Inflation, and Long-Term Sustainability
With the US enacting unprecedented stimulus as a result of the COVID-19 pandemic, the debate over the growing national debt has again come into focus. In past four years, US public debt has increased by $7 trillion to approximately $27 trillion, or a record 125% of GDP. This ratio is greater than during the economic mobilization of WWII, with an additional $1.9 trillion imminent as a result of the most recent stimulus. As a result, concerns that this continued deficit spending and related monetary expansion will trigger inflation are growing, prompting economists to debate on the long- term implications of the increased national debt.
This debate comes at an important inflection point in global markets, where years of persistently low inflation and structural changes in developed economies have driven interest rates to record lows. Factors such as aging demographics, automation, and the globalization of labor and trade have contributed to these dynamics, all of which seem likely to persist going forward. In turn, this environment has allowed economies like the US to take on additional debt in order to drive growth without creating inflation and even lower their interest payments in the process. This has represented a marked departure from prior episodes in history where such outsized fiscal and monetary expansion triggered an inflationary crisis and eventual recession. Is this time different? The debate among economists now is primarily whether the factors that have enabled a high-debt, low-inflation outcome will continue to dominate going forward, or whether we are at an inflection point where traditional textbook theory again takes over.
Comparisons to Japan and the ‘Great Inflation’ of the 1970s offer important insights into this debate by illuminating critical differences from the present situation in the United States. Key factors among these differences are the special role the US now occupies in global trade, the deflationary impacts of technology, and the transitory nature of the pandemic with regards to labor and growth. This analysis suggests that the US can continue along this path for the foreseeable future while also recognizing the important factors that make this possible. This point of view assumes that policy makers continue to successfully ‘thread the needle’ with regards to inflation and interest rates, as well as implement future fiscal adjustments to bring long-term debt dynamics into balance. Such stewardship should allow the US to maintain its distinct advantage as issuer of the global reserve currency, keep interest rates manageable, and reduce the risks of its nominal debt load. While not without risks, we firmly believe that the economic leadership in Washington is up to this task and look forward with cautious optimism.
As a result, we remain constructive on the financial markets over the medium-term while recognizing important near-term risk factors that may arise from rising interest rates, revised inflation expectations, and elevated asset valuations. We have already seen some volatility in recent weeks as markets digest a notable increase in bond yields. Nevertheless, the primary driver of these movements has been the improving outlook for economic growth, which is, of course, fundamentally good. Corporate earnings are expected to improve this year as various COVID-impacted sectors resume normalcy. And after a year of the ‘stay at home’ trade, the markets are healthily adjusting themselves to a broad-based recovery, which has triggered rotations in the market between technology and cyclicals. Despite the pickup in volatility, we believe this behavior is a natural and healthy process in a continued bull market, with various long-term trends intact.
In particular, we believe technological change will continue to have an outsized effect on productivity and costs, helping to offset inflation risks while at the same time boosting profits and scalability for businesses. Likewise, aging demographics and a ‘sea’ of low interest rates abroad are likely to keep rates contained in the US, forming a support for equities, even, as bonds lose some of their attractiveness. Still, we plan to keep a close watch on debt dynamics in coming years, particularly the interest expense as a share of GDP and the pace of rising interest rates, factors which will determine the magnitude of the debt’s long-term drag on economic growth. Inflation, or the lack thereof, will continue to be a key theme driving these factors. Lastly, political polarization, particularly as it relates to fiscal adjustments (the direction of taxes and spending) that are needed to normalize debt trends over the long term, will be a key factor in the path ahead. These dynamics will be playing out in tandem with continued changes in labor markets, economic sectors, and societies at large, forces which will drive sociopolitical debates that may end up being the most important drivers of markets in the coming decades.