“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”
Winston Churchill: November 10, 1942
We present this Churchill quote for two reasons. First, we understand that PIM clients are avid readers so we thought you might enjoy a book recommendation. Erik Larson, formerly of Seattle and a prolific writer with whom many of you are familiar, has a new book out: The Splendid and the Vile: A Saga of Churchill, Family and Defiance During the Blitz. If you know and appreciate Larson’s work, and if this topic is of interest, give it a look.
Second, we think it important to put the COVID-19 public health crisis and resulting economic situation into chronological context. The first battle against COVID-19 may be won, but the not the war. Opening the economy without a significant spike in new cases will require social distancing and other preventive measures until there is a vaccine. According to the Financial Times, there are 87 candidates in some form of clinical testing now. While perhaps optimistic, a vaccine may materialize by the end of the year. Such a timeline, from early development to final approval, would be unprecedented. As mentioned somewhat cynically in last week’s letter, there will be significant economic benefits to the company that is first to market with a vaccine. Financial enrichment is a strong motivator. Indeed, it is the primary tenet of a market economy.
The economic impact will stretch far beyond a year or two. What follows is a deeper dive into crisis economics than we have offered before. We were prompted by questions about the economy from PIM clients. Indeed, the topics presented in our communications are often answers to questions asked by one or a small number of
you, and that we assume may be on the minds of many more. We hope that what follows is understandable and interesting.
A crisis reveals fragility. The common theme in each economic downturn of the past forty years is excessive financial leverage, and this one is no different. From the Savings and Loan crisis of the ‘80s to the tech bubble of the ‘90s and the financial crisis of the ‘00s, the core of the problem was too much debt. The COVID-19 crisis was not triggered by bad debt, but excessive financial leverage in corporate America today negates any ability for many companies to remain solvent without government intervention. That support has been immense. The Federal Reserve has added two trillion dollars to its balance sheet since the end of February and will likely add another three trillion by year-end. This is effectively moving private debt to the public balance sheet. The Federal Government has provided $2.9 trillion in stimulus spending over the same period.
It is deeply ironic that the answer to too much debt in the economy has been to add even more debt. In this bailout process, the debtholder shifts from private sector participants to the government. In the financial crisis, the bad actors were over-leveraged individuals and the banks that enabled, even encouraged their behavior. Today, it is largely non-financial corporations and hedge funds. These institutions took advantage of a decade of low interest rates to borrow capital to raise share prices through financial engineering, which is no replacement for real profit growth. Even after adjusting for increased output, corporate debt increased by 13% over the past decade to 15 trillion dollars, making it the largest source of private debt in the country. In both the financial crisis and the current COVID-19 crisis the Federal Reserve was forced, by moral hazard, to bail out the guilty parties from the consequences of their actions.
We are not arguing that policy makers should have played the role of Nero during the COVID-19 crisis, playing the violin as the global economy burned. What they have done has been an appropriate response given the speed and impact of the epidemic. Both deserving and undeserving firms are receiving government support. Yet, to more fully understand the long-term consequences, it is important to recognize the cyclical pattern that has emerged.
Capitalist economies used to be characterized by what famous Austrian Economist Joseph Schumpeter called “creative destruction.” This is a euphemism for the ruthless economic efficiency that existed before modern central banking. When a firm became obsolete due to stronger competition, or a crisis for which they were ill
prepared, they were liquidated, and their resources were reallocated for more productive uses. The “invisible hand of the market” worked without being encumbered by artificial influence such as government intervention.
This laissez-faire approach is painful but does feature the accurate pricing of investment risk, something made more ambiguous by the current approach. If the Federal Reserve will bail out financial risk-takers, there are no consequences for making bad investment decisions. Responsible investors may not realize the fruits of their wise decisions because assets are not priced to reflect their true value. Poorly managed firms can stay in business due to the mispricing of risk and the low interest rates that allow them to remain just profitable enough to keep the doors open. These poorly performing firms tie up capital resources that could be more productively used elsewhere, resulting in higher growth rates of the overall economy. The Bank of International Settlements estimates that 12% of firms globally earn just enough money to pay the interest on their outstanding debt, with no remaining income to pay the principal. These “zombie” firms cannot exist in a normal interest-rate environment.
Our current system has produced an ever-increasing level of debt at the Federal Reserve and the US Treasury, along with a less dynamic and slower growing economy. U.S. federal debt has recently reached $24 trillion, but as the holder of the reserve currency of the world, the U.S. Government has incredible borrowing power. Let us pause briefly to explain. To raise money, the United States sells Treasury Securities (Bills, Notes, Bonds), generally considered the only true risk-free asset (free of default risk, certainly not free of interest rate risk). On Monday of this week, the government sold $190 billion (yes, billion), in Treasury Bills and Notes. Demand was strong, despite historically low interest rates.
The amount of outstanding U.S. Government debt is high, but relative to the size of the U.S. economy it is manageable at this point. Japan is the poster child for long-term deficit spending, with a debt to GDP ratio of 237%. U.S. debt to GDP is 137%, according to the most current information from the Organization for Economic Cooperation and Development (OECD). Despite our flaws, the U.S. is still an open, transparent democracy, and is the economic and financial engine of the world. Global investors view U.S. dollars as the
safest store of value available for their savings, creating continued strong demand for U.S. Government debt. For as long as this remains the case, there is virtually no limit to how much the U.S. can borrow.
Just because the U.S. can continue to borrow does not mean that it should. The years following the 2008-2009 financial crisis marked the slowest post-recession recovery ever. Although the unemployment rate hit a post war trough, the quality of the jobs created by the economy were mainly low-skill and low-pay, not the sign of a balanced and healthy economy. With each successive recession, the recovery becomes weaker as we see the diminishing returns of deficit spending.
The solution to this cycle is painful. In terms of the federal debt, there is only one option; pay it off. The problem here is obvious. If more tax dollars are being used to pay down the debt, there are fewer dollars for everything else. This would lead to an increase in tax rates or a reduction in government spending. Would any configuration of the U.S. Congress support this approach? Has any politician in recent memory, from either party, suggested anything other than increased spending?
There is a “stealth tax” that some economists believe will materialize at some point: inflation. Inflation is too many dollars chasing too few goods. The US Government and Federal Reserve have made sure that there are plenty of dollars in the economy through stimulus spending and asset purchases. So far, those dollars are sitting in bank savings accounts, not chasing goods and services.
U.S. Treasuries are mostly fixed rate (not variable rate) securities. If the Federal Reserve allows inflation to increase, it becomes easier for the government to find the dollars to pay debt. Again, a brief pause to explain why. Inflation is an increase in prices. Increasing prices are eventually followed by increased wages. With increased wages, the government collects more tax from employers and employees that it can use to pay down debt. With inflation, the government wins, and holders of U.S. Treasury securities lose, as the buying power of the interest payment on those securities is eroded. Finding the inflection point where inflation is supportive without being oppressive is difficult to do. The Federal Reserve has been trying for a decade to get the inflation rate over 2%, without much success. Market-based indicators of inflation expectations are currently at all-time lows.
The more formal way of measuring how quickly capital flows through the economic system is called “money velocity.” When economic activity is strong, money velocity is high as dollars move from employers to employees and to providers of goods and services. At present, there is not much velocity at all. Banks have record levels of cash in deposit accounts. Until the COVID-19 situation is resolved, confidence is restored, and consumers and business have time to repair their balance sheets, money velocity will remain low, as will inflation.
The Federal Reserve will likely keep interest rates low for a very long time to stimulate the growth of the economy. Federal Reserve Chairman Powell said as much on Wednesday of this week. Low interest rates for long periods, in theory, lead to inflation. But the Fed’s low rates have not produced sustained inflation above their target in more than a decade. The most likely outcome over the next few years will be more of what we experienced after the ’08-09 financial crisis. That era was characterized by a fair bit of market volatility, growing federal deficits, modest real economic growth and strong investment asset prices.
After another sluggish recovery, somewhere down the road, this will happen again. When it does, those best positioned to weather the storm, whether private persons, corporations, or governments, will be those with reasonable, responsible levels of debt. Will any of these stakeholders heed the lessons of today and past recessions? Surely some will. The more, the better.
This conclusion may seem unsatisfying for many. It is a common for market observers to speculate that the crisis will be a major turning point for the economy, either for the better or worse. If the policy response from the Federal Reserve and US Government to this crisis, and those to follow, does not change, then we should not expect the results to be much different.
Our objective today is not to instill a sense of hopelessness. It is to discuss, to inform. These are big, complex problems. Fair-minded, informed people can disagree about the extent to which government intervention into the economy is appropriate. In a crisis, nearly everyone agrees that we must pull out all the stops. The question is, will we do anything different afterwards. We will find out.
If you have questions or comments about this, or anything else, please be in touch. From all of us at PIM, to all of you, your families and friends, be well, stay safe and look forward.
Personal Investment Management, Inc.