Heavy debt levels increase financial risk. This is true for families as well as businesses. The 2008 financial crisis and this year’s pandemic-induced recession have caused many large companies to become insolvent and bankrupted thousands of small businesses. The escalated financial stress was arrested by massive government bailouts and the Federal Reserve’s emergency lending and there is more to come.
When will the US government realize the threat of debt to the economy? The US near-term economic outlook at this moment is difficult to assess. Most economic indicators bottomed in the spring and the recovery remains underway. However, recent data suggest a hiring slowdown, and this trend combined with a new wave in virus cases, suggests we may be headed for a double-dip recession. At the same time, the US government faces an unprecedented fiscal situation as there is a desperate call for more fiscal stimulus to combat the Covid-19 induced recession.
The US economy has relied on debt to grow. Data suggest that to achieve future growth it probably will necessitate taking on more debt to reach the same level of output as in the past. Equity investors evidently believe higher US stock market values can be justified with low nominal and negative real interest rates regardless of the health of the economy. High debt levels reduce the capacity to explore better economic opportunities while increasing the risk of another financial crisis when rates begin to rise. Equity investors might wonder how strong the support for stock prices would be if buybacks are curbed by future government legislation.
With each new financial crisis, an even louder clamor rises from the business community and the population at large for government action. In the past, this has meant a measured response by the Federal Reserve and eventually a fiscal response by the White House and Congress. There was some sense that the debt undertaken to pay for the cure would eventually be repaid and that the Federal Reserve would let the interest rates return to normal ranges so capital could be rationed by the market.
But we believe the pandemic has changed this approach. The Fed has driven interest rates to near zero and announced they intend to keep rates very low for the foreseeable future. At the same time, the fiscal response has moved from the normal extension of employment benefits to sending checks to a predetermined group of people as well as making potentially forgivable loans to businesses. High debt to equity ratios, whether in a family, business, or country increase volatility in the residual cash flow after fixed debt costs. High debt to equity reduces operating and financial flexibility and often portends slower future growth. The classic way to solve the heavy debt load is to reduce the purchasing power of the currency the debt is denominated in so that borrower repays the lender in cheaper currency. The task for the treasury and central bank is to create inflation to cheapen the currency. This is not a secret so it must be done carefully. For clues watch interest rates, gold, and the currency in the foreign exchange market.
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This excerpt from Money Memoirs was republished with permission.