Deficits, Debt, and Violence: The Economic and Political Implications of Pandemic Stimulus

I’ve long felt that there are a handful of musical albums that are complete perfection where every song is, well, perfect. I also believe that only a few artists are capable of producing such an album, and at best they can muster one or two in their entire career. U2’s Achtung Baby, The Killers’ Hot Fuss, Manic Street Preachers Everything Must Go, Volbeat’s Rewind, Replay, Rebound, and Pulp’s Different Class are a few on that list. Another such album that came to mind as I was writing the latest quarterly was Metallica’s self-titled album from 1991, which some call the Black Album. To me, the theme of the album seems to be about entering a new and uncertain future, perhaps because it was released just as the Cold War was ending. The literal interpretation of Enter Sandman is about being taken to “never-neverland,” which is an unknown place. Wherever I May Roam has multiple presumed meanings, one of which is about being a nomad, out in the world, and the chaos that comes with the freedom. Sad But True is about how future outcomes are based on past decisions, and we can’t escape our past, which is precisely what I was thinking as I pondered the long-term implications of policies implemented during the past two years. Many of these policies were necessary to mitigate a deep and protracted economic crisis. But perhaps it’s time to analyze the economic benefits of these policies, and how these past decisions could affect future outcomes.

I’ll be breaking this piece up into two publications.

First, in this current piece, I’ll look at fiscal policy itself (as a concept), why it’s the go-to policy choice for governments, how countries responded to the 2008 and 2020 challenges, and the impact of this spending on the overall global government debt stock.

Second, in a follow up piece, I’ll look at the economic implications of the ramp up in spending, whether it achieved the goals of policy makers (i.e., did it help economic growth?), and how all of these factors could affect potential political violence around the world in the future. ?

Fiscal policy is basis of all human activity??

Fiscal policy sounds like two already boring words conjoined to making an even more drab phrase. But it’s a very basic concept, as old as human civilization itself. It’s simply where and how a person or government collects money, versus where and how they spend the money. The difference between the two is either a surplus, or deficit, and a deficit is often funded by issuing debt (government bonds). Increase spending, or collect less revenue (tax), and a country has a fiscal deficit. If those deficits persist, then it starts to accumulate debt.

I’ve always said that socialism, communism, capitalism, or any other economic theory is largely a difference in fiscal policy. The common denominator differentiating them is where, when, and how the different models of economics choose to raise revenue (tax) versus where, when, and how they chose to spend the money.

We engage in a version of fiscal policy in our day to day lives when we determine which shirt to buy, or where to eat. For example, a person may buy something cheap to save money, or purchase something expensive and save less. The difference though in a person’s choice of what shirt to wear doesn’t really move the overall economic growth needle, or the potential for political violence for that matter, as we’ll see shortly. However, when a government makes the decisions, it can have significant macro consequences. And this is precisely what we wanted to explore in our latest quarterly.

2020 experienced an uptick in fiscal stimulus as more countries utilized this option…

?The global response to the pandemic was very similar to the 2008 Global Financial Crisis (GFC), even though the culprit was very different. The response to both was an easing of monetary policy (cutting interest rates) to spur borrowing demand and make credit and liquidity cheap and readily available, coupled with heightened government spending, i.e. fiscal stimulus. The one difference though is that while in 2008 almost all countries cut interest rates and engaged in monetary easing, it was mainly the US, Western Europe, Japan, and China that engaged in fiscal stimulus. However, in 2020 nearly every country ramped up fiscal spending. This raises two questions: Why did more countries engage in fiscal response in 2020 relative to 2008? And why engage in fiscal stimulus at all?

First, 2008 was largely a US economic crisis that then became a global challenge. The US faced a housing crisis, which led to overall economic weakness including falling employment, wages, and therefore consumption. But most of the rest of world was facing economic weakness due to weak US demand and volatility in capital markets. Thus, countries faced some sort of economic headwind. However, the fundamentals of their economies (particularly the more insulated ones) were generally sound. COVID-19, on the other hand, effected all countries in the same way. Even insulated economies faced internal economic weakness as demand and economic activity declined. Accordingly, we saw a more uniform response on the fiscal front.

…mainly because it’s the easiest lever to pull during weak demand causing an immediate impact on economic growth

Second, countries engage in a fiscal response because it’s often the fastest and most impactful method of putting a floor on economic activity, while simultaneously trying to boost it. Gross Domestic Product, or GDP, is the collective output of a country and can be calculated by adding up:

·????????Private Consumption: Where we as individuals spend our money

·????????Private Investment: Where we and corporations invest our money

·????????Net Exports: The net value of goods we ship abroad, since that brings in money

·????????Government Investment: Where the government spends money

Pulling on any and all of those levers can make an economy grow or shrink. The first three levers are very hard to pull on and solicit an immediate reaction. However, governments can easily pull on the fourth – government investment and spending. This can come in the form of infrastructure spending, which is currently being debated in the US. In general, expanded government budgets and spending can be a growth additive. But not all spending is the same. Thus, targeting spending on economic growth inducing areas like infrastructure, construction or procurement of supplies can be the most impactful. Plus, let’s not forget that this form of spending can also create jobs, and the holders of those jobs may increase their consumption (the first part of the equation).

Governments can indirectly control the other three levers too. Often, tax incentives, abatements, deferments, and reductions can incentivize individuals to consume more, invest, or manufacture goods to export. While this is not spending, it does often result in less revenue collected by the government and thus is considered fiscal stimulus.

Essentially, any action by the government that injects money into the economy, either through a direct increase in spending, or through policies that reduce government revenue and thereby (often) increasing the fiscal deficit (or lowering the fiscal surplus in surplus nations), can be referred to as fiscal stimulus. And the object is to grow the economy.

However, stimulus adds to debt, which in the right dose is important

As I mentioned earlier, when the fiscal deficit is widened on account of stimulus, it’s funded by the issuance of debt (government bonds). Following the ramp up in US deficits in 2008, and again in 2020, we saw an increase in the supply of US Treasury securities. Traditionally, the accumulation of debt is seen as a negative and too much of it is in fact not good. However, we would argue that some levels of debt are actually quite important, if not imperative, for a properly functioning financial market.

Case in point are the US and Australia. In late 2001, US fiscal deficits had fallen to the point that the US Treasury stopped issuing the 30-year bond. But as spending ramped up due to the Iraq War, and deficits widened, the instrument was brought back by 2005. However, the four-year halt created a gap in the US yield curve, which some could argue affected price discovery in the long end of the yield curve.

But what if the US never brought back the 30-year? Over time the US yield curve would have topped out at 10-years. This in turn would have caused challenges for corporations issuing debt as they (and other countries) often price their debt in instruments as a spread to the US yield curve. And corporate bond traders would have hedged their investments by shorting US Treasuries. Without a 30-year Treasury bond, it would have been difficult for corporations to issue, and for traders to hedge, a 30-year corporate bond.

Similarly, in the 1990s and early 2000s, Australia mostly ran surpluses and had a very limited supply of government bonds because they did not need to borrow much. As a result, the Australian government bond market lacked liquidity and a few investors could easily buy up all the government debt. This limited transparency and liquidity in the government bond market. Of course, it’s great to run surpluses, but there can be some adverse effects to not having deficits and debt. Just like our personal finances, some level of debt can be beneficial if calibrated properly.

Thus, some debt is good, and helps maintain a liquid government bond market, which is the bedrock of all financial markets. But too much debt is naturally problematic, as we’ve seen recently in Greece, Italy, and Argentina. What happens if private investors no longer want to buy a government’s debt? Not only would yields spike raising the cost of borrowing down the road, but the country could go into default as it may not be able to refinance its debt. And that’s precisely what we are focusing on with this publication.

The increase in fiscal stimulus in 2020 led/will lead to a surge in global government debt

We now know that 2020 was a historic moment for global debt. As we noted above, more countries engaged in fiscal stimulus relative to 2008 causing a significant spike in global government debt, which is now close to 100% of global GDP.

COVID-19 hit in 2020, and if we compared 2019 (before COVID-19) to 2021 (since most of the debt was added in 2020), we can see that debt to GDP spiked from 83% to just below 98% - a near 15 percentage point increase. Post GFC, debt to GDP increased from 64% to 77% in 2010 - a 13 percentage point increase. Globally, the percentage increase is similar, but in nominal terms it’s much more since we are talking about global GDP being much higher. Plus, reaching 75% debt to GDP globally is much different than 100% as funding the debt becomes a question of the availability of global savings and liquidity. If global savings is a function of GDP, which is directed towards investment activity like buying government bonds, then the availability of savings declines as debt rises. Hence why debt to GDP in excess of (let’s say) 75% or so is viewed as unfavorable, especially for many developing countries. And the same argument could be applied on a collective global basis.?

(Source: IHS Markit, IMF, and CCER)

In nominal terms, the largest increases in debt between 2019 and 2021 came from the US, China, Japan, Germany, UK, India, France, Italy, Canada, and Australia, i.e. the largest economies. And again, we are opting to look at a two-year window since the growth was clustered between 2020, and part of 2021, as evidenced below.

(Source: IHS Markit, IMF, and CCER)

But when observing a two-year window around GFC, to the two-year window around COVID-19, we start to see the magnitude of just how much nominal debt was added during the pandemic relative to 2008. For example, US debt increased by USD 6.9 trillion during COVID-19 compared with USD 3.5 trillion during GFC.?For China, it was USD 3.4 trillion versus USD 800 billion, and in India it was USD 520 million versus USD 240 million.

(Source: IHS Markit, IMF, and CCER)

At this juncture, we can conclude that fiscal stimulus was/is the desired policy prescription during an economic crisis because governments can easily pull this level to support GDP. And given the dynamics during COVID-19, which stemmed from shutdowns and a loss of economic activity, fiscal policy was arguably more impactful than monetary policy with respect to the real economy (particularly in the short-run). Thus, fiscal stimulus was the go-to tool, and arguably more widely used during COVID-19 relative to GFC in 2008. We can substantiate this statement by looking at the increase in global debt to GDP, as well as by scanning the breadth of countries that increased spending, and the nominal levels of debt increases too.

In the next publication, I’ll look at the economic affects of the policy decisions and how it could affect our thinking about the likelihood of political violence in various markets.?