Fiscal Funding Forever?

The debunking of the 90% debt-to-GDP limit on economic growth proposed in the academic paper of Reinhart and Rogoff (2010), combined with unprecedented public support during the pandemic, has provided the cover for an ‘avalanche’ of government debt (and deferral of policy to achieve fiscal balance).

Increasingly, populist governments around the world set to continue this trend, as social spending, cost of living support and ageing populations underpin structural budget deficits. This raises the question of whether governments continue deficit funding forever?

Even if the 90% limit on debt-to-GDP is no longer the line in the sand, and the link to debt and growth is non-existent (see below), there must be a limit to the tolerance of bond market vigilantes. The tension we contend is ultimately ongoing debt service to the detriment of either service delivery or need for higher levels of tax.

We need only look at the ill-fated prime ministership of the UK’s Liz Truss to see the influence that the bond market can have over governments. That was a narrative confined to the UK economy, but nonetheless, instructive.

Even before accounting for the Trump presidency promise to cut taxes, the US budget deficit is currently running at 7.5% of GDP, taking total debt to 123% of GDP, the highest since WWII and roughly triple the peaks of WWI, The Great Depression and the American War of Independence. According to the IMF, the US will need to issue bonds exceeding 50% of GDP for the remainder of this decade, an incomparable period outside of wartime. It is stating the obvious, but where the US economy is in good health, a failure to be able to plan and foresee, let alone achieve fiscal balance is a significant forward risk. It is politically easier to lower taxes than raise taxes, and equally easier to increase spending than lower spending.? For 2025, the net ‘sugar hit’ benefits of Trump 2.0 are likely to outweigh the medium-term risks of fiscal imbalance.

Even in the absence of a UK bond market tantrum, the quantum of debt sales points to an incremental upwards creep in bond yields. In a country that already spends over 20% of government income on debt costs (50% more than defence) this increase could prove substantial.

Solving the Debt Puzzle?

Printing money, raising taxes, spending cuts, or selling assets are the simplest means of addressing debt, yet these are unlikely to be popular at the ballot box. Historically, this leaves financial repression - where inflation above the level of interest rates erodes the real value of government debt over time, as the preferred route to deleveraging.

Full financial repression requires numerous restrictions on banks’ asset holdings, lending and borrowing rates, credit growth and capital controls. One would think this would be hard to recreate in the current environment, where central bank independence is entrenched, prized and fundamentally necessary to support bond market confidence in inflation management and in turn, the ability to absorb future debt issuance.

2% Ceiling or Floor?

Full-blown financial repression remains unlikely in the short-term, but an increased influence and pressure on policymakers to tolerate higher inflation going forward may be possible. This is the essence of the new inflation regime, post COVID, where the combined forces of deglobalisation and structural deficits, result in a 2% inflation target as the floor rather than the ceiling.

In Australia, where we have a targeted inflation rate of 2-3%, we might expect inflation to operate at the upper end of the range.

If governments are emboldened to accept higher inflation, and able to incentivise the quasi-government institutions, this would pose a challenging environment for asset prices - a lesson that all investors felt in 2022.

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