A Simple Twist of FAIT?

“Fate is like a strange, unpopular restaurant filled with odd little waiters who bring you things you never asked for and don’t always like.”

~ Lemony Snicket, children’s author. 

Question: Should we be concerned about current U.S. debt levels?  

Answer: According to the Treasury Department, our national debt has doubled in the last decade, going from $14.34 trillion on July 29, 2011, to $28.46 trillion on July 29, 2021. On Sunday, August 2, 2021, the $1.9 trillion pandemic relief passage drove the U.S. government debt level to the highest relative level since 1945 at 118.6% of gross domestic production (GDP). There are several factors that influence whether or not this will become unmanageable in the future.

The first is that interest rates are currently lower than GDP growth rates. What this typically means is that the debt payments can be serviced by current growth levels. When the debt-to-GDP ratio exceeds 100%, as it has in Italy and Greece, things can quickly spiral out of control, especially when a country’s interest rates are higher than growth rates. That is not the situation in the U.S. today with nominal interest rates lower than growth rates. The risk is for a nonstop surge in inflation that would increase interest rates in order to slow economic growth.

There’s no doubt that our economic position was impacted by the COVID-19 pandemic. The U.S. isn’t a unique outlier in this regard. Debt levels around the world are increasing with everyone looking to orchestrate a soft landing financially to compensate for the widespread economic and physical lockdowns. This past February, the Institute of International Finance reported that Government debt worldwide reached $82.3 trillion, or 105% of GDP, in 2020 which was up from 88% in 2019 indicating that we are a global economy.

In the U.S. there is a built-in demand for U.S. Treasury debt and other dollar denominated assets. This is because the U.S. dollar is the global reserve currency. Reserve currency refers to the most widely held global currency, which at this time is the U.S. dollar which has a perceived low risk of default. Many commodities are priced in terms of the U.S. dollar making U.S. Treasury debt a relatively “risk-free” asset against which most other assets are priced. These attributes support demand for U.S. government bonds, which in turn helps support our debt burden.

However, the higher the debt burden, the greater potential there is for problems. Similar to a household budget or cash flow analysis, the solution for reducing debt is to lower spending or increase income. In the case of a country, income can be provided with higher taxes. Right now, the administration is looking at raising taxes as one solution to lowering the debt levels. As seen after World War II, it can take decades to pay down debt. The other solution is to reduce spending.

At the moment, it’s likely that taxes and government spending will both increase. This doesn’t have to be negative for the deficit, however. Innovation and higher levels of productivity could boost growth, especially as we see rapid changes in technology. Growth may make the debt level more manageable.

Price inflation usually means that the deficit is too big (too many dollars chasing too few goods and services) while higher unemployment indicates the deficit is too small. Countries who issue their own currency, like the U.S., according to Modern Monetary Theory (MMT) are thought to have no financial constraints. Governments decide what they need to spend and address this through taxation and borrowing using debt.

The goals of the Federal Reserve have evolved since it was established in 1913. The primary purpose remains as outlined to keep a lid on inflation and maximize employment. Recently the Fed’s moved toward average inflation targeting or flexible adjusted inflation targeting (FAIT). It’s expected that low interest rates will continue to support GDP growth, allowing the federal debt level to remain justifiable. It is useful to keep an open mind regarding fiscal and monetary policies, as well as political positions.

COVID-19 brought the U.S. and other mature economies around the world to debt levels not seen since World War II. The definition of a debt crisis is when investors are no longer willing to purchase a country’s debt. When that will occur is very difficult to predict, although it doesn’t seem likely to happen in the U.S. anytime soon. Traditional analysis suggests that debt levels are sustainable as long as the cost of debt remains below the level of economic growth, but there are limits to this theory; what they are, however, is unclear.

Markets can act as a signaling tool, which in turn can affect political choices and the role played by the Federal Reserve. The economy is also changing due to technology, new behavior driving innovation and improved productivity. Suffice to say that there are many forces that can influence debt levels, and the federal response to it, going forward. As we navigate uncharted waters, stay focused and plan accordingly.

The opinions expressed are those of the writer as of August 1, 2021, but not necessarily those of Raymond James and Associates, and subject to change at any time. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Past performance does not guarantee future results. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

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This article provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at (239)389-1041, email darcie.guerin@raymondjames.com Website: www.raymondjames.com/Darcie.