The Fallacy of the Broken Window
At the end of 2020, analyst Tom O’Keeffe reviewed the impact of COVID-19 on the US fiscal deficit and debt using Carraighill’s Matrix approach. This framework allows us to better understand the links between an economy, its financial system and individual stock ideas. It also helps us better appreciate investment risk across key sectors including property, asset management, banks, payments and online and instore retail. Through this, we can also review and analyse structural investment opportunities and speak more competently with management teams.
This has been our approach in Europe/CEE and Turkey to date. In time, we hope to extend this approach to a more thorough review of the US/ Brazilian market. This post focuses on three areas:
1. The decline in economic activity.
2. Deficit spending and the fallacy of the broken window.
3. What happens next and the options available.
The Decline in Economic Activity
The onset of the COVID-19 pandemic will have lasting effects on the US economy. In real terms, the US economy shrank c. 5% in 2020, driven by a decline in private consumption and global trade. Exports and imports are expected to fall by 18% and 15% YoY respectively. Government expenditure increased to counteract the virus’s financial damages, through income supports, subsidies and other automatic stabilisers.
US GDP is unlikely to surpass its pre-pandemic level until at least 2022. The recovery will primarily depend on domestic consumption and investment recovering, with the former forecast to rise 6% in 2021. Exports are unlikely to rebound until 2022, highlighting the scarring effects of the crisis. The recovery is heavily dependent on the rate of vaccinations and the easing of lockdown restrictions. We continue to monitor these developments.
Figure 1: The decline in economic activity due to COVID-19 and subsequent recovery.
Deficit Spending
The COVID-19 pandemic required extensive government support with the US fiscal deficit forecast to reach 15.3% of GDP in 2020. In comparison, Germany and France’s budget balance is forecast to be 6% and 10.5% of GDP in 2020. The US response is larger in scale, but Europe’s approach is long-term focused with the EU recovery fund and domestic supports lasting for many years. Politics and the vaccination rate will determine the US deficit in 2021 as it is forecast to normalise to pre-pandemic levels. These forecasts were made before the US election and therefore do not account for further stimulus due to be enacted under the Biden administration.
Figure 2: The impact of COVID-19 on the US deficit.
Private Supports
Through our sectoral balance approach, we can show how public deficits are private surpluses. Government supports through direct payments jobless aid, credit guarantees and tax credits have increased net transfers to households significantly. The initial Families First Act, CARES Act and Payment Protection Programme provided fast and direct assistance to citizens and small businesses. Stronger household savings combined with limited consumption opportunities have pushed flows into asset management and mortgage demand higher. Net cash flow increased due to the decline in consumption. Households are expected to consume a greater level of this income as the economy opens, reducing net cash flow to pre-pandemic levels.
Figure 3: Transfers to households and corporates
Like households, corporates have received extensive government support. Various schemes ensured businesses received loan guarantees, subsidies and tax exemptions. Industries such as airlines and pharmaceuticals also received additional funding. Corporate cash flow has increased due to limited investment opportunities and will remain dependent on government subsidies throughout the recovery.
Growth in US Debt and the Fallacy of the Broken Window
The broken window fallacy states that if money is spent on repairing economic damage, it is a mistake to think this represents an increase in economic output and economic welfare. If the window of a bakery or butchers shop is shattered by a burglar, it must be repaired. Even though this helps GDP in the year, it is not a productive use of funds as you are merely replacing what was already lost. The shop front looks no different.
Current deficit spending in most regions (Europe/ USA/ UK) is arguably like this, in that money is merely being spent on repairing the COVID-19 induced damage. It is not being spent on productive purposes and consequently the opportunity cost is higher debt for no change in output (unproductive).
For example, the US’s large budget deficits have led to record-high debt levels (and the repair of windows). Government debt is forecast to reach 128% of GDP in 2020, similar to France and Spain but significantly higher than Germany at 71% of GDP. Questions about the sustainability of this debt have arisen following the COVID-19 crisis. Our view is that debt is always sustainable in a fiat money system and interest rates are likely to remain low through to 2022, as any near term ‘inflationary’ pulse will subside in time given this debt legacy. Growth in interest expenditure is expected to be minimal compared to the overall increase in debt stock.
Figure 4: The impact of COVID-19 on government debt due to rising deficits
Increasing the economy’s productive capacity will be essential to managing the rising debt. A key metric to follow going forward is the marginal productivity of debt (GDP growth relative to the increase in debt) which has been declining consistently over the last decades. While government investment as a share of output is higher in the US than European economies, increasing productivity will be required to reduce the debt-to-GDP ratio structurally. This seems a difficult ask.
The US has few choices on debt reduction as a share of GDP in the future. These are:
1. Outgrow debt levels at which the debt-to-GDP ratio declines – This is possible through structural reforms to improve productivity and GDP growth (albeit unlikely). This would require extensive productive private sector spending.
2. Debt restructuring and defaults – This can be catastrophic for asset markets and most likely would introduce a deflationary financial depression. It is unlikely and widely regarded as unthinkable for advanced economies such as the US. Unlike households, government can roll over debt into the long term.
3. Inflate the debt away – Increasing inflation will increase nominal GDP and is possible only in economies where debt is denominated in the local currency and is more likely in countries where the Central Bank is government controlled. This debate is gaining traction (albeit still limited) in some advanced economies who increasingly try to influence Central Bank policy (e.g. US and President Trump). Such a migration should rapidly change the inflationary outlook as evidenced in some EM countries we have reviewed (Turkey).
4. Austerity – This remains politically unpopular and improbable following the Great Financial Crisis. However, it remains the most effective method based on history.
The Fed has acknowledged that no–one knows how high the ratio can get before consequences arise, but of the options outlined above. The authorities continue to choose the debt accumulation process. The reflation thesis is gaining media attention, but inflation requires various factors such as persistent wage growth and a higher velocity of money. If money is not productive, and is merely used to fix broken windows, any inflationary impulse may tire rapidly.
This has implications for how we think about key investment ideas.
Carraighill will continue to monitor these structural and cyclical trends.
Note: On November 5th 2020 the EU commission published the US economy forecasts as part of its AMECO dataset.
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