Focus
March 03, 2023 | 13:41
Fiscal Outlook: The Fire Next Time
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Fiscal Outlook: The Fire Next Time |
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Bringing inflation to heel is undoubtedly the most important economic priority for policymakers globally, and the most pressing issue for financial markets. However, after this inflation episode is over, we suspect that the next big concern will be the (wounded) state of government finances in many major economies. After being dealt a terrible blow by the pandemic, public finances now face the ugly combination of much higher borrowing costs, prospects of chillier economic growth, and challenging demographic trends. There have already been a few loud warning shots on this front in recent months, including the spectacularly sour market reaction to last fall’s U.K. mini budget, as well as the opening tremors around the U.S. debt ceiling showdown. |
Long-term government bond yields are grinding higher again on renewed inflation concerns, although they remain relatively stable in the face of the looming fiscal forces. But, the U.K. experience suggests that this is a fragile calm which could easily be upset, by a protracted U.S. debt ceiling battle this summer, for example, or perhaps by a renewed spark in energy prices. And any further rise in long-term yields would simply compound fiscal pressures, ultimately leading to the need for restraint even amid a tougher growth backdrop. Essentially, we have quickly morphed from a seeming fiscal free lunch (as espoused by Modern Monetary Theory), to very serious constraints on the public purse in the short space of a little more than a year. Government finances globally were heavily stressed by the intense demands of the pandemic, with revenues crushed by the economic shutdowns, and spending spiked by income support packages and health care needs. While revenues have largely recovered, and spending has calmed, the pandemic’s legacy is a heavier debt burden, weighing in at over 100% of GDP in the advanced world (Chart 1). During the height of the pandemic, the groaning budget deficits were seen as: a) a necessary evil as policymakers had few options; and b) manageable, due to near-zero interest rates. But the latter soothing balm has evaporated with the historic rise in rates in the past year, at a time of record debt levels. To cite one specific and representative example, the U.S. federal debt held by the public (arguably the single best measure of debt) has surged in the past three years and is poised to head even higher (Chart 2). This measure rose from just under 80% of GDP right before the pandemic to almost 100% currently. The CBO recently estimated that it will rise another 20 ppts over the coming decade with no change in policy, to levels far beyond anything previously seen—including the temporary spike after WWII. Notably, this year’s budget deficit is expected to clock in at $1.4 trillion (5.4% of GDP), up from the pre-pandemic level of just under $1 trillion (4.6% of GDP). Keep in mind that this still-hefty shortfall is at a time of full employment and the peak of the economic cycle, and before the surge in Treasury yields has been fully reflected in interest costs. On the debt ceiling debate, while one may understandably decry the tactics of those using it as a tool to rein in fiscal largess, one can also sympathize with the goals. |
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The main reason that markets have largely shrugged off fiscal concerns in this cycle, both in the U.S. and most major economies, is because debt dynamics have been very favourable—until recently. During the European debt crisis of early last decade, investors became all-too-familiar with some of the debt sustainability metrics, which essentially boiled down to: Were real interest rates above or below real growth? Below meant the possibility of fiscal sustainability, above meant pain and the need for austerity. In the aftermath of the Great Recession, real interest rates cracked for most major economies and stayed low for a decade. But the aggressive policy tightening of 2022 and a taste of serious inflation have pushed some real interest rates to their highest levels in a decade (Chart 3). While real rates are more challenging, they are not yet sustainably above potential GDP growth in most cases—for example, U.S. 10-year TIPs are now about 1.6%, while U.S. potential growth is pegged at about 1.8% over the next decade. So, debt dynamics are not yet a pressing problem, but this does not give fiscal policy a free pass. Even if real interest rates remain generally mild, government debt/GDP can still ratchet higher if core finances (i.e., ex interest payments) remain in deficit and/or deteriorate, as is the U.S. case. Moreover, budgets everywhere face a heavy demographic challenge in coming years (Chart 4). Spending will be pressured by the slow-moving train of rising health care and pension costs, which has been well-telegraphed for decades. Perhaps less appreciated is that economic growth could slow more than expected as labour force growth cools sharply (already declining in Japan and some European economies), undercutting the revenue side of the ledger. |
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Against this fiscal backdrop and with budget season now upon us, Canada is in relatively better shape. Demographics are less challenging, and interest rate increases may be done. Moreover, the fiscal starting point is better than most, notably for the current deficit—Ottawa and the provinces combined will have a shortfall of around 1% of GDP this fiscal year. Government debt is mostly lower than the OECD norm, depending on the measure (Canada fares well when viewed on a net debt basis as public pension assets are included), and there has been notable improvement since the COVID-related spike in 2020. But don’t be lulled by Ottawa’s relatively mild debt ratio of about 42% of GDP, as gross general government debt is now around 90%—basically back to the bad old days of the mid-1990s (Chart 5). Again, the key difference with that episode is the much, much lower level of real borrowing costs currently (say 1% now versus over 4% then). |
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Financial markets are mostly unfazed by the looming fiscal issues in many key economies, aside from simmering concerns about the coming U.S. debt ceiling drama, with the inflation fight and recession worries dominating. But we would harken back to what unfolded in the wake of the last great inflation battle, culminating in the deep 1981-82 recession. The aftermath saw a decade of very high real interest rates after inflation was quashed (Chart 6). And while economic growth recovered strongly in the 1980s, a legacy of debt and high real borrowing costs left fiscal policy in a tough bind for that decade and even beyond in some economies. The period was punctuated by the Latin American debt crisis, years of budget battles in Washington, and a 10-year struggle in Canada to corral deficits, which only ended with a deeply austere budget in 1995. For some, policymakers went straight from the inflation frying pan to the budget deficit fire. |
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Key Takeaway: Every cycle has its own unique features, and there are clearly many differences with the current episode and the great inflation of the 1970s/early 1980s. But given that advanced economies are already faced with a tough budgetary position—record debt, weakening growth, demographic pressures, and positive real interest rates—we should heed the lessons of the last major battle with inflation and its fiscal aftermath. For policymakers, the main message is to get the fiscal house in order now, both to assist monetary policy in taming inflation, but also to avoid an ugly budgetary position after the battle is presumably won. |