Now that the budget bill has passed Congress, we can see clear projections for how it will impact deficits, government debt, and debt service expenses.
In brief, the bill is expected to lead to spending of about $7 trillion a year with inflows of about $5 trillion a year. So the national debt, which is now about 6x of the money taken in, 100% of GDP, and about $230,000 per American family, will rise over ten years to about 7.5x the money taken in, 130% of GDP, and $425,000 per family. That will increase interest and principal payments on the debt from about $10 trillion ($1 trillion in interest, $9 trillion in principal) to about $18 trillion (of which $2 trillion is interest payments). This will lead to either a big squeezing out (and cutting off) of spending and/or unimaginable tax increases or a lot of printing and devaluing of money and pushing interest rates to unattractively low levels.
This printing and devaluing is not good for those holding bonds as a storehold of wealth, and what’s bad for bonds and U.S. credit markets is bad for everyone because the U.S. Treasury markets are the backbone of all capital markets—which are the backbones of our economic and social conditions. Unless this path is soon rectified to bring the budget deficit from roughly 7% of GDP to about 3% by making adjustments to spending, taxes, and interest rates, big, painful disruptions will likely occur.
To explain why I believe this, I should describe where I’m coming from. Over my 50 years of experience as a global macro investor, I have developed and written down principles to help me anticipate events so that I can successfully bet on them. These principles are based on an understanding of the mechanics that drive changes in economies and markets. The most important principles for understanding big deficits and government debts like the ones the U.S. (and many other developed nations) are experiencing today are:
- When countries have too much debt, lowering interest rates and devaluing the currency that the debt is denominated in is the preferred path government policy makers are most likely to take, so it pays to bet on it happening.
- The most hidden way, hence the most preferred and common way, for government policy makers to deal with having too much debt is to lower both real interest rates and real currency rates.
- While lowering interest and currency rates in response to too much debt and the problems it creates can be a short-term palliative, it can reduce demand for the currency and the debt and create longer-term problems because it reduces the returns of holding the currency/debt, which reduces the value of the debt as a storehold of wealth. And over time, it usually leads to higher debts since the lower real interest rates are stimulative, making the problem worse.
In summary, when there is too much debt, interest and currency rates tend to be driven down. Is that good or bad for economic conditions? The answer: It’s both. It depends on one’s position.
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Lowering real interest rates and real currency exchange rates is beneficial over the short term because it is stimulative and tends to lift asset prices while it is detrimental over the intermediate and long term. This is because it gives holders of these assets lower real returns (because of the currency devaluation and the lower yield. And also because it produces higher inflation rates and leads to greater debt.
In any case, it certainly doesn’t avoid the painful consequences of overspending and getting deeper into debt.
When interest rates fall, borrower-debtors benefit because debt service costs are reduced, making it cheaper to borrow and buy things, which raises investment asset prices and stimulates growth. That’s why, over the short term, most everyone is happy with lower interest rates.
But at the same time, lowering interest rates to undesirably low levels is detrimental to lenders and creditors. Reducing interest rates (most importantly real interest rates), including central banks pushing bond yields down, raises the prices of bonds and most other assets, which leads to lower future returns. For example, when interest rates went to negative levels, bond prices went up. It also leads to more debt, which creates bigger debt problems down the road. So, lender-creditors get less return on their debt assets, and more debt is created.
Lower real interest rates also tend to lower the real value of the currency because it lowers the currency/credit yield relative to other countries’ alternatives.
Still, lowering currency rates is the preferred and most common way for government policy makers to deal with too much debt for two reasons. First, lower currency exchange rates make countries’ goods and services less expensive relative to those from countries that have rising currencies, so they stimulate economic activity and raise asset prices (particularly in nominal terms).
And second, they make it easier to pay off debt in a way that is more painful for foreigners holding the debt assets than for the countries’ own citizens. That is because the alternative way of handling debt problems requires tighter money and credit, which keeps real interest rates higher, constricting spending and typically leading to painful service cuts and/or tax increases and tougher lending conditions that citizens don’t like.
In contrast, as I will explain below, lower currency rates are a “hidden” way of paying debts because most people don’t realize that their wealth is decreasing.
A lower currency rate also typically raises the price of foreign assets when measured in the depreciated currency. For example, if the dollar devalues by 20% percent, foreign holders of dollar-denominated debt will be repaid with money that is worth 20% less (i.e., they will have currency losses of 20%). What is harmful but less apparent is that those with the weaker currency have less buying and borrowing power—less buying power because their currency goes less far and less borrowing power because buyers don’t want debt assets (i.e., promises to receive money) when they believe the value of the money the debt is denominated in is going down.
The reason most people in the country whose currency is being devalued (e.g., Americans dealing in dollars) don’t see their buying power and wealth decline is because they measure the value of their assets in their own currency, which gives the illusion that their assets are going up even though what’s actually happening is that the currency is going down. For example, if the dollar falls by 20%, U.S. investors won’t directly see that they lost 20% in their buying power of foreign goods and services if they focus only on the fact that the US assets they own have gone up in dollars. The fact that most people have this distorted perspective is what makes these ways of dealing with having too much debt “hidden” and more politically acceptable than the alternatives. However, for foreign holders of U.S. dollar-denominated debt, it will be obvious and painful, and they will increasingly hedge (sell) the currency that the debt is in and/or sell out of the debts, leading to more weakness in the currency and/or the debt.
What does all this mean for the economy and politics? History shows that big debts that can’t be supported with hard money lead to big easings of money and credit, which lead to big declines in both real interest rates and the real currency rates. The most recent time this happened was the stagflationary period from 1971 until 1981, and it caused big shifts in wealth, financial markets, economies, and political circumstances. Based on the existing sizes of debts and deficits (not only in the U.S., but also in most fiat-currency countries), the potential for similar very big shifts exists in the years ahead.
It’s also worth noting that the way people look at the value of money has changed a lot over the years. When money existed as paper notes that were claims on gold (let’s call this gold-backed money, which was the case before Nixon de-linked the dollar from gold in 1971), people viewed the value of paper money as rising and falling. Its value almost always fell, and the only question was whether it fell faster than the interest rates one received when holding currency in a debt instrument. Now that the world has gotten used to viewing prices through the lens of fiat/paper money (which is what we’ve had since 1971), people have the reverse view—they view the prices of things as going up, not the value of money going down.
Because prices of things in gold-backed money and the quantity of gold-backed money have historically been more stable than prices of things in fiat/paper money and the quantity of fiat/paper money, I believe that it’s more accurate to view prices in gold-backed money. Apparently, central banks have a similar perspective because gold has become the second largest reserve asset they own after dollars and ahead of euros and yen, partly for these reasons and partly because gold is at less risk of being confiscated.
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At times when debt and budget issues are very large, it’s good to have hard money, which for many centuries across the world, has been gold. Much more recently, some cryptocurrencies have been viewed as hard currencies.
So how much hard money/gold should one have? While I’m not trying to give you advice on specific investments, when thinking about what amount of gold relative to bonds I want to have, I think of their relative supplies and demands and the relative costs and returns of holding them. I also know that gold and bonds diversify each other, so I think about how much of each I should have for good risk control, and I know that a gold holding of roughly 15% can be an effective diversifier in that it produces a better return/risk ratio for the portfolio. Inflation-linked bonds do the same, so it is worth considering adding both to a typical portfolio.
I am sharing this perspective with you rather than telling you what I think the markets will do or suggesting exactly how much of each asset you should have because my goal is to “teach you how to fish rather than give you fish.”