Tuesday, September 29, 2020

Daunting Debt Dynamics

In Daunting Debt Dynamics, originally published May 28, 2020, Goldman Sachs writes "Our key takeaways: the benefit of running large deficits today far outweighs any eventual costs; developed market bond yields are likely to rise modestly as a result; worries about distress in emerging market are largely warranted, in munis are mostly not [dependent on "phase 4" stimulus that did not pass as expected], and in the Euro area are somewhere in between; and a likely wave of corporate bankruptcies could prolong--but likely won't derail--the economic recovery."

Quotes below, from Harvard Professor Kenneth Rogoff, Goldman Sachs Chief Economist Jan Hatzius and Chief Interest Rates Strategist Praveen Korapaty, and Penn Professor David Skeel. 

Rogoff and Hatzius agree that government should step in and increase spending to offset the decrease in private spending. "In the current environment of exceptionally weak demand and economic activity, running large government deficits won't be inflationary, and is not a reason to worry about a debt crisis, at least in countries like the US, UK, Japan or other advanced economies that have a floating exchange rate and their own central bank." They differ in how they view the chain of causation between debt levels and growth, which might indicate different policy suggestions in non-crisis times:


"academic literature published over the last 10 years thoroughly supports our conjecture that higher debt and lower growth are correlated. The causation remains debated, but ... countries with very high debt levels are sometimes more reluctant and less able to vigorously support their economies in a crisis, which in turn impacts longer-term growth." 


"I can see why debt levels and growth might be correlated, and why very high debt levels might leave a country less well-positioned to invest in areas like infrastructure that promote growth over the longer term. But the causation probably mostly goes the other way, from weak growth to high debt levels. Certainly in the short term, it's hard for me to see how larger deficits would lead to weaker growth; all else equal, a bigger deficit delivers more stimulus to the economy."

Korapaty summarizes how much of the new debt issuance will be absorbed by central banks. As of this report, the ECB owned 42% of German debt outstanding, the BoJ 50% of JGBs, the Fed 22% of Treasuries, and the BoE 20% of Gilts. 

"So the US and UK, in particular, still have substantial room to increase purchases from here. That said, of the $4tn in US issuance that we expect in the current fiscal year, we estimate that the Fed will end up buying about $2.5tn, which would leave $1.5tn to be absorbed by market participants [primarily money market funds] ... whether you want to call that fiscal-monetary coordination or not, the reality is that a large fraction of sovereign debt issuance will end up on central bank balance sheets to ensure normal market function ... This is not problematic right now because the government is essentially replacing lost demand. But it could become an issue if it represents a paradigm shift toward deficit financing without any safeguards that continues well into a recovery."

Shifting gears, Skeel discusses the potential for a wave of corporate bankruptcies.

"I wouldn't be surprised if filings increase a lot more than they did during the Global Financial Crisis, when they essentially doubled ... many firms were already sitting on a significant amount of debt before the coronacrisis, and this is just the type of disruption that could push some of them over the edge."

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