This blog is a modified transcription of a virtual event hosted by Venturi Private Wealth, with guest speaker, Alejandra Grindal. The event was held on October 30, 2020.
Chris: Good morning and welcome to another Venturi Market update. We are excited today to have a special guest with us. We have Alejandra Grindal from Ned Davis Research. Alejandra has spent 15 years at Ned Davis where she has been focused on global labor trends and demographics. Alejandra is going to walk us through the implications of an increasing governmental role in the economy and the aftermath of the effects of COVID, so welcome Alejandra and thanks.
Alejandra Grindal: Great. Thank you so much, Chris. Thank you everyone for joining me today. As Chris mentioned, I am going to discuss the increased role of government on the economy. This has been a hot topic, especially in light of the recent pandemic and the ongoing pandemic. So my presentation is divided into three main sections. I start off looking at the recent global trends. I am not just going to talk about the U.S. I want to talk about the rest of the world and make some comparisons between the COVID pandemic compared and past cycles; what makes now a little different. Then in the middle of the presentation, I want to discuss what the consequences of all this government spending are, and ultimately, is this something we need to worry about and what are the reasons for that? In the final segment of the presentation, I would like to spend some time discussing the long-term view. Perhaps this stimulus could be a symptom of something much bigger. What is the cause of all the stimulus and ultimately, what should we expect going forward? Hopefully, I will go through several time frames.
We [Ned Davis] cover investment ideas through various facets and various forms of research. I am the macro economist so this is going to be more macro oriented, but realize we do have a pretty broad breadth and approach to our research overall.
Just focusing on this very first slide I do not think it is any surprise when I tell you that the global economy has really experienced its worst recession of recent history and by recent history, very likely since the post-war era. These right here are projections of real GDP growth for 2020 from the IMF among some of the world’s largest economies, and these declines are unprecedented. We have not seen these in a really long time. Led by Italy, France and the UK, so Europe expected to have larger declines. China may end up with a little bit of a gain this year, but at around 1% this is nothing like what China has been used to over the past few decades. One unique characteristic of this recession is that even though it was very, very deep as a recession, it’s been actually fairly quick. In fact, we have been calling an end to the global recession – late Q2, early Q3. Some of the European countries, because they are going back into lock down, could see a bit of a double dip, but for the most part it was a very deep but also very short.
There are two main reasons why it happened. The first one is the obvious one – if you have most of the world going to a complete stop, shutting down with nothing functioning, schools closed, businesses closed and then you reopen, even if you reopen a tiny bit, you are going to get a rebound in economic activity, so mathematically we knew that was going to happen. But the other major driver, which of course is the topic of this presentation, is massive fiscal stimulus. I think there were a lot of unique characteristics with the stimulus, not only was it very large, but it also happened very quickly. Usually when we have recessions it takes a while for governments to agree – who should we stimulate to? And at what time should we do it? But in this case, governments all over the world were able to unify and realize there is a bad guy, it is a pandemic. We could all line up behind that. So the stimulus happened very, very quickly. In fact, it was announced within the first months of the recession.
The following chart illustrates a comparison between the fiscal policy response among various economies to COVID-19, that is in the blue bar, and then the orange bar, for sake of comparison, is the global financial crisis, which at the time we thought was the worst recession in the post-war era. You can see, the numbers are absolutely off the charts for many parts of the developed world. The forms of stimulus were actually somewhat similar among different countries, lifelines to businesses, whether it be through loans or grants, direct checks to households. In fact, you may have seen this step for the U.S., that disposable income actually increased during the recession because of direct checks to households.
We saw similar trends in Canada, Japan, Australia, so very different from what you see in past crises, also enhanced unemployment as well as furlough schemes. You will see the larger exponential jumps in Europe as well as Japan. Although in that case, a lot of the reason the number looks big is because these are loans to small, medium and even large businesses, so at one point they would need to be paid back. If you look more at the U.S. and Canada, it tended to be more grants so that was not necessarily money that has to be paid back, so the net amount is still quite high. These countries tend to have more automatic stabilizers so the European countries, so they do have a little more built into the system. But you cannot deny that the stimulus is significantly higher and exponentially higher than it was during the global financial crisis.
In terms of the market impact, if you look at global equities, U.S. equities, they absolutely loved this stimulus and even if you look at market action over the past few weeks or even more than that, a couple months, it is often been in response to whether there is going to be more stimulus or whether it is going to be delayed. But just to give you a depiction of it right here, what we are showing with an indicator we have created looking at stimulus information from Oxford University, and so what we are doing in this bottom clip is we are measuring the breadth of government support to households by country. As you can see, this number just shot up in mid-March and since then, we have been at roughly 96% of the world’s major economies providing some sort of fiscal support to households.
You look at this top clip right here, this is global equities, and you could even argue that the fiscal stimulus had somewhat of a leading tendency to the bottom in markets. Markets were really happy by this, and it did help fuel a lot of upside, so far this year anyway. So it’s definitely justified. However, one consequence is, if you spend a whole lot right now it will add to your cumulative debt. If you look at this chart right here, this is looking at government debt as a share of GDP. A good way to calibrate it by country and by history and we are looking at it for some of the world’s largest economies, especially the ones that I showed you previously that engaged in a lot of fiscal stimulus and you will see countries like the U.S. and Japan. They will see their fiscal stimulus or overall government debt as a share of GDP rise by about 30 percentage points in just one year, this is unprecedented. In the case of the UK and Euro zone, still some pretty big jumps, about 20 percentage points so very, very big, big numbers.
As I promised at the beginning of the presentation, I wanted to discuss what the consequences are and should we even worry about the fact that we have higher government debt. So just to kind of give you a little bit of a primer on it, if you see the chart on the left, this is a common framework that we use in macroeconomics, the IS-LM curves. If any of you took undergraduate macroeconomics, I hope I am not bringing back any bad memories of these curves, saying – I left economics because of these, these are driving me crazy, but it is strictly for explanation purposes.
But if you look at the L.M curve right there ultimately that is measuring the liquidity preference. It is driven by central bank policy, as well as how banks ultimately, through the fractional reserve banking system, can put liquidity out in the system and then the I.S curve reflects the investment savings curve. This can be the demand for goods and services, so this can be shifted by government spending, which is obviously the context of what we are talking about today, but also consumption and investment. Ultimately the way this framework works is holding all else constant, so that is the key word, that’s the hint I am giving you there, holding all else constant, whenever you have an increase in government spending, it leads to a rightward shift in the I.S curve and ultimately you get higher interest rates.
That is ultimately the consequence – the higher interest rates, and what are the issues with that, what are the consequences? So,I list a few right here on the right side and one of the first ones that comes out is this notion of crowding out of private investment. If governments spend so much and they drive up interest rates and makes it more costly for private businesses to borrow, they crowd them out of the industry. The general perception is that private industry makes better use of loanable funds and makes better use of investment decisions than the government does. So, we would prefer to put more hands on them as opposed to directly to the government and so by the government taking that role, it crowds out private investment. So, that is one major consequence that comes out.
It also increases the cost of further government spending. Let’s just say we decide to engage in fiscal discipline now, well another recession is going to be inevitable. It is going to happen sometime in the future and the government is going to have to step in and support those that are negatively impacted by that. If interest rates are higher, it is going to cost them a lot more to do that. At the same time, if you look at what the U.S. government spends most of its money on, it’s social security and Medicare, those entitlements which are here to stay and they are getting more expensive, even if we do not make them more generous, they are getting more expensive. Medical care prices are going up and more people are getting older than in the past, so that cost is going to go up. Government is going to have to spend for it, at least for the time being they are promising to; that in turn will make it more costly if interest rates are higher. Then within your budget picture, your percentage of total spending will go higher toward interest rate expenditures just to pay off that past debt. So again, you are putting a bigger share into that. And then perhaps in a worst case scenario, if the government spends a lot and it is becoming unattainable, then those people who buy the treasuries whether it be foreigners or domestic, they will lose confidence in the U.S. Government. That will in turn drive interest rates higher, and then create a feedback loop to all these other negative consequences I mentioned before. Ultimately in a nutshell, that is the issue with very high government debt.
Interestingly though that relationship has actually broken down over the past decade or so. If you look at this chart right here, what we are looking at is the correlation between interest rates and federal government spending. Over the past 10 years or so it hasn’t really mattered. The government has been able to spend more and interest rates really have not reacted. I think ultimately the question behind this, and again, I will take you back to those IS-LM curves that may bring for you nightmares, is that we are seeing that increase in government spending, which is shifting the I.S curve to the right. But there are a lot of other things that are going on at the same time that are shifting the I.S curve to the left or shifting that L.M curve to the right, that is keeping interest rates lower.
So ultimately the takeaway for now, as well as the next five years or the near future, is we just have more fiscal space, and I will discuss those in the next few pages. In terms of this high government spending, do we think it is going to be an issue anytime in the near term, probably not, and I will show you the reasons why, as well as perhaps discuss reasons for concern.
If we look at this next slide right here one reason we have not seen a huge surge in interest rates is because we have a new entity, not so new for Japan but new for other parts of the world. A new entity that is buying a lot of this government debt and these treasuries and that is central banks. So what this chart right here is looking at, is central bank government bond holdings as a percentage of total government debt. You can see how that number, especially this year, has surged for a lot of countries. In the case of Japan, it has been rising for quite some time. In fact, they are number one at almost 50% of total debt are they holding, if you look at it with respect to total government debt. Europe is not far behind nor is the bank of England. Bank of Canada, the Fed is a little lower but they have seen a pretty big spike up so far this year. So one is, you have a big buyer of the debt out there that is able to keep interest rates fairly low and most of these central banks have promised to continue to buy this debt going forward, which will also keep yields in check in the near term.
Another potential argument for why we have not seen, over the past few years especially, why we have not seen such a surge in interest rates is that, maybe there is just not that much demand from the private sector. They are not crowding up that loanable funds market, and that can often happen after global financial crises and when debt levels are very high. When debt levels are very high and nominal growth is pretty low, you do not have an incentive to want to borrow more. So while you are getting that upward interest rate pressure from the government borrowing more, you are getting the downward pressure from the private sector. So that could be something that is potentially balancing that out. Another driver of why interest rates have remained low and likely will continue to be low, at least in the long-term, is also high demand from foreigners. A lot of foreigners believe in the value of the treasuries. They think it is a really good store of value, safe place to go and as you can see right here, you have countries with very high saving rates in other parts of the world, particularly China and Japan, and they own a great deal of treasuries. In fact, each of those countries owns over a trillion dollars worth of U.S. treasury. So again, another factor that has allowed that relationship between interest rates and debt to break down.
I think the final major argument is – well what is the alternative? Just in the near term or in the meantime, there is just not much of an alternative to the security offered by advanced economy debt and for that matter the dollar, and countries all over the world hold a lot of it. So if you look at this chart right here, this is looking at foreign exchange reserves by currency as a share of total global reserves, and if you look at this very top clip, the dollar reigns. In fact, two thirds of total global foreign exchange reserves are held in US dollars. A very, very high number. So let’s just say all of the savers around the world lose confidence in treasuries and they are like – well, what is the next country in line, it is the Euro, right? Well, they are doing the same thing we are so it is not like you can put a lot of confidence in there and then there is always ongoing goods concerns; will the Euro even exist in the long-term? They are number two at 22%. After that it is the Japanese yen, again they are doing exponentially more government spending as a shared GDP than we are. And then after that, it is the pound Sterling, which has the debt issues like we do as well as Brexit. So there isn’t really a great alternative out there, and so that buys us quite a bit of time to be able to get away with this greater fiscal space.
There could potentially be alternatives in the long-term, I just don’t see that change happening anytime soon. One particular alternative that’s gained a lot of popularity recently is cryptocurrency. Like any sort of fiat currency it doesn’t really have intrinsic value – it’s the value that we put into it. That’s one reason it’s not a viable alternative in the near term. It’s also very volatile and not a good medium of exchange, but it is gaining traction. So much to the point that a lot of central banks particularly in Europe, the bank of England and the ECB, are now researching having their own digital currency because they know there is probably going to be some changes going forward. So again, I don’t see this becoming a huge issue anytime in the near term, but long-term, it could be an alternative.
Gold is always an alternative, but there’s just not enough out there to be able to satisfy the size of the dollar market. Another alternative, which some people don’t like to hear, could potentially happen, is the Chinese Yuan. If you look at the most actively traded currencies, it’s usually ranked by economic size or has some sort of variation with economic size, and less than 10 years from now, China’s probably going to be the world’s largest economy. Now it takes some time for that to shift, but it could potentially happen and I think that’s what China would prefer. I doubt it will happen anytime soon – one, it’s very hard to make these changes over short periods of time, but also China has somewhat of a pegged currency or fixed currency. So it’s really hard to make better a major foreign exchange reserve when it’s not a floating currency, but the alternatives are out there, it’ll take a while to change, but they are out there.
Just a quick view on inflation – does all of this massive fiscal spending lead to higher inflation? At least historically it actually doesn’t and the reason for that is, usually when governments engage in a lot of fiscal spending, it’s during recessions, that’s when they come in to help. So you’ll notice by these shaded areas right here, these reflect US identified recessions. Usually when the government increases spending, they do it during recessions, and when you’re in recession, aggregate demand is really weak and holding all else constant that tends to put downward pressure on inflation. In fact, it tends to be disinflationary. So that’s why when deficits are large, we do tend to see weak inflation pressures and when you look at this recession in particular, even though we got that quick bounce back, getting back to pre-COVID levels is going to take quite a bit of time. This isn’t something that’s going to happen overnight. A lot of the way we function day to day has changed and things really aren’t going to get back to normal until there’s widespread herd immunity, whether it comes through a virus or whether it comes through naturally, and that’s not going to happen for some time. In fact at the earliest, we don’t expect global GDP levels to get back to pre-COVID levels until the end of 2022. So aggregate demand should remain somewhat constrained in the near term, and at least from a broader perspective, not put upward pressure on inflation which clearly puts upward fresh pressure on nominal yields.
So in this next section, I wanted to take just a quick moment to discuss why we’ve gotten to this point of excessive fiscal spending. A lot of people think it’s because of COVID-19, but I think it was already happening and COVID-19 just brought the increase forward. It was something that was already inevitable. In fact, I would say one of the biggest reasons is we’ve been engaging, even though fiscal spending has gone on and off since the great financial crisis, monetary policy has remained very, very robust and it’s just not working anymore. It’s working but we’re getting diminishing returns, and I think one of the issues with that is that monetary policy, it’s sort of a blunt force object. It doesn’t address specific issues, it doesn’t address things like structural reform productivity and equality. It just provides liquidity to those who can potentially get their hands on it and Central Bank heads knew this. Mario Draghi, who was previously the head of the ECB, European central bank, followed by Christine Lagarde, even before the COVID crisis, they were pushing governments to engage in more spending, especially types of spending that increased productivity. Jerome Powell was saying the same thing as well.
So just to show you the diminishing returns of monetary policy, it’s pretty stunning and I think you all might be aware of this relationship as it is, but just to see it is interesting. So what we did right here was we aggregated Central Bank balance sheets of the major Central Banks and looked at it as a share of G7 GDP. Just look at this exponential rise, the number was relatively low pre global financial crisis and then just look at this rise, astronomical really, really big. So what we did in this bottom box right here is we looked at what our various measures of asset classes and the economy are whenever the balance sheet has been at various levels, because you would assume when the balance sheet is really big and there’s a lot of monetary stimulus out there, it would have a much larger impact on the economy and inflation and in turn, that didn’t really happen. So if you look here before the global financial crisis, real GDP gain per annum and the CPI was about 2.2%. In these interim periods, it ranged between 0.5% and 1.5%. So all of this rise in stimulus from here to here, this is the growth we got. Industrial production, not that great either, disposable income, that’s more of a toss-up that didn’t do so poorly. Inflation, I remember after the global financial crisis and central banks all over the world started stimulating, people thought we were going to see a surge in inflation and in fact, all of this has actually seen inflation go at almost half the pace of what it was before. Where we have seen a big increase is in asset prices. So if you look at house prices, this is before the global financial crisis, this is now over the past five or six years, so about the same. One interesting thing about the COVID crisis, not just in the United States, but globally, they’ve bucked the trend doing extraordinarily well. Then, obviously, global equities. Global equities have seen an enormous boom as a result of monetary policy, but in terms of impacting the US economy directly, not quite as much.
Now we’ve seen the diminishing returns and monetary policy, the new future, and I’ll talk a little more about why I think that’s the case, will be more fiscal policy, we have to make the best of it. So what types of the fiscal policies can boost or reduce potential growth? And when I talk about potential growth, I don’t talk about – oh, what’s one year boost of stimulus. I’m talking about increasing that long-term growth potential, that long-term average you go to. What are the things we can do to boost it? What are the things we can avoid? And from the get-go this is not an exhaustive list. There are many more things out there and I’m just stating a few examples. But the benefit of policies that boost potential growth is if we’re right, that interest rates will remain relatively low for an extended period of time, then we can engage in fiscal policies that boost potential growth, and that can help us grow out of the debt because the debt is often shown as a share of GDP. If we can grow our way out of the debt, we can even stabilize the number or reduce it just straight from the growth end.
So here are a few examples: one which I think has traction on both the left and the right, is infrastructure investment; it’s sort of a win-win. When you look at infrastructure investment, it has one of the highest fiscal multipliers. What I mean by that is when the infrastructure investment goes out there, you get the increase in spending from the government plus more, so it has a multiplied effect. That’s just great for the year in which it’s implemented, but it also does boost productivity in the long-term and higher productivity leads to higher potential growth. So that’s a good policy. Promoting innovation and technological change: this is something that’s been in a downtrend in the U S over the past few decades. In fact, in 1960 government research and development was 1.6% of GDP, today it’s only 0.7%. So that could be a potential way to boost productivity. Also promote competition, reduce barriers to entry, simplify taxes, reform the tax system so you can simplify and allow more entrance into the system that could potentially gain a competitive advantage. Reduce negative externalities, that’s often what governments do, they tend to provide the goods that no one else wants to that can give negative externalities.
In terms of policies that could reduce potential growth, so reduce long-term growth, the existence of zombie companies, we saw this quite prevalent in Japan during the lost decades. You could argue this could be going on in China right now, or even in other parts of the world. Because the stimulus this time around was in many cases un-targeted, we wanted something very quick, so we put a lot out there. But when you have a lot of un-targeted stimulus it tends to go to companies that aren’t as strong and maybe shouldn’t have survived to begin with in a recession. So you’re keeping them alive longer, and that could potentially reduce potential growth. Also policies that reduce competition such as increased trade barriers, corruption, those types of things. Policies that increase regulation, especially if it’s regulation to protect a certain industry that can also impede on potential growth, and then any sort of policies that downplay market forces. So if you want to nationalize everything have what was private industry now public industry and controlled by the government, that command economy that usually reduces potential growth because the market does the best job of aligning supply and demand. We should keep that in the hands of the market.
I think this is more of the bigger picture, which is pretty interesting but perhaps could come off a little depressing to some of you, is the need to step back and think about why have we reached this point? Why have we reached this point of massive monetary and fiscal spending? The fiscal has gone off and on over the past few years, but we can all agree it’s definitely higher than what it used to be, and then no doubt the monetary spending is off the charts. We’ve never had to do this before and to me, the cause is just low potential growth. Sort of inevitable low potential growth that’s being forced by poor demographics.I always talk about our demographic destiny. Unless you’re a really small populated country, it’s really hard to change that dramatically in the long-term. Some of the best forecasts you can look at, the most accurate forecasts in the long-term. And I think because of poor demographics and low potential growth, especially in the developed world, this includes the US, but I would say more so this is the case for Japan and Europe, is that we are addicted to these growth rates that we had in the past, and we’re stimulating like crazy to get back to what they used to be, but there’s a possibility they’re just not attainable. So we can keep on throwing more money in, but it’s not necessarily going to make a difference. If you look at this chart right here this is a calculation of potential GDP growth in the developed world.
It’s the best possible growth we can have in the long-term. It’s where you tend to gravitate toward the mean and what you do is you add up the long-term growth in your inputs – so labor force plus productivity growth, how well you use it, and then right here you get potential growth. Now it has gone down a bit because of the COVID crisis it’s at about 1%, but even before the COVID crisis, it was just a little over 1%, and that’s 1% for an entire year. You go back to the late eighties, early nineties, it was 4%. Our best possible growth in the developed world is just a fraction of what it used to be. So we’re throwing all of this money into the system, whether it be through monetary and fiscal, to try to achieve these really robust growth goals, but they’re not really attainable. And a lot of it is demographics. Holding all else constant, if you have fewer people making stuff, you’re just not going to grow as quickly.
Unfortunately, if you look at this next slide, that number is actually going to get worse for a lot of parts of the developed world. This is looking at working age population projections – people aged 15 to 64. In the United States, we have relatively high participation of people above the age of 65; we tend to work longer so our number is actually even a little better, this is underestimating it. The U.S. isn’t quite so bad. You look at quite a bit of emerging markets, but looking at the previous developed markets, I mentioned you have Germany, you have Japan, a few countries in Europe and they’re projected to see outright declines over the next decade or so in their working age population. Again, holding all else constant, if those people aren’t working and they’re not making stuff that potential growth is going to be lower.
The last comment I want to make about demographics, as Chris mentioned, I’ve done a lot of demographic work over the years, and I think it just explains so much of what’s going on in the world. Demographics may also be the source of potential change going forward. You all may have seen, maybe not this chart in particular, but may have heard this stat and if not I’m perhaps introducing it to you, but in this 2020 election the largest voting cohort is going to be millennials, right? They’re now all of voting age and I think a lot of people don’t realize, you know, we always think – oh, the baby boomers are a big generation, but the millennial generation is actually a little bit larger. So they’re now going to be the largest voting cohort. Also coming up the pipeline is Gen Z. They will be able to vote for this election for the first time. They really weren’t old enough to vote for the 2016 election, but they’ll be able to vote this time and are going to be in growing numbers for subsequent elections going forward. If you look at these two age groups, they’ve really been bombarded by some pretty bad times; two horrible recessions and a corresponding surge in inequality and a flat-lining of wages despite higher levels of education. So what’s happening with these age groups is they typically tend to favor policies that promote equality and fairness, especially compared to their boomer parents.
So to give you an example, people often say – oh when the young get older, they’ll start to vote more conservatively. But to give you an example, millennials today look at that. They’re not that young. Millennials today, not all, but in general, wanted Bernie Sanders and they wanted Jeremy Corbyn. Their boomer parents when they were their age were voting in Ronald Reagan and Margaret Thatcher, so very different views. So I think this change toward greater government spending was probably going to happen anyway, but the COVID-19 crisis brought forward even greater. So recession and inequality will promote this bigger role of government going forward.
I just want to reiterate the main points. The first being the COVID crisis may have triggered an inevitable move to massive fiscal spending. If we’re looking at the short to intermediate term, yes, the ballooning debt has consequences. It can be worrisome, but in this day and age specifically for the U.S., we have more fiscal space, so it’s not a near term concern. Then finally the big point I was making at the end; demographics is really the underlying cause and the big role behind the surging overall stimulus over the past decade and will likely be the source of change going forward.