War and peace – Making sense of the biggest spending splurge in peacetime

Only the arrival of inflation is likely to put an end to the biggest round of government spending seen in in times of peace.

The extent of the surge in government spending and borrowing and money creation currently under way, especially in the richer nations, has no precedent in peacetime. Perhaps that’s because we are not really at peace. We are at war with a virus and, as in most wars, this is accompanied by warlike amounts of impenetrable fog, multiple chaotic situations and much wealth destruction.

Yet there is no sign of any taxpayer revolt to the spending propensities of governments. The current spat between Republicans and Democrats over additional spending is by no means asymptomatic. As I write these words, Congress and the President have already approved extra spending of US$3.2 trillion. The Democrats have now proposed an extra US$3.4 trillion of relief divided up their way. The Republican offer is of an extra US$1.1 trillion spent very differently. For a US$20 trillion economy, either set of spending proposals is formidable.

The global outlook for government debt is truly astonishing. The US fiscal deficit is predicted to approach 25% of GDP shortly, much larger than it has ever been, but for World War 2. In the UK, the debt/GDP ratio was below 60% in 2015 and forecast by the Office for Responsible Budget to fall marginally by 2050. The latest forecast is for a debt/GDP ratio, currently at 100%, to double by 2030. Managing government debt with the aid of central banks and their power to create money, usually the cheapest non-interest bearing form of government debt, is characteristic of all funding arrangements in and after wartime. But if this is war, then it is one without more inflation, either now or expected in the future. 90% of all developed market debt now yields less than 1% a year, of which 10% offers negative returns. It is therefore an inexpensive war for taxpayers to fund.

The recent growth in the size of developed market central banks is equally and consistently awesome. Or is it awful? It could not have happened without them. And there is every prospect of further growth in their assets to come. The balance sheets of four of the largest economies (US, Japan, the European Union and the UK) have increased by the equivalent of US$5.7 trillion (16% of GDP) since February, in other words, by about 30% in five months. Further purchases of securities, mostly issued by their governments, combined with support for extra private bank lending, can be expected to take their balance sheets to about US$27 trillion by 2021, the equivalent of 67% of GDP.

They have similarly increased their liabilities, in the form of extra deposits held by private sector banks at the central bank. These and other central banks have been exchanging their cash for government and other debt on a scale that has made them completely dominant in the market for government debt. They dominate over all maturities that are the benchmarks for all other yields, including earnings and dividend yields in the share market.

The US Fed will soon own 25% of US debt. The number was 10% in 2009. The Bank of Japan has grown its share of government debt from 5% in 2012 to over 40%. The European Central Bank held no European government debt in 2015. It now holds 25% of such debt. The Bank of England now holds 27% of UK government debt. Thus it would be incorrect to describe the low rates of interest on debt as market determined. The flat slope of the yield curve is under central bank control and they are likely to want to keep it that way, because there is no inflation or higher interest rates in sight. Economic revival is their priority.

When will the splurge of (always popular) spending end, while it can still be financed so cheaply? Only when and if inflation rears its ugly head again. And politicians and central banks may then do what their electorates have demanded in the past from post-war regimes: bring inflation down by raising interest rates and reducing money and credit growth (especially by governments) to better balance supply and demand in the economy. Inflation therefore will have to rise, surprisingly and sustainably so, before interest rates do, as the Fed has clearly indicated this week. Asset price inflation in such circumstances should not come as a surprise.