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Deficits which trigger more debt piling

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In the U.S, we are currently seeing a federal deficit of more than 1 trillion dollars and around 90 percent of federal debt load over nominal gross domestic product. A situation the U.S has never experienced. So how will it affect the economy and investors?

Analysing an economy seemed simpler before – most economists would have looked at the numbers and might conclude that the economy might evolve into a weaker situation. The situation would result in either an economic slowdown or a rapid rise in the inflation rate, reducing the real value of the deficit and the federal debt. Today we are experiencing a different sort of behaviour by the federal government and the Federal Reserve, with such behaviour changing prospective outcomes.

That said, one has also to consider the fact that private debt over the years has increased remarkably, primarily supported by the prolonged accommodative monetary stimulus. Indeed, corporations have taken an opportunistic approach by tapping the bond market at the current benevolent low yielding environment. This said supply was balanced with the notable increases in demand as investors continued the hunt for returns.

Since the end of the Financial Crisis, different drivers of stimulus were implemented and were used with little positive spill over in generating economic growth. The most popular recent monetary tool quantitative easing was used by the U.S. and after several rounds of QE, in addition to low interest rates, it managed to stimulate an economic upward move. Interestingly enough were the flows of capital movement. After the recession recovery, money flowed out of value investment vehicles and moved into passive asset management operations – U.S stock prices hit new highs.

However, despite the increase in asset prices, the rate of growth of the real economy in the current economic recovery seems to be the lowest in history. This is a clear indication that monetary stimulus efforts have done little to trigger growth at a faster pace. The inflation rate is below the Fed’s target levels of price inflation ,while a continuous debate within the Fed about how monetary policy might be tweaked in order achieve the targeted level of inflation.

A conclusion that we can draw from this is that, like monetary expansion, debt expansion appears to be remaining as a tool to be used in the markets. This is because investor expectations are closely tied to debt expansion created by the government and corporates. Thus, although the concerns voiced about the size of the federal deficits and the growth of the federal debt by the markets have died down, it seems that the debt ceiling limits will continue to be breached.

Deficits supported by debt pilling is more seen as a populism tool to support electoral campaigns, with welfare arguments such as “the policies we support keep the unemployment rate lower than it would have been otherwise”, continue to be popular propagandas.

Also, as was seen in events surrounding the Financial Crisis, if the economy does downtrend for a while because of market distortions, politicians are highly likely to revert back to refreshing debt expansion to try and get the economy and financial markets back on track again. In our view this is more seen as a short sighted vision, rather than a long term view for a more sustainable economy.

This article was issued by Maria Fenech, Credit Analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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