As the coronavirus surges, Fed Chairman Jay Powell warned Congress that cutting spending to contain the economic damage from COVID-19 would imperil the U.S. recovery, raise unemployment to Depression era levels and lengthen our period of economic weakness. With cases rising in 23 states and record increases in three, Congress should listen. The risks of not spending far outweigh the risks of spending more.
The House Democrats passed the Heroes Act asking for another $3 trillion in spending to mitigate the pandemic’s impact. Senate Republicans called it “dead on arrival,” citing the $1.481 trillion deficit and an increase in the national debt to $25.5 trillion. Speaker Mitch McConnell (R-Ky.) put a pause on any additional spending before more stimulus is enacted, and he postponed consideration of more stimulus until late July. In the House, a bipartisan group of 60 Representatives warned of “irreparable damage … if nothing is done to stem the tide of red ink.”
What are they afraid of? First, that more spending will beget higher deficits and more debt with higher borrowing costs. Those costs could rise if the volume of Treasury securities strains the demand for them or if investors start to worry about the ability of the U.S to pay its debt.
There are also fears that the Fed’s $2.4 trillion lending and bond purchase programs are flooding the economy with so many dollars that it will stoke inflation, and that those loans and bonds could default at the expense of taxpayers.
The dreaded outcome could be a self-perpetuating upward spiral of higher deficits, more debt at higher interest rates, leading to higher deficits and so on. The word “exponential” comes to mind.
But these concerns are overstated.
It is unlikely that the government or taxpayers will suffer meaningful losses from loans made or purchased by the Fed and Treasury. Unlike private investors who buy corporate bonds and have no power to improve the corporations’ creditworthiness, the U.S. government has the power to make its investments pay off. For example, in the 2008 Recession the government spent $633.7 billion to rescue 985 recipients, including the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, commercial and investment banks, the auto companies, and AIG. That investment returned $754.8 billion to taxpayers.
Nearly half of the spending authorized by the Cares Act is in the form of loans to businesses, state and local governments and consumers. If the government’s efforts to restore the economy and the borrowers’ solvency are successful, the majority of the loans will be repaid with interest, minimizing — or possibly avoiding altogether — a hit to taxpayers.
The risk of U.S. borrowing costs going up is also low. The strength of the U.S. economy and the insatiable demand for the dollar have made U.S. Treasury securities the world’s favorite safe harbor and have kept Treasury rates at historic lows. Nearly two-thirds of central bank reserves, over 80 percent of global trade and 90 percent of foreign exchange trading are in U.S. dollars. Dollar denominated debt of non-financial institutions was three quarters of the $16 trillion of debt incurred outside the U.S.
The interest cost of U.S. national debt is lower than it seems. Of the $25.7 trillion in outstanding national debt, the Fed owns approximately $8 trillion, and U.S. government agencies own about $5 trillion. The Fed remits all the interest it collects on its Treasury bonds, net of its nominal carrying costs, back to the Treasury, and the U.S. agencies pay all their interest to themselves, which is the same as paying it to the government.
Although COVID-19 has wreaked heavy damage to the U.S. economy, investors are unlikely to worry that the U.S. will default on its debt. The U.S. economy will remain strong in comparison to the rest of the world, and the Fed can always print enough dollars to pay our debt.
Printing money, whether to pay off debt or to contain the pandemic’s damage to the economy, is unlikely to stoke inflation in the foreseeable future. The lockdown and consumer caution have boosted the personal savings rate to a record 33 percent and slowed consumer spending, which typically accounts for two-thirds of the economy. Inflation eased sharply in March, is projected to hit an all-time low by the end of 2020, and to rebound to a reasonable 2.4 percent by the end of 2021.
Inflation should continue to be benign until government stimulus reaches its goal of the economy approaching its full potential. How long that will take depends on so many variables that it’s hard to predict. Bloomberg, noting improvement in many of them, predicts an earlier recovery than some economists, who say it will be “a very, very lengthy process.”
Eventually, when confidence returns, so will inflation. A recovery will unleash massive spending from the record accumulation of consumer savings. Lending will also spike as companies depleted of capital from the pandemic will need loans and banks will chomp at the bit to provide them. Consumer spending and bank lending will boost the money supply and put upward pressure on inflation.
The question then is whether the Fed can stem inflation by mopping up excess dollars from the money supply by selling securities off its balance sheet, raising interest rates on excess bank reserves and raising reserve requirements.
This could prove difficult, because the Treasury will need to issue trillions of dollars’ worth of government bonds to fund the deficit from the COVID-19 rescue. Inflation will also risk creating an asset bubble as investments with higher interest rates offer investors alternatives to stocks. And in an inflationary environment the Treasury will need to finance an abundance of short-term debt at higher rates, sending the deficit and interest costs higher.
These may be legitimate concerns. But as Fed Chairman Powell pointed out, these risks pale in comparison to the risks of not spending whatever is necessary to contain the economic damage we’re experiencing now — and possibly worse damage if an increase in COVID-19 cases shuts us down again.
Neil Baron advised the SEC and congressional staff on rating agency reform. He represented Standard & Poor’s from 1968 to 1989, was vice chairman and general counsel of Fitch Ratings from 1989 to 1998. He also served on the board of Assured Guaranty for a decade.