Averting a Depression and Your Cheques for Free

Averting a Depression and Your Cheques for Free

We’ve written at length of late about the crucial role that fiscal and monetary policy will play in helping the global economy recover, and avoid a repeat of the Great Depression. With the size of the cheques being written (in the trillions, particularly in the US), many people rightly ask:

Can governments afford to fund these massive programs? And if central banks are printing money at this unprecedented rate, won’t we get massive inflation and/or currency collapse? Surely there is a limit?

All good questions. We’ll try to address them below, with a focus on the US. A warning: you may be surprised by what you learn.

Why This Won’t be a ’30s-Style Depression

The key difference between the Great Depression and today is the size and role of government. In the 1930s, total government expenditures were only 12% of the economy. Keep in mind, we didn’t have unemployment insurance (1932), banking insurance (1933), or Social Security (1935). And importantly, we didn’t have central banks and federal governments willing – as they are today – to do whatever is necessary to avert a recession. For this year, prior to the stimulus packages recently enacted in response to the current crisis, total US government spending was expected to be close to 40% of GDP. These tools of fiscal policy (government funding of economic and social programs) are further augmented with monetary policy (mainly setting of short-term interest rates and management of the money supply).

Monetary Policy I: Cutting Interest Rates

Cutting rates is the first way the Fed can help promote risk-taking when the economic outlook sours – by lowering financing costs for businesses and individuals. If you look back at the inception of the Great Depression, the US Federal Reserve (Fed) actually began tightening monetary policy (hiking interest rates) in 1928. Their mistake (outlined in this morbidly fascinating San Francisco Fed paper written in March 1999) was keeping rates high – peaking at an effective rate of 6% – right through 1930, well after the stock market had crashed and the recession had dug in.

As current fixed income investors are all too aware, such is not the case today. Central banks globally initiated multiple rounds of aggressive cuts in March from an already-low base, taking interest rates in many developed economies within spitting distance of zero – while the signs of a recession were just beginning to materialize.

Monetary Policy II: Generous Quantitative Easing

Another tool in the central bank toolkit is quantitative easing (QE), which could be compared (perhaps unkindly) to a modern form of alchemy. Essentially, QE involves central banks printing new money, and using the money to buy assets to support the economy. Traditionally, that means buying back government bonds – the intended effect being to push down interest rates, keeping longer-term borrowing costs accessible for businesses. (Following the Great Financial Crisis, central banks have become more creative in where they’ve lent money, to target the areas of credit weakness in the capital markets.) QE plays a very important role in the current crisis, as it provides governments with a means of effectively eliminating the new debt they’re creating to fund their massive fiscal spending programs. More on that below.

Fiscal Policy

Another key contributor to the breadth and length of the Great Depression was the US government’s approach to fiscal policy. Back then, rather than injecting money into the economy to help businesses retain workers and workers to continue supporting the rest of the economy, governments tightened the purse strings. This caused a seizing of various interdependent industries and a general downward spiral of the economy as a whole.

By comparison, today the US government has earmarked upward of $2.4 trillion of fiscal stimulus to support businesses and promote employment. When combined with efforts from the Federal Reserve, which include the purchase of $2 trillion of credit instruments, the total commitment tops $6 trillion.

Such a massive stimulus program sounds like an appropriate response, but does that mean the US will then struggle under a massive debt burden for generations to come? And wasn’t it already highly indebted coming into the crisis?

The Sustainability of Policy Responses

In fact, both Canada and the US came into this crisis with sustainable government debt levels, which gives both countries the ability to respond to this crisis and smooth the impact from the economic dislocation. The question then turns to the size and sustainability of the response. In our view, while fiscal stimulus is not endless, it has a much longer runway for sustainability than many consider.

At a high level, it helps to think of debt sustainability as being the relationship between economic growth (measured by nominal GDP, which includes inflation) and interest rates: if your revenue from taxes (a function of economic growth) is growing faster than your expenses from debt service, you’re able to manage through growth. As such, the Fed will need to maintain real rates of interest below real rates of growth for long enough to earn out of the debt burden. This can be done by getting the right mix of inflation, debt growth, real income growth, and importantly, real re-investment in the domestic economy. That last one ideally means maintaining an environment that is attractive to capital re-investment through fiscal policy initiatives such as tax policy and direct resource commitments.

With interest rates less than 1%, you only need the combination of inflation and real economic activity to be above 1% for the medium term to be sustainable.

But what could shorten that runway? There are two key risks to maintaining this balance: significantly higher interest rates in the future, or a weaker currency which then leads to inflation. Neither of these are material in our view.

On Higher Interest Rates

The risk of higher interest rates has been somewhat mitigated by aggressive central bank buying. You’ll recall from the QE discussion that when a central bank goes into the market to buy up government bonds, those bonds are removed from circulation. In practice, once the Fed has the government bonds on their books, they essentially retire them and no longer require further payment. Since the US Federal Reserve is currently buying nearly as many bonds as the government is issuing, the effect is to nearly wipe out all net issuance. As Figure 1 shows, the same process is occurring across many developed economies, many of which are expected to see net issuance actually declining.



So while President Trump decided to sign his own name to the stimulus cheques being sent to in-need Americans, the appropriate signature is that of Federal Reserve Chairman Jerome Powell.

But wait, you may say, countries can’t just print money without consequences. Won’t you undermine the currency by expanding the money supply so much? Generate inflation?

On Currency Devaluation

A key point to remember with currencies is that they are always quoted relative to another country. There is no singular value of “the US dollar”; it is USD/CAD, USD/EUR, USD/JPY, and so forth. When every country is simultaneously undertaking the same money supply expansion, it has the effect of balancing out for period of time. In addition, for the US dollar in particular, its role as reserve currency globally gives it additional runway. 

There are a few risks to this model to keep in mind, however. Aligning interventions across countries such that the magnitude impacts all currency pairs in an equal way is not easy (and not currently being overtly coordinated). Also, currencies reflect productivity differences between countries, and with borders closed, there will likely be a divergence between the recoveries of different economies. Finally, this conclusion may not hold for emerging market economies. In fact, those countries with significant foreign borrowing from either governments or corporations are facing significant risk if they try similar measures. 

On Inflation

What about inflation? Yes, we should theoretically see some inflation as a by-product of this approach, but with a lag. We would argue, however, that stronger inflation is actually not a bad thing at this point, as it further reduces a chance of the deflation that gripped the Great Depression. If anything, the economic recovery relies on policy makers maintaining a reasonable level of inflation (as well as debt growth) to ensure the mix stays positive. Propping up asset values is actually consistent with both inflation (which is asset inflation) as well as debt growth (it serves as the collateral to support the debt).  The alternative, declining asset values, sparks the reverse effect - debt liquidation and deflation.

Starting from a point where the market is anticipating less than 1% inflation over the next 30 years, there is room for it to grow without having a negative impact on the health of the economy. 

Too Good to be True? The Risks.

We’ve laid out how US monetary policy has the potential to act as a sort of magic wand on government borrowing. The strategy is not, however, riskless. One of the key risks the US faces is that a larger role of government, reduced immigration, reduced globalization, and reduced productivity may lead to lower growth – which we know is crucial to the economy ‘earning its way out’ of the stimulus. Lower real interest rates mean continued expectations for anemic income from bond portfolios, and governments will have less flexibility in addressing future shocks. We may also see cuts in entitlement programs down the line and additional tax measures – possibly higher income taxes, wealth taxes, and/or a value-added sales tax.

Another criticism of the approach is that capitalism needs capital destruction sometimes, even when it’s painful. Japan provided corporate bailouts and very low interest rates in the 1980s and 1990s and ended up locked in a cycle of stagnant growth and price deflation.


With all that said, in the medium-term, the dynamics described above should permit the US government to absorb the economic losses inflicted by COVID-19 without burying itself in debt. This is not the Great Depression, but a global recession that will be smoothed by aggressive fiscal and monetary stimulus . It’s going to be a long and arduous work-out period, the costs both human and financial will be large, and governments will need to be vigilant to avoid stalling growth or causing deflation. But as miraculous as it sounds, through quantitative easing, government debt won’t explode, burdening future generations. There is a way through this; it will just take time.