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Mechanics of Debt and Policy Levers
The limit of borrowing is defined by the amount of accumulated capital; we simply can't borrow something that doesn't exist. Often, however, the borrowing limit is defined by our ability to service the debt, a function of the outstanding debt and the interest rate on borrowing. The potential for mounting debt to suddenly drive up interest rates tends to further complicate matters. To deal with this debt problem, policymakers can choose any combination of the levers within their control, depending on the situation.
Lessons from history: policy likely to drift toward inflationary options
Historical data shows us that when limited in their ability to implement fiscal austerity or to boost real growth, policymakers will target higher nominal GDP and likely drift toward more inflationary policy options. Overall, high-debt countries struggled with slow growth and often used inflation to reduce the debt levels. History has provided several lessons about managing high debt in the decade after hitting this high-debt level:
- Slow real GDP growth was the norm
- Fiscal austerity was not a key swing factor
- Higher inflation was the pivotal factor
- Successful debt consolidation often involved multiple tools
Median Values During the Decade After Hitting High Debt Levels
Source: IMF working paper "A Modern History of Fiscal Prudence and Profligacy," by Paolo Mauro, Rafael Romeu, Ariel Binder, and Asad Zaman (2013), DMS, Fidelity Investments (AART), as of 3/31/20.
Past accommodative policies failed to reach their goals
Over the last decade, initially successful monetary and fiscal policies have failed to increase inflation or GDP growth rates and have exacerbated negative distribution effects. Alongside fiscal and monetary policies that were not always in sync, some of the unintended consequences included higher household savings rates and impaired bank profitability. Today, many mainstream proposals call for more structured monetary-fiscal policy coordination, and they are ultimately about putting money directly in the hands of spenders, rather than of buyers of financial assets.
Wealthy Individuals and Corporations Take a Greater Share of Wealth and GDP
Data represented as 5-year moving averages. Source: Bureau of Economic Analysis, World Inequality Database, Fidelity Investments (AART) as of 12/31/18.
Policymakers will try even harder to hit their goals
Even beyond the COVID-19 recession, policies will likely still be inadequate. There's the same sense that monetary and fiscal policies are accommodative but not effective in reaching growth, inflation, and distribution targets.
Nominal GDP and inflation expectations could be boosted through policies centered on redistribution, spending, and industrial policies as well as inflation anchoring.
Descriptions of Redistribution, Industrial, and Inflation-Anchoring Policies
Source: Fidelity Investments (AART), as of 5/31/20.
Bolder policies and different circumstances would be more inflationary than in the recent past
To date, the Fed's actions generally fit into financial repression, quantitative easing, and lending to non-government borrowers. But one thing these actions have not done was create higher inflation. For policymakers, the risk of accidentally creating too much inflation or anchoring inflation expectations is risky. In addition, there's a risk of destabilizing currency markets if major central banks fail to achieve sufficient coordination in their interventions.
If the trend toward greater fiscal and monetary experimentation continues in this direction, rising inflation and inflationary expectations are likely. The real question is, to what degree?
Unsustainable Global Debt:
Roadmap for Strategic Asset Allocation
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- Diversification and asset allocation do not ensure a profit or guarantee against loss.