The U.S. look, not just ill, but broke. To offset the COVID-induced Great Cessation, the Federal Reserve and Congress have pumped in staggering sums of stimulus, fearing that the economy would otherwise sink like a dense dumpling in a bucket of broth at a 1930s soup kitchen. The 2020 budget deficit will hit about 18 percent of GDP, and the ratio of debt to GDP is hurdling over the 100 percent mark, numbers not seen since Franklin Roosevelt was photographed with a cigarette holder jauntily protruding from his patrician lips.
Assuming we eventually defeat COVID and do not devolve into a dystopic Terminator scene that would bring Arnold Schwarzenegger out of retirement, how will we avoid the fiscal cliff and national bankruptcy? To answer these questions, we should grasp some lessons from the World War II era. That war did not bankrupt the U.S., and even though the debt-to-GDP ratio soared to 119 percent, by the time of the Vietnam War, that ratio had slid to just above 40 percent.
The War was financed with a blend of roughly 40 percent taxes and 60 percent debt. Buyers of debt received a measly return. The Federal Reserve joined the war effort by intervening in markets to keep one-year paper at 3/8 of a percent, compared to the prevailing 2-4 percent peacetime rates. Ten-year notes yielded just 2 percent. Of course, in 2020 those rates sound downright lofty!
Who bought U.S. bonds, the majority of which were denominated in small notes of $25 or less? American citizens, many from a sense of patriotism as they planted Victory Gardens and saluted posters depicting young soldiers hurling grenades across enemy lines. Federal Reserve Board employees got into the act, too, and competed to see which offices could buy more bonds. In April 1943, New York Fed employees snapped up over $87,000 worth of bonds and were told that their purchases enabled the Army to buy a 105mm howitzer and a Mustang fighter-bomber plane. The Army sent the New York Fed a letter and photograph, displaying the aircraft with the name “N.Y. Federalist” painted on the side. The plane flew across the English Channel to battle the Luftwaffe over France and Germany.
Patriotism aside, many Americans snapped up the bonds from the sheer lack of other good choices. Until banking deregulation in the 1980s, federal laws prevented banks from offering high rates to savers. And the thought of swapping American dollars for higher-yielding foreign assets seemed ludicrous and likely to lure J. Edgar Hoover’s team to stomp down your door. While the U.S. equity market was open to investors (the Dow Jones Industrial Average actually rallied after 1942), broker commissions were hefty and only about 2 percent of American families dared to own stocks. Stock investing seemed best-suited for Park Avenue swells, or for amnesiacs who forgot the 1929 crash. In contrast, today a majority of American families participate in equities.
In sum, during World War II the savings of American families were locked in their home country and locked into bonds. Treasury paper bore three things: a paltry yield, a distant maturity, and the stern-looking photo of a former president.
But how did the monumental war debt get resolved? Three factors stand out. First, the U.S. economy sped along quickly. From the late 1940s to the late 1950s the economy averaged a 3.75 percent growth pace, which shunted massive revenue flows into the Treasury. During this period U.S. manufacturers faced few international competitors. Germany and Japan’s fearsome factories had been pounded to rubble, and China’s primitive foundries could turn out little paper umbrellas for poolside, suburban Mai Tai parties, but not automobiles and home appliances. Second, inflation took off after the war, as prices were released from government captivity. From March 1946 to March 1947 prices jumped 20 percent. This was not a result of reckless monetary hanky-panky. This was merely allowing prices to reflect the true cost of doing business. But because government bonds paid so much less than the 76 percent rise in prices between 1941 and 1951, government debt obligations decayed.
A third force came from locking in borrowing rates for a long time. The average duration of debt in 1947 was over ten years, about twice today’s average duration. By the end of the Eisenhower era, the combination of these three factors pushed down the debt-to-GDP ratio to about 50 percent.
So what should we do today? The U.S. Treasury should give tomorrow’s children a break by issuing 50 and 100-year bonds, locking in today’s puny rates for a lifetime. You might think that no one would trust that a government would be around in 50 or 100 years. But corporations have successfully auctioned long-term bonds. Disney issued "Sleeping Beauty" bonds and the market scooped them up. Norfolk Southern enjoyed a similar reception when the railroad issued 100-year bonds. Imagine, buying 100-year bonds from a railroad. Will rails even exist in the twenty-second century? Dozens of other companies, including Coca-Cola, IBM, Federal Express, and Ford have also issued 100-year debt.
Though they may be compromised by COVID, institutions of learning—including the University of Pennsylvania, Ohio State, and Yale have also issued 100-year bonds. In 2010, buyers even grabbed Mexico's 100-year bonds, despite a pock-marked history of devaluations that stretch from 1827 to 1994. More recently, Ireland, Austria, and Belgium have issued 100-year bonds. The average maturity of UK debt is three times longer than U.S. debt.
Longer duration will not be enough to solve the debt problem, of course; we must also reform retirement programs, though that discussion is for another day.
Finally, I must mention the inflation strategy. Should we ignite inflation and launch prices into the stratosphere to shrink debt? I don’t think so. Investors no longer represent a captive audience as they did in the 1940s, and “bond vigilantes” will sniff out a devaluation scheme in advance, driving interest rates higher and punishing the value of the dollar and the buying power of citizens. Of course, if the Fed were to take the dangerous, inflationary tack, it would be a lovely time for holders and hoarders of gold and cryptocurrencies.
Unlike military campaigns, the war against COVID will not end with a bombing raid, a treaty, or a sailor and nurse smooching in Times Square. Regardless of the final image, COVID will leave us with a debt time bomb. We can defuse it, but only if we can also win the battle against policy inertia and policy stupidity. This war won’t end in a bang -- but it better not end in a bankruptcy.
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