The investment community is divided down the middle into a deflation camp and an inflation camp. From a high level, both parties agree on much of the same issues, such as the negative consequences of overusing debt capital to sustain economic growth. The two parties, deflation and inflation, don’t even necessarily disagree on the ultimate end game. The next several years, however, are still up for debate.

A very similar phenomenon is unfolding in nearly all developed economies. An overuse of debt capital for unproductive projects and initiatives has rendered all major economies impotent in terms of the ability to generate real economic growth without borrowing something in the range of $5 of debt for $1 of growth. Clearly unsustainable.

Our focus will be mostly on the US economy in this note, although a similar process and potential outcomes are available to most developed nations.

To summarize briefly, the US economy came into the COVID crisis with public and private debt to GDP near 370%. The ratio was near 260% if we exclude the foreign and financial sectors. In order to ease the pain of the COVID crisis, as an economy, we borrowed an extreme amount of money to keep failing businesses and households afloat. These actions, while necessary, pushed nonfinancial debt to GDP above 270% and well beyond all critical thresholds studied and deemed to cause negative impacts on the economy.

With the Federal Reserve pushing overnight interest rates to 0% and signaling that rates will virtually never rise, we have exhausted much of the impact monetary policy has to offer. The Federal Reserve will continue to expand various credit and liquidity facilities. Still, without the ability to print money or absorb losses from defaulting assets, the Federal Reserve is limited in its effectiveness to stimulate economic growth or inflation.

The Federal Reserve has winked at Congress, suggesting the Fed is limited in its capabilities.

Our current situation presents three possible paths to take, each one outlined below.

First, fiscal stimulus can remain tied up in Congress, and ultimately, we let corporations and households default. Both camps agree this path is deflationary. The Federal Reserve cannot print cash flows and cannot save assets that are in/will be in technical default.

Second, we can change the Federal Reserve Act to specifically allow the Fed to spend money and/or absorb losses rather than limit their power to lending only. Both camps agree this would be wildly inflationary.

The third path, the most likely path, is where the disagreement comes to the surface. Although we know that excessive uses of debt capital created the current situation, it is possible the government can embark on radical fiscal policy and universal basic income. This will prevent technical defaults at the household level and potentially at the business level. To facilitate this policy, the Treasury will issue trillions of dollars of new debt, virtually in perpetuity. This process has to be perpetual because a deflationary crisis will emerge as soon as income levels collapse with the removal of government stimulus. The inflation camp says this fiscal spending will be inflationary. In contrast, the deflationary camp thinks the massive government intervention will crowd out private investment and lead to an unproductive society that will undermine the standard of living and lead to deflation.

We will tackle each part in some detail, as objectively as possible, after starting with some remarks about the current debt overhang.

Current Situation

In the most recent [Quarterly Webcast] presentation, released to members of EPB Macro Research, we looked at the level of debt to GDP for the three main nonfinancial sectors of the economy: household, business, and government.

With the context of the study from the BIS paper, “The Real Effects of Debt,” we have various thresholds for each sector of the economy in terms of when debt to GDP starts to have negative impacts.

Each sector is slightly different in terms of the threshold, but at roughly 85%-95% debt to GDP. Cumulatively, when nonfinancial debt exceeds 260% of GDP, growth starts to suffer.

Total Nonfinancial Debt to GDP Ratio:

Source: Z.1 Financial Accounts, BEA, EPB Macro Research

With businesses and households overindebted, banks are unwilling to lend, and consumers are less willing to borrow.

After the COVID crisis, total nonfinancial debt to GDP will push towards 300%, resulting from an increase in the numerator (debt) and a decrease in the denominator [GDP].

After GDP normalizes, the ratio will come down slightly but remain well above the critical 260% threshold.

The US economy will not be able to grow with these levels of debt as private investment will decline and reduce productivity growth.

A deleveraging must occur, but that is strongly deflationary, something that the Fed and Congress are trying to avoid with insufficient tools.

On a seasonally adjusted annualized basis, gross domestic income fell by roughly $2.2 trillion since Q4 2019.

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Gross National Income:

Source: BEA, FRED

Historically, a multi-trillion dollar income hole leads to defaults.

However, due to the first COVID relief bill, personal income surged during the pandemic, which allowed households to cover expenses during a time when income was reduced.

It is hard to overstate the significance of the rise in personal income and the impact on consumption and reduction in defaults.

The stimulus that boosted income, namely enhanced unemployment and one-time cash payments, has now rolled off, and the coming months will likely show a decline in total personal income.

Personal Income:

Source: BEA, FRED

With millions of Americans still without work, the risk of defaults and delinquencies rises without more fiscal aid.

The fiscal aid, however, is not without consequence, as we’ll cover in section three of this note.

Real economic growth has suffered, and estimates suggest trend growth could slump as low as 1% per capita in real terms for the next several years.

The yield curve is reluctant to steepen meaningfully, which limits bank lending, on top of reduced incomes and uncertain fiscal aid.

Historically, after recessions, the spread between 10-year rates and 3-month rates widens greater than 200bps. Today, we are stuck around 60bps, which questions the ability for a lending cycle and more sustained inflationary pressure.

Yield Curve (10-Year Minus 3-Month Rate):

Source: Bloomberg

Looking at total bank loans and nonfinancial commercial paper, we see a large jump in the middle of the crisis, which came mostly from corporations drawing down credit lines to build a war chest of cash and also from Paycheck Protection Loans, backed by the government.

This surge in loan growth came with an accompanying rise in money supply growth.

As capital markets opened up and credit lines were paid down, loan growth started to decline, now sitting at -13% on a 3-month annualized basis.

Total Bank Loans + Nonfinancial Commercial Paper, 3-Month Annualized Change (%):

Source: Federal Reserve, EPB Macro Research

While the rise we recently witnessed was larger than normal, a recessionary spike is not uncommon. A similar situation was seen in the middle of the 2008 crisis, with bank lending jumping 20% annualized before cooling into negative territory for over a year.

Total Bank Loans + Nonfinancial Commercial Paper, 3-Month Annualized Change (%):

Source: Federal Reserve, EPB Macro Research

Because the economy failed to deleverage after 2008, loan growth never increased to the level of the prior economic cycle.

From 2001 through 2007, total loans + nonfinancial commercial paper increased 8.7% annualized. The same metric only rose 3.8% from 2009 to 2020.

Total Bank Loans + Nonfinancial Commercial Paper: Annualized Change (%):

Source: Federal Reserve, EPB Macro Research

As we sit here today, with a flat yield curve and a highly indebted economy, loan growth is unlikely to pick up materially and will continue to decline. If loan growth falls short of the 3.8% rate seen from 2009-2020, then we’ll see even lower rates of inflation and economic growth.

The Federal Reserve can create bank reserves, but they cannot create cash flows nor force a new loan agreement.

The economy is at a crossroads. If government spending even just returns to the bloated pre-COVID levels of 20% of GDP, personal income will decline, defaults will rise, and loan growth will prove even more scare against less creditworthy borrowers.

Fiscal spending to prevent household and small business defaults will help in the immediate term but will cost the economy trend growth in the long-term. Below we’ll outline the three paths forward and what the implications of each path will be.

(1) Limited Fiscal Spending, Let People Default – Deflationary

The first potential path forward is slowly tapering fiscal spending to pre-COVID levels. Government transfer payments averaged about 17% of total income before the pandemic and surged to 30% during the peak of the stimulus efforts.

For context, since January 1st of this year, total personal income increased about $1 trillion on a seasonally adjusted annualized rate (SAAR). Government transfer payments, however, jumped $1.7 trillion SAAR.

For reference, total personal income increased $228 billion (SAAR) from January 2019 through July 2019.

Change In Total Personal Income & Transfer Payments (Billions):

Source: FRED, BEA, EPB Macro Research

Without the increased transfer payments, personal income would have declined in the aggregate, which raises the probability of evictions, defaults, and foreclosures.

Transfer payments as a % of total income increased from about 17% to 30% and are starting to taper off, down to 25% as of the July figures.

Without another spending bill from Congress, transfer payments will likely fall near the pre-COVID levels, around 20%, which will translate to a likely decline in total personal income.

Transfer Payments As A % of Total Income:

Source: FRED, BEA

The economy remains more than 11.5 million jobs shy of the 2020 peak.

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Loan growth, in aggregate, will not be able to exceed prior cycles with millions out of work.

Job Losses From 5-Year Max In Employment:

Source: Bloomberg, BLS, EPB Macro Research

Aside from government transfer income, real personal income excluding transfer payments is in a worsening trend as well, only increasing 0.9% over the last five years.

While government transfer payments have increased from about 5% of income in the 1960s to over 20% today, real personal income growth has fallen from a trend level of 2.3% to 1.5%.

Real Personal Income Ex. Transfer Payments:

Source: FRED, BEA, EPB Macro Research

If government spending returns to pre-COVID levels, total personal income will likely decline in the aggregate, which will lead to more defaults and tighter lending conditions. This is a deflationary outcome agreed upon by nearly all sides.

(2) Change The Federal Reserve Act – Inflationary

Under current rules, the Federal Reserve cannot solve a deflationary spiral, particularly when short-term rates are already pinned at 0%. The Federal Reserve cannot print legal tender nor absorb losses from failing assets.

The corporate bond facilities have equity investments from the Treasury (taxpayer), which will absorb losses from any failing bonds purchased by the credit facilities.

Quantitative Easing “QE” can create a first-round increase in the money supply if the Fed purchases a bond from a non-bank entity, using the primary dealers as an intermediary, but unless loan growth follows, a multiplication effect will not occur.

If a deflationary spiral begins, led by consumer defaults from a lack of income, the Federal Reserve will struggle to alleviate the problem without the ability to absorb losses from bad assets. The losses must accrue to someone, and right now, it cannot be the Federal Reserve.

As conditions become more dire and real income growth starts to decline for a majority of the population, more radical ideas become possible. There is not a long track record of countries successfully using the Central Bank to print money or absorb losses, but there are serious proposals that recommend such a change.

Any policy that allows the Federal Reserve to create spendable dollars without an accompanying increase in Federal debt, or allows the Federal Reserve to absorb losses from failing asset shifts the balance of risk hugely in favor of inflation.

This path doesn’t appear to be an imminent risk, but any new policy measure that is implemented or discussed must be looked at carefully, differentiating between spending powers and lending powers granted to the Fed.

(3) Massive Fiscal Spending – Undecided

The third path, which appears to be a consensus opinion despite the current gridlock in Congress, is for more massive fiscal spending to continue.

Continued and accelerated deficit spending is widely acknowledged to continue, yet the impact, inflation or deflation, is still in debate.

The inflation crowd argues that large fiscal transfer payments can shift the burden of debt from households to the government by sending household checks to clear their existing debt load.

The debt will grow massively at the Federal level and hopefully shrink at the household level.

The Federal Reserve will “buy” all the new Treasury debt, and banks will start to lend again against a clean consumer balance sheet.

This may be possible, but the current evidence argues the contrary.

Large scale QE, as we have learned over the last ten years, did not generate a boost in lending nor inflation.

Further, strong research argues that increases in government spending result in weaker rates of GDP growth over the long run.

A 2011 working paper titled “Government Size and Growth: A Survey and Interpretation of the Evidence” concluded that “the most recent studies find a significant negative correlation: An increase in government size by 10 percentage points is associated with a 0.5 to 1 percent lower annual growth rate.”

Government Size and Growth: A Survey and Interpretation of the Evidence:

Source: Research Institute of Industrial Economics

Prior to COVID, Federal outlays hovered in the range of 15%-20% of total GDP. Due to the massive pandemic related spending, outlays reached 45% of a diminished Q2 GDP.

Government Spending As A % Of GDP:

Source: FRED, BEA, Treasury Department

Increasing government spending is not new, however, which begs the question as to why continuing on the same path will provide results that deviate from the current research.

Transfer payments have increased from 5% to more than 15% of total income prior to COVID.

The 10% increase in government spending, according to the research, should have an adverse impact on growth.

Transfer Payments As A % of Total Income:

Source: FRED, BEA

We know the trend rate of real GDP has been declining, and analyzing real disposable income growth per capita, excluding transfer payments, shows a decline in trend from 2.3% to 1.5%, in line with the research.

Real Disposable Income Per Capita Ex Transfer Payments, Growth Rate (%):

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Source: FRED, BEA, EPB Macro Research

Furthermore, increasing government spending from 5% of income to 25% of income today has not resulted in higher inflation expectations. In fact, lower inflation expectations have prevailed.

Permanently increasing government spending from 15% of income to 25% of income or higher will more than likely reveal the same negative multiplier concluded in the most recent research about government spending.

5Y5Y Forward Breakeven (%):

Source: FRED, BEA, EPB Macro Research

The results are nuanced, and tax structures create varying impacts on the multiplier of government spending. Another conclusion from the 2011 research paper is that government spending on social transfer payments has a more negative multiplier than spending on investment or infrastructure.

At debt levels greater than 125% of GDP at the government level, any kind of government spending is likely to carry a negative multiplier, reducing private spending by more than the amount of government spending.

The current plan to increase transfer payments is likely to result in a negative government multiplier that is towards the high end of the 0.5% to 1.0% range outlined by Bergh and Henrekson.

Government Size and Growth: A Survey and Interpretation of the Evidence:

Source: Research Institute of Industrial Economics

Increasing government spending from 5% of total income to 17% of total income did not have positive impacts on real disposable income growth per capita, nor did it help the household sector deleverage.

It remains unclear why doubling down on a similar policy will produce materially different results.

The third path, increasing fiscal spending, is likely to stabilize conditions in the short-run and prevent a sharper, more severe deflationary “event.” Over the longer-term, adding more Federal debt for uses that do not provide an income stream will result in weaker levels of private sector income growth.

Private domestic investment will suffer as the demand for financial capital is dominated by the government sector, and the country has insufficient savings to supply capital to both the government and private domestic investment.

Pursing path number three and abusing government budget deficits will lead to a slower grind down to weaker conditions, and will ultimately make option number two the most probable end game.

Real Per Capita GDP Growth: 10-Year Annualized Rate:

Source: Bloomberg, BEA, EPB Macro Research

Option two is not immediately on the table, but runaway inflation is the less likely outcome from paths one and three.

The current body of evidence does not suggest increasing government spending through budget deficits will generate sustained inflation.


The global economy has moved into a new domain. Total debt has now exceeded most critical thresholds that imply negative impacts from the debt burden.

Monetary policy has exhausted its potential with overnight rates at 0% and the ability to generate inflation limited by the current laws.

Fiscal spending appears to be the only option left, but the best available research argues the negative multiplier will stabilize the situation in the short-run at the expense of an even weaker rate of trend growth in the future.

The three possible outcomes are either reducing government spending and allowing defaults, a deflationary situation. As a country, we can change the Federal Reserve Act or allow the Fed to absorb losses from bad loans, an inflationary situation. Lastly, we can double down on the policies of the past and increase government spending from 5% of income to 25% of income and perhaps even greater in an attempt to generate lending and inflation.

You can handicap options one, two, or three in any way you feel is correct.

Option three has an inflation camp and a deflationary camp.

Based on the best available data, without option two firmly on the table, the most probable outcome continues to be a disinflationary path to lower bond yields that press near 0% over the medium to long-term.

In the meantime, we’ll have to watch all policy proposals for key information and balance the ongoing pent-up demand rebound in the industrial side of the economy.

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