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BFI Perspectives 

Debt at World War II Levels

As governments around the world increase their spending in order to support their economies and battle the impact of their lockdown measures in response to the new coronavirus, public debt has risen to levels, relative to GDP, not seen since the end of World War II. The general consensus is that debt and deficits are no problem for advanced economies, as long as interest rates can be artificially kept at extremely low levels.


According to the International Monetary Fund, among advanced economies debt rose to 128% of global gross domestic product as of July, surpassing its 1946 high of 124%.

The consensus amongst most economists is, however, that advanced economies should not worry about mounting debt. Just like in WWII, there is a more important war to win. According to an August 23 article published by the Wall Street Journal, Mr. Hubbard, dean emeritus of Columbia University’s Graduate School of Business, said this: “The war analogy is exactly the right one. We were and are fighting a war. It’s a virus, not a foreign power, but the level of spending isn’t a problem.”


So, first of all, equating the Second World War with the coronavirus pandemic seems, in our view, like a slight exaggeration, to say the least. But even if we accept that these crises are comparable, the central claim that “debt is not a problem” now as it wasn’t then either, is still highly questionable and egregiously ahistorical.


Government Debt as Percentage of GDP, Compared to WWII Debt

--> Source: International Monetary Fund (IMF), Wall Street Journal


After World War II, advanced economies were able to bring down debt quickly, thanks in large part to rapid economic growth. The ratio of debt to GDP fell by more than half, to less than 50%, by 1959. We wonder whether we can expect that same kind of “luck” this time around. Is it likely that it might be a little more difficult this time, given very different demographics, slower growth, and a variety of financial bubbles created by a decade of increasingly extreme quantitative easing?


Additionally, are we not coming to the end of a credit and business cycle, and the end of a secular period of wealth and peace, whereas in 1945 the world stood on the brink of a new age of optimism and rebuilding? The whole psyche and resilience of Western society looks very different today than it did 75 years ago...

Governments can inflate their way out of debt, but that has consequences, doesn't it? ~ Kent Conrad

The quote above is from Kent Conrad, a Democrat senator in the 80s. Obviously, Democrats were very different back then too. We doubt that Mr. Conrad would have considered today’s deficit spending an irrelevant matter posing no problems whatsoever. Today, even most Republicans appear to see no problem in “stimulus spending” without limitation.


In the optimistic era after the war, birth rates boomed, leading to gains in household formation and growing workforces. Circumstances were ripe to reap the benefits of electrification, suburbanization, and improved medicine. Through the late 1950s, economies soared. Growth averaged around 5% a year in France and Canada, almost 6% in Italy and more than 8% in Germany and Japan. The U.S. economy grew almost 4% a year.


Rapid economic growth and lower military spending in the post-war years made it easy to reduce debt. In the U.S., federal outlays fell by more than half between 1945 and 1947, not accounting for the effects of growth or inflation. We are clearly in a very different place today and we very much doubt that the mountain of debt we are watching grow before us is irrelevant.


Real GDP Growth, five-year moving average

One of the common features in both periods is the low level of interest rates. The Federal Reserve kept borrowing costs low in order to reduce the costs of public financing, i.e. to remain solvent. That is very similar to what we see today. Against a backdrop of low growth, a damaged labor market and low inflation, most central bankers will view an extended period of ultra -low rates as appropriate, if not as the only option available.


Therefore, it is reasonable to expect advanced economies to end up accepting much higher debt levels than we already have today. It is a typical “kicking the can down the road” scenario.


Source: Penn World Tables via St. Louis Fed, Wall Street Journal


How will governments deal with this debt crisis and what are the tools available to them to reduce debt? The answers to these questions have considerable implications for investors, and those who want to protect their wealth in general. There are five available pathways, in theory:

  • Growth

  • Financial Repression

  • Inflation

  • Austerity

  • Default

We will be publishing a Special Report with a much deeper analysis of this issue soon, but our conclusion is quite simple and straight-forward: financial repression and inflation will be the ultimate way out of debt. And, while this insidious process of debt reduction will be long and very slow, it makes a lot of sense to start preparing for this “new era” now.


The WSJ article mentioned earlier ends with a quote by Mr. Sheets, who formerly headed the Fed’s international finance division: “My expectation is central banks will be successful, but it does pose challenges. Whenever you’re in such unfamiliar terrain, there’s always the risk of something possibly going wrong. It is a generational question that we’ll struggle with for some time to come.”


We agree and think we should all heed these very prudent words!

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