US National Debt Sustainability | Mohamed El-Erian Analysis

[00:00:00][Music] welcome to the Lauder Institute at the University of Pennsylvania I'm Jules van binsbergen director of The Institute and a finance professor at the Wharton School and I'm Jonathan bur a finance professor at The Graduate School of Business at Stanford University this is the all else equal podcast [Music] welcome back everybody welcome to the new season of all El sequel we have some news to share with our audience Jules why don't you start and tell us the new position you've taken thank you Jonathan since July 1 I'm the new director of the ler Institute which is an Institute at the University of Pennsylvania that offers students a joint degree program an MBA from the Wharton School as well as an MA degree in international studies and so it brings together two key areas that train students to be Global Business Leaders as well as Global political leaders we're really training laud students to be diplomats in the broadest sense of the word and I think those skills are in very high demand particularly in the current day and age and also Jules the Lord is to have stepped up to the plat and sponsored or else equal and I think it's a great partnership because the concepts we speak about are absolutely applicable for Global managers and so I think it's a great partnership I'm very happy that the all else equal part will be a Lauder Institute podcast in addition to being a Stanford podcast in fact the first guest that we have today in the podcast is a global senior fellow at the Lauder Institute I think that there are many geopolitical themes that we have talked about in previous episodes and we will undoubtedly talk about them in future episodes and those themes sit very well within the academic mission of The Institute yeah let's start with one of the most important GE political themes which is National bet and that's what we're going to talk about today Jules what we start from a naive perspective if you look at debt levels of market economies what you find is that government debt has always increased if you look at the United States they've been a few times and their debt levels have decreased but generally US debt has been in an upward trajectory since Independence so the question then is what's the fast about it's always been increasing yes indeed Jonathan if you look at the numbers we're currently hitting a level of $34 trillion in debt and that one of the highest numbers that we've ever seen for you as debt but the question is are these raw numbers all that interesting and the reason why I'm saying that is in growing economies all of these numbers will hit alltime high records all the time meaning if we would look at us GDP hits as a total size number as a flow number US GDP constantly hits all-time high numbers and every time we have growth it grows by another one or two% then becomes an even bigger number the same is true for the stock market in a growing economy the stock market will constantly hit new records and so the question is not so much when we think about the national debt whether or not that level is high but whether it's high relative to some other quantity that we think is the relevant quantity and one thing that we need to discuss today is what that other quantity needs to be let's start with the one that almost everybody uses the ratio of national debt to GDP if we look at that ratio there may indeed be reason for concern because that ratio is hitting all-time high levels as well just to give you some numbers in 1975 we were a little under 40% of GDP and in 2024 we're now over 120% of GDP in terms of the debt level so by that measure it does look like we have reached levels of debt that have been unprecedented but you know Jules both of us the finance professors one of the things that we keep discussing is the ratio of Deb to GDP is a very strange ratio because the numerator is a stock measure the level of debt and the denominator is GDP which is a flow measure the amount of domestic product produced in a year and we don't usually measure things by putting stocks over flows so example a company if we want to know the level of debt we'll put debt to assets of the company if if we want to put flows on case then often we'll put interest coverage over say earnings so it's flow to flow and stock to stock so Jules it doesn't seem to me that the measure that people use is such an informative measure there are circumstances in which stock to flow measures could be interesting we have certain valuation ratios like price earnings ratios and price divident ratios that we sometimes use but I think you're on to something Jonathan because in this particular case depending on what we compare to what we're going to get very different answers and so maybe particularly in this example this stock to flow measure may actually not make the most sense one thing that we could look at consistent with your example is to say let's take the national debt and divided by some measure of assets and then we can think a little bit about as a country as the US what would be an appropriate measure of assets maybe a measure of total wealth would be a good one to use although we know that measuring that fully as hard we can certainly get at certain pieces of it so let me tell you some pieces that are not that hard to measure for example we can look at the total stock market capitalization of the United States so the collective value of all the equity we can look at what the total residential housing stock is worth and how that value has developed and once we take ratios like this it turns out that the national debt to the total stock market capitalization of the United States is actually pretty flat since 1975 it hasn't increased right so let's again recall those numbers from debt to GDP from 38% to over 120% if we look at the debt to the stock market capitalization we have a number some a little bit below one pretty much throughout the entire period since 1975 of course during the internet boom that number was low because the stock market valuation was so high and then that corrected again during the financial crisis when it went back to similar numbers like the ones that we had in 1975 if I do the same thing with national thatb to say the value of the residential housing stock you're going to get that the numbers look pretty flat it doesn't look that alarming at all in terms of how much the debt of the United States has increased and so what about the flow to flow measures well so we can think a little bit about what flow tolow measures we would like to use but indeed one thing that we could do is we could use the total interest expense to GDP ratio and what is interesting there is that the amount of dollars that you need to pay in interest is going to be a product of the outstanding debt that you have times the interest rate that you need to pay on that debt overall if we look at the total interest expense GDP ratio it is going to be pretty flat let's take a step back here we have one measure that's exploded we already are worried about that measure because it's a stock to flow so then we say okay let's look at the flow to flow stock to stock measures those are two completely different measures but they both are flat yes so the question is what can we learn from that now first if we lived in somewhat of a stationary environment and that's an economic term or statistical term that people use when we mean that variables that very overtime seem to revert to some long run mean and therefore do not seem to have important Trends in them it doesn't really matter which any of these measures she use she could even use a stock to flow measure but the thing is that particularly over this time period that we're talking about a lot of these quantities haven't behaved in quite that stationary Manner and that means that the answers we're getting from these different measures is just going to be really different so let's just bring this down to an example let's say we want to use the price earnings ratio to measure value of a company right and if we're in a world where all companies are kind of the same then that stock to flow measure is a fine measure to use but if we're in a world where some companies are you know startups and other companies are mature we're going to have a big problem with that measure absolutely right there are very fundamental differences essentially we're saying that the stock to flow measure works when ratios stay about the same yes when ratios don't stay the same the stock to flow measures fail dismally let's think about this in terms of country so one of the big puzzles is why is Argentina default at a 40% debt to GDP ratio whereas Japan has a 250% debt to GP ratio nobody's even thinking about the possibility of Japan defaulting with a clear difference between those two countries are interest rates absolutely Japan has an incredibly High one of the highest debt to GDP ratios in the world but of course everybody also knows that interest rates are absolutely un precedented low levels for a very long time in Japan now recently they've come up a tiny little bit maybe by a percentage point or so and the interest rates were essentially at zero for a 20y year period before that which means that if you would compute the interest to GDP ratio for Japan you would end up with an incredibly low number despite the fact that the debt is so high and so that really makes you wonder what would be the correct measure for us to measure sustainability of debt but suppose that for what whatever reason interest rates in Japan would go up substantially Japan will have to roll over that debt at those new rates and that might lead to a different situation now the question is why are the interest rates so low and will they stay low exactly because of the circumstances that Japan is in and so that is a general equilibrium and all else equal discussion that we need to have here in terms of what drives those low interest rates yeah so that's certainly another episode I mean the question you're raising is are interest rates low because Japan borrowed a lot of money or is Japan borrowing a lot ofy reflecting a low interest rate environment a naive VI would say something like well if interest rates are low isn't the opal thing to borrow money yeah and you could also say well if somebody borrows a lot of money shouldn't that at some point lead the interest rates to be higher there's also the macroeconomic linkages that we need to think about maybe interest rates are low for Japan because the growth outlooks so low right coming back back to the Assumption of stationerity I think there's certain quantities that have been trending in very non-stationary ways for a long time now for many countries in the developed World which is demographics the demographic developments we've had growing populations in most of these places for decades and then gradually that population growth has stopped and now even has turned into population shrinkage in many places if you think about Japan peing at 120 million people in 2010 by the end of the century the United Nations predicts that they have 70 something million people left so that is a drastic cut in their population size the big question is to what extent do population Dynamics interact with indust trade Dynamics and that cuts to maybe as economists we don't fully understand what's going on but the market itself understands that Japan is able to keep borrowing at very low interest rates because somehow the market understands these Dynamics and so I think this is a good time to uce Our Guest because our guest has been a bond investor his entire life Our Guest today is Muhammad L Arion Muhammad was CEO and co-chief investment officer of Pimco one of the largest fixed income investors in the world he's currently president of Queens College at Cambridge and chief economic adviser at aliance which is the corporate parent of Pimco and most importantly Muhammad is currently a global senior fellow at the Lauder Institute so Muhammad thank you so much for being with us on the podcast it's really wonderful to have you thank you for having me thank you mamad we really appreciate it so what we want to talk to you about today mainly is the sustainability of the fiscal position of the United States in the context of the large debt buildup that we've seen at least measured by taking the ratio of the US debt to the GDP so I think what many investors and people are worried about and our students as well is why are Bond markets still willing to money to the US at quite low interest rates despite the fact that one this debt to GDP ratio is as high as it is and we are at this point even running primary deficits with no indication of this changing in the near future yeah I mean there's reason to be concerned about the fiscal situation the easiest way I think about it is that it would have been Unthinkable for the United States to go 30 straight months with the unemployment rate at 4% or below and yet we have a fiscal deficit of six to 7% of GDP that combination would have been Unthinkable to use John Kennedy's words that ECB president lagard likes to mention you fix the roof when it's sunny when unemployment rate is so low the economy is sunny you're not supposed to run large fiscal deficits so I understand that concern I also understand the concern that herbstein famously summarized by saying what is unsustainable will prove unsustainable there are two qualifications one is the time frame and the other one is the relative comparison not the absolute one so let's start with the second one the reason why the US interest rates are so well behaved is that in relative terms the US is what you can think of as your cleanest dirty shirt imagine that you are on a trip you have packed exactly for the dur of the trip your trip is extended what are you going to wear you're going to wear your cleanest dirty shirt so while the US is not pristin in terms of its economic characteristics it's a lot cleaner than elsewhere so the US will tend to attract funds into the spawn market and after all it is the deepest it is the market where others are are willing to Outsource their savings too so the US will always have that inherent Advantage so that's the first element and it's of course helped by the fact the dollar is a reserve currency the second element is time you cannot replace something with nothing it takes a very long time to build an alternative system so what's happening right now is no one is challenging the us at the core of the system but they're building little pipes these little pipes fragment the system but don't completely replace the US so yes we should worry about fiscal but it is not a day one concern in terms of disorderly markets in terms of the us being rationed from foreign Capital Muhammad let me take a step back here if you look historically the US has always in periods of where had borrowed a tremendous amount run primary surpluses and paid it back and I think that's the reason we can still borrow at the rates we are borrowing at because to First approximation we've never defaulted but I look at this and I look at the current political situation and I really don't see any path right now to primary surpluses I mean in my interpretation the bond markets are they're saying no history is going to be represented the future and what we're seeing right now is temporary you think that's true so first I think the Bond markets also learned from Japan Japan went a debt to GDP that was enormous and somehow continued to manage it the market has also learned from quantitative easing the notion that you can have a central bank that comes in and buys up to 9 trillion of government bonds and mortgages so most people in the market would agree with you that as yet there is no path to primary surpluses there is no path to turning the thatb dynamic but they say we have time to find that path so that's the way the markets are thinking right now some feel that that is complacent others feel that that is realistic I'm somewhere in the middle I do believe that we need to find a path to better fiscal sustainability you know Jonathan it's part of a bigger change when I grew up life was easy the domestic policy stance was governed by the Washington consensus in order to grow in a sustainable fashion you needed liberalization deregulation and financial prudence today liberalization has been replaced by protectionism and sanctions deregulation is being replaced by industrial policy and fiscal Prudence is being replaced by fiscal responsibility so it is a much broader change in the domestic economic Paradigm I can't agree with you more I mean it's worrying to me because you know as I like to tell my students only one system works all the other systems fail and that system worked for us very very well there is no other system so Muhammad you brought up Japan one thing that I've started wondering and that Jonathan and I have been discussing too is is the that's the GDP ratio actually the right number to look at because there are two other measures that you can think about the first one is there are annual interest expenses that you need to pay and you can take the interest expenses over GDP those are both flow measures rather than the ratio of a flow measure and a stock measure right because the debt is a stock measure and the GDP is a flow measure the other way to think about it is is that whenever we think about how we Finance ourselves whether it's with debt or with Equity also at a corporate level we take a ratio of say a stock measure of debt to some wealth measure debt plus Equity or some other bigger measure and obviously in the United States stock markets are incredibly highly valued housing markets are incredibly highly valued so perhaps if you take the debt to Total wealth ratio it may actually look quite fine I don't know whether anybody's properly done those calculations but how do you think about this should we even be looking at debt to GDP is this the right ratio to look at and maybe do you know historically why that became the measure to look at so first on Japan the three measures you cited which was the stock measure the flow measure and then the broader balance sheet measure were all debated quite a bit 15 20 years ago before Japan entered negative interest rates and everything else that pushed back because fundamentally you were taxing creditors and subsidizing debtors yes and in a regime like that this regime of financial repression you can continue but you're absolutely right so what we really are looking for is debt sustainability yes and the shortcut to that sustainability has become Deb to GDP but debt to GDP doesn't measure a few things first it's not netted usually against the wealth of the country yes and the argument for not doing that is ultimately the government cannot claim the wealth of the private sector the wealth of the private sector has a way of going away going elsewhere as lots of developing countries have tried so that's why people say yes in theory that's correct but in practice is it really right the second element you're write is that servicing and in particular interest servicing how is that relative to your earnings so normally it's your interest payments relative to what it is you collect and then the third element is the element of vulnerability you can have and we have had a complete sudden stop on financing that has nothing to do with you that has to do with a shock elsewhere in the system and suddenly you cannot refinance your debt and that in itself can cause a debt problem in a big way so yes Jules you're right that's Su stainability is a much B concept than simply debt to GDP and getting out of Deb sustainability is also a much broader concept than simply running fiscal surpluses you know I keep on reminding people even if you limit yourself to the debt to GP ratio you have a denominator and there's four ways to deal with excessive debt the best ways to grow out of it the equivalent for an individual of getting a second job and paying off the credit cards and being able to maintain the standard of living if you can't do that you can opt for austerity but we have found that after a certain point austerity becomes counterproductive the third is financial repression but that requires you to fool a lot of people for a lot of the time and distort your system and the fourth is an outright restructuring or default and when you put them in that order it's clear that growth the denominator of the debt to GDP is really important when talking about debt sustainability and I think it's a good time to start talking about growth so you know Jules and I are pretty pessimistic at least in the short term about certainly World growth and also us growth I mean we have a demographic problem on our hands as all Western countries to and actually also Eastern countries and then add to that our current issues with immigration I mean historically I would have said okay big deal America has a demographic problem but we we can easily solve That We're a nation of immigrants the extent to which we walk back on that then you really wonder where's the economic growth going to come from yeah look I used to be pessimist I must say I'm less so today and let me explain why it's not because there is something that's going to change or move the needle in a fundamental way over the next 12 months but there are things that will move the needle in a significant way over a three to five year Horizon and governments are realizing this so take the UK government as an example they've been stuck in a low productivity low growth equilibrium and the incoming new government has put growth as a mission and there's two elements to the mission the first that could release the braks take off the constraints on current obstacles to growth for example planning rules and trying to increase the supply s and then there are the future drivers of growth so you don't just release the break but you enhance the engine of growth and here's where my optimism comes in think of a world that's shaken from above and From Below above you've got three massive transformational enabling Innovation that I certainly believe will change not just what we do but how we do it and I'm talking here of technology and particularly Ai and a different type I'm talking about life sciences and I'm talking about sustainable energy and then from below you have certain sectors that historically have had massive positive externalities that are being forced to adjust think of Health Care think of Defense think of food security so if I look forward I have this notion we're on a very bumpy journey to a better destination as long as we can navigate the journey and that's what I feel so yes there is nothing that's going to move the growth needle in a significant way in the next 12 months unless it's irresponsible Sprint for growth that will end up in tears but there is quite a bit to make you more optimistic if you take a longer time frame and so the demographic decline is not something that worries you from a growth point of view because historically I do think that population growth and economic growth have had important synergies and first of all GDP itself because it's GDP per capita times capita if you just have population growth you get part of your GDP growth for free right and so if we think about growing out of the debt to GDP ratio measure and you would think that's the right measure then you just get GDP growth from having the your population growing you can essentially deal with a lot of debt even today but that it seems is largely over for most countries even for the US I think population growth has slowed down tremendously you think that the big engines of growth that you just mentioned will be enough to get growth back to levels that we've seen say 20 years ago 30 years ago I mean both what you and Jonathan said played out in the US in the last couple of years where there was a massive positive Supply shock to the labor market many illegal immigrants coming in enhancing the labor market maintaining wage growth relatively low and that has allowed what a lot of people call us exceptionalism or at least has supported what a lot of people call us exceptionalism and the extent to which the US has outperformed the rest of the world so I don't disagree at all that in a world where there's a flow of new labor if it's productively utilized then you can increase your growth potential I completely agree but that's not the reality we live in anymore I remember many years ago I was taking an entrance exam to the University of Cambridge and I was at school and the first question I had to answer was quote with every Pair of Hands God sends a mouth discuss and the idea was trading the productive element versus the needs of a population especially as it ages so if you look at Capital labor and then multiactor productivity then you can't rely on labor to be The Driver of growth you're gonna have to rely on the other two absolutely and that's where my optimism comes in relative to where we are you know we all have a huge obligation because if we don't believe in these new tools of productivity then we're leaving the Next Generation low growth high debt High inequality and a climate crisis hopefully we're also going to leave them with tools to manage all that better than we did well I mean let me just say that I don't completely share that optimism I agree we are leaving the Next Generation with a problem but unless the government is prepared to think about putting in place policies that are going to increase our I mean it'd be great if AI works out and of course if AI works out we're fine it does seems a little bit too good to be true well I'm also quite worried about the geopolitical stability of the system that we've had in the last couple decades and to what extent those geopolitical relations will stay in place and what that will imply for the United States right so to give you one example I think that it's clear that the future of warfare and of international stability from that point of view has changed marketly since the introduction of AI and the use of drones in combination with AI and I do therefore think that the US is in some sense in an arms race with many other countries and the question is can the US win that arms raise and I'm actually wondering to what extent very large government investments in technology will be required in the short term making the fiscal situation even more dire potentially but that may be worth it I don't know do you have thoughts on this on how all of this interacts with the geopolitical risks that we're facing so first the US is way ahead of other countries in terms of putting resources into all this the chips act the IRA all that a lot of people feel that actually we've committed too many resources to all this look I think of this in a simplified manner as the 020 problem that these Innovations and especially AI has 80% that's good and 20% that's bad and the 20% that bad certainly includes enabling non-state actors to acquire weapons that otherwise they wouldn't be able to acquire and small drones and the like so typically when you go to those involved in the Innovation they say guys you're looking at 8020 the whole focus is on the 80 we will do good go to Europe and face them with an 8020 they'll be obsessed with the 20 and they want to regulate because they're so scared of the 20 the truth is you've got to embrace the whole distribution you've got to recognize that your challenge is both to unleash the 80 and risk manage the 20 and you can't just do one of them on this so yes but I remember if you look back and I'm sure you have if you look at the steam engine if you look at the car there was always the that this was going to create harm in this and we've learned over time to get the ad20 right now I'm hoping the same thing no I agree with you there I think we're way too focused on the negative and not thinking about the positive or in fact I would say it's a bit differently we take the positive for granted and we don't realize wait a minute the lives we Le are all result of this let me change the subject for a moment you know you mentioned various different ways out of our de to GDP problems one of the ways is inflation what do you think the long-term outlook for inflation in the US is so as everybody knows we went from a world where the problem with inflation was that it was too low to a world where it was too high and now we are transitioning back to a world where inflation is just right with a question mark As does it settle around there or not my own View and I'll summarize it in a very provocative fashion that if central banks could revise their inflation targets which are all anchored on 2% they would choose a higher equilibrium inflation rate that they would choose closer to two and a half to three why first thing is because we're no longer living in a world of deficient aggregate demand we're living in a world of deficient aggregate supply secondly the jaop politic we talked about is fragmenting the system Supply chains are increasingly becoming less commercial in design they are being influenced by natural security consideration yes so when you think me Shoring friend Shoring thirdly companies having been burned quite a bit during the pandemic are now trying to build in more resilience in their supply chains so again this is no longer just in time Inventory management this is resilience and not just efficiency if you were to put all this together the equilibrium inflation rate for the system is higher than the 2% Target that we have so this is a more inflationary world it's not a a world where inflation expectations get de anchored but it's a world that if central banks are not careful they maybe end up pursuing an inappropriate inflation rate I would actually have to say I agree with most of what you just said I'm not a macroeconomist as I tell people I know absolutely nothing about macro but I will say this I think the people that spend their lives thinking about inflation do not spend enough time thinking about Supply Changers I completely agree and you would have thought after the pandemic they would have said wait a minute look what happened yeah I mean we learned three things during the pandemic that somehow we forgetting one is that Supply chains really matter yes yes two is that we can supplement our normal data sources with really interesting high frequency data which we had to do during the pandemic and then the third thing we learned is that public private Partnerships can be really powerful as the vaccine Discovery and dissemination showed us but somehow as we have gone back to normal all three lessons are seeming to have much less of an impact than I would have expected I agree I agree with you entirely on that I mean let's just say the following that I think what we've seen in the United States in the last few years is something we've never seen before we've seen deficits huge deficits but they all is associated with war it's like we've had a war without the war well you know you can also say that the United States perhaps through proxy wars is involved in many military conflicts right now right let's not forget that but nothing at the level of the wars that require deficits that is true Civil War the world wars anyway I mean My worry is that if you think about that analogy when the war ended there was a huge side of relief in the country and everybody said okay get back to work right I don't see that huge side relief coming but again who knows I think the big difference is I agree with you but I'll take it one step further if I may is that when we had an explosion in debt and spending and fiscal deficit it was understood that it was justified but that we will need to reverse it over time this time most of the explosion that happened in response to the pandemic were seen to be Justified but there was no common understanding that it needs to be reversed so you settle at the much higher debt level and then you keep on climbing from there there wasn't this notion that we need to reverse what was an exceptional increase in the use of the public balance sheet and to come back to something you said earlier I think that there's certain lessons that we could have learned from the pandemic it seems that those lessons haven't been learned and we mean reverting to the past and there are other places where since the pandemic we are not mean rever rting to what was Common Sense before in that sense maybe we're getting the worst of Both Worlds and that does concern me I do think that also for younger generations to post pandemic world does have structural shifts compared to the ones before I think things have become normalized that we hadn't seen for a long time and perhaps a structurally higher deficit is part of that no I agree thank you so much for joining us on the show thank you very much for having me thanks for listening to the all else equal podcast please leave us a review at Apple podcasts we love to hear from our listeners also be sure to catch our Next Episode by subscribing or following our show wherever you listen to your podcasts for more information and episodes visit all else equal podcast.com or follow us on LinkedIn the all lse equal podcast is a joint production of Stanford University's Graduate School of Business and the Lauder Institute at the University of Pennsylvania it is produced by University FM [Music]