Sunday, July 16, 2006

Public Debt and Government Bonds in a Pandemic

Conversation in the hallway:"Don't you think that a pandemic will drive up public spending, drive down the GDP, increase the debt-to-GDP ratio and thus have a negative impact on US Bonds?"

Well, while it is true that the debt-to-GDP ratio will increase, you have to look at the over-all net effect. A pandemic is very likely to prompt a classic "flight to quality" situation, which would increase credit spreads. Moreover, central banks around the world will do everything they can to preserve order, and their tool of choice would be to increase liquidity.

Debt-to-GDP in Perspective

There are good reasons to believe that the increase in the debt-to-GDP ratio is a much smaller order effect. For example, consider the current CIA Fact Book list of debt-to-GDP ratios. Using the 2005 data, the US ratio is an uncomfortably high 64.7%, but this is not the worst the US has seen. The ratio at the end of the Second World War was 120%. Also, this ratio is not bad in comparison with Japan with a current ratio of 170%.

To be sure, Japan's debt level does hamper its economy, and it should be reduced. The point is simply that if the US debt-to-GDP were to increase substantially in the event of an H5N1 Pandemic, then the long-term impacts on the bond market or economic activity would probably no worse than those of a "normal" recession.

Practical Advice

I am not a registered financial advisor, nor do I play one on TV. Still, I happily argue that if the H5N1 virus acquires efficient H2H transmission, then---
  • Stocks will go down
  • Credit spreads will widen
  • Reserve currencies (USD, JPY, EURO) will appreciate vis-a-vis non-reserve currencies
  • US Government Bonds will do very well
"It's hard to make predictions..."

And, as Yogi Bera continued, "especially about the future." Moreover, Yogi was right. In particular, it is hard to make a serious, scientifically defensible prediction of the arrival time of the next influenza pandemic.

Still, the uncertainty of the arrival time should not cloak the fact that some subsequent economic developments are essentially forced. Specifically, I would argue that price appreciation of US Government bonds is as close to a "lock" as one is likely to find in a financial lifetime.


Blogger gs3gs3 said...

seems that the 120% was war-related:

11:32 AM  
Anonymous Florida1 said...

I completely agree with your practical advice. We have been discussing these issues since February at FluTrackers in our economic forum.

12:57 PM  

Post a Comment

Links to this post:

Create a Link

<< Home