One way to think about it, is that instead of funding the large fiscal stimulus through taxes, the funding for the stimulus instead comes from a partial drain on existing currency value.

Lyn Alden

This has been by far the biggest year of federal deficits as a percentage of GDP since World War II.

The United States came into this year with roughly $1 trillion in structural annual deficits (nearly 5% of GDP), annual tax revenue will likely fall temporarily by $300-500 billion or more due to decreased economic activity, and pandemic-related government spending has already approached about $3 trillion.


As a back-of-the-envelope calculation, that puts the deficit this year at perhaps $4.5 trillion, which is more than 20% of 2019’s pre-pandemic annual GDP figure of $21.4 trillion.

Government transfer payments, as just a subcomponent of this, are up 80% year-over-year so far, as extra checks and extra unemployment benefits and extra business loans with forgiveness-clauses were sent out in response to the pandemic shutdown:

Chart Source: St. Louis Fed

Congress and the President’s financial team are currently working on another round of stimulus estimated to be $1 trillion or more, but due to an impasse, the outcome of that stimulus remains unclear at this time. This would conceivably push the deficit up past 25% of GDP if passed.

Most of this was paid for by the Federal Reserve creating new bank reserves to buy trillions of dollars’ worth of Treasury security issuance, a practice effectively known as debt monetization, although for legal reasons they buy through the large banks rather than from the Treasury directly.

In fact, the Federal Reserve accumulated more Treasuries during a six-week period from mid-March through April of this year, than the entire foreign sector accumulated over the past six years.

This brings up some natural questions. What, if any, are the consequences for this from an economic perspective? If this much money is printed and spent, are we pushing up against any unseen limits? Are there any steps that investors can take with their portfolios to protect against some of the risks, or benefit from some of the results?

A Look at History

Economists will naturally have different answers to those questions, so perhaps a simple activity is to look back to history at the only other time that federal deficits and accumulated federal debts became this high as a percentage of GDP: the 1940’s. It’s often said that history doesn’t repeat, but it does rhyme.

The largest hedge fund in the world, Bridgewater Associates, put out a great chart last year that showed a century of monetary policy, including interest rates and money-printing.

While it was a great chart in 2019, I found it to be even more relevant for 2020, so I updated the chart’s red and blue lines for 2020 data so far, and added some annotations in purple and green for additional context:

Chart Source: Bridgewater Associates, updated and annotated by Lyn Alden

In many ways, the 1930’s period and the 2010’s period were similar to each other (disinflationary economic environments after major private debt bubbles popping, with interest rates hitting zero) and the 1940’s and 2020’s are similar to each other so far (ballooning federal debts and deficits after a decade of slow growth, in response to a crisis, with heavy fiscal spending that is significantly monetized by the Federal Reserve rather than borrowed from the private sector).

The outcome of this the last time we had a policy environment like we have now, ended up being that Treasury bonds for the most part didn’t keep up with inflation for nearly four decades, meaning that some of the federal debt was effectively inflated away compared to nominal GDP.

Anyone who bought-and-held 10-year Treasury securities from the mid-1930’s through the mid-1970’s, for example, lost purchasing power on that investment, despite making a nominal gain from interest and a return of their principle.

This chart shows the 10-year Treasury yield (blue line), and the annualized inflation-adjusted rate of return that an investor would have received from buying and holding a 10-Year Treasury to maturity from that year (orange bars):


Data Sources: Prof Damodaran and Prof Shiller, chart by Lyn Alden

If we zoom in on the 1940’s in particular, this was an intentional policy to fund the war effort. The Federal Reserve instituted a yield cap on Treasuries, so rather than letting the market set the yield for Treasuries based on supply and demand like normal, the Federal Reserve set the yield at 2.5% or less.

With the power of the printing press, the Federal Reserve bought as many Treasuries as were needed to fix the supply and demand balance to keep Treasury yields suppressed to their target rate.

So, even though there were three big spikes of inflation in the 1940’s (which would normally mean that the market would demand higher Treasury yields to compensate for the loss of the dollar’s purchasing power), yields remained low:


Data Source: Prof Shiller, chart by Lyn Alden

As a result, anyone who bought a 10-Year Treasury note in the early 1940’s and held to maturity, had a nominal gain but lost about a third of their purchasing power by the time it matured, because inflation greatly outpaced the interest paid by the bond:


Data Sources: Prof Damodaran and Prof Shiller, chart by Lyn Alden

Since 2019, and more frequently in 2020, Federal Reserve officials have been discussing potentially performing yield curve control again, and they cited the 1940’s example in their meeting minutes, and also cited modern examples of yield curve control from Japan and Australia.

In general, both in U.S. history and in international economic history, periods of large deficits that are funded by monetization (printing money to cover those deficits) tend to result in some degree of currency devaluation, and persistently negative real yields is one of the mechanisms to achieve that. One way to think about it, is that instead of funding the large fiscal stimulus through taxes, the funding for the stimulus instead comes from a partial drain on existing currency value.

Many trends are deflationary in the United States and elsewhere, such as aging demographics, improving technology, and other factors. On the other hand, when debt levels hit historic highs and turn towards central bank monetization, it tends to be a somewhat inflationary reversal. We’ll see how these competing forces play out in the years ahead.

The simplest form of defense to this has historically been diversification. Owning domestic equities, foreign equities, and some cash and bonds for liquidity and rebalancing, historically preserves purchasing power in the long run. Alternative asset classes like real estate, precious metals, and commodity producers, notably tend to hold their value particularly well during more inflationary environments, such as the 1940’s and 1970’s.

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The TSP, Gold, and the Possibility of a Fiscal Cliff (July 27)

Pop Quiz: Test Your Federal Retirement Knowledge

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.

FERS Retirement Guide 2020