Through the Looking Glass: The Reverse World of the Pandemic Economy

This paper is part of a new initiative from the Peterson Foundation to help illuminate and understand key fiscal and economic questions facing America. See more papers in the America's Fiscal and Economic Outlook series.

By Diane Swonk

Encountering the pandemic made me feel like Alice with her trip through the looking glass. Many of the previously held notions about the economy suddenly worked in reverse. Inflation surged even with factories idled; labor shortages erupted despite millions of jobless. Long-term interest rates plummeted even though federal deficits and debt ballooned. Those shifts were most pronounced in the U.S., which is still protected by the dollar’s status as the world’s primary reserve currency. Even so, you literally could have knocked me over with a feather if you had told me that the 10-year Treasury bond would flirt with a level of 52 basis points at the same time that deficits soared into the trillions in 2020.

Why did interest rates fall so low, and remain so low? The bond market has been on a four-decade long roll. Inflation and growth have slowed and with that, global bond yields have plummeted. The drop in bond yields below the overall pace of growth has enabled us to service rising deficits and debts, without making tough decisions about spending and taxation. It ushered in a period of a sort of tax and spending bliss, where old rules of thumb disappeared; we were able to finance what we needed with little to no consequences.

There were two major exceptions to the four-decade long bond rally. The first was in February 1994 when Former Federal Reserve Chairman Alan Greenspan raised rates to preempt what turned out to be a nonexistent inflation threat. Inflation was already decelerating on a global scale when he made that decision. The result was the worst bond market rout since the years when Paul Volcker was chairman of the Fed and yields on long-term debt soared from a little above 5% to more than 8% in a year. Hubris in the Fed’s ability to forecast inflation prompted the once gradualist, Greenspan, to overshoot.

The second was in May 2013 after former Fed Chairman Ben Bernanke warned that the Fed was close to tapering its purchases of Treasuries and mortgage-backed securities, which began during the 2008-09 financial crisis. Threatening to pull the plug on that support triggered what has become known as the “taper tantrum” and threw emerging markets into turmoil. Brazil, India, Indonesia, Turkey and South Africa were the hardest hit. Back then, Bernanke was adamant that the Fed is not responsible for what happens outside of the United States; we don’t hear that from the current Fed. There is no Las Vegas in the global economy; what happens abroad quickly washes up on our shores. (The law of unintended consequences.)

Other missteps occurred but did not have such dire consequences. The Fed realized that efforts to preempt inflation in 2018 went too far and backed off to allow the unemployment rate to dip farther than in the past and, perhaps more importantly, level the playing field for the most marginalized workers. The gap between the unemployment rate for white and Black workers finally narrowed as employers were forced to cast their nets wider and remove their biases when hiring in the later stages of the last expansion.

I bring up those examples because they underscore just how outsize the Fed’s role has become in determining what were once considered market rates. The Fed is now the largest single buyer of U.S. Treasury bonds; the Fed balance sheet has ballooned to $8.5 trillion, nearly two-thirds of which is in Treasuries. Just for comparison, the current federal debt outstanding is $28.5 trillion. The Fed is not in the business of monetizing our government’s debt but is skating close to the edge, which has upped the risk of a misstep.

The bond market has started to get nervous but most financial market participants remain complacent, believing that 1) the Fed will not repeat the mistakes of the past or make new ones, and 2) that the Fed will be there to bail them out if and when something does go wrong. They could be wrong on both counts.

Inflation has already surged faster and for longer than most within the Fed anticipated. Fed Chairman Jay Powell has pledged that inflation will be transitory, one way or another. Either it will abate on its own, as bottlenecks in the supply chain are resolved, or the Fed will raise rates to curb unwanted inflation. Sounds good in theory. Reality is another story.

Shelter costs are accelerating and likely to continue to do so, even as some bottlenecks are resolved. This, coupled with recent wage gains, suggests that it could take well into 2023 instead of 2022 to get inflation back down to pre-crisis levels. It has been decades since the Fed actually had to chase inflation; it is unclear how financial markets will react to such a shift in strategy.

Add a tapering of the Fed’s massive monthly purchases of Treasury bonds and the era of cost-free deficit financing may come to an abrupt end. Most are hoping that event will be manageable, comparing it to other bond market blips, but there is no real benchmark for the pandemic-induced inflation we are experiencing or how it will play out.

That is not the only problem. Debt across developing markets has ballooned at the same time it has surged across the developed world. Much of that debt is now held on the balance sheets of banks in those developing economies. If a country is forced to default, those losses will quickly morph from a sovereign debt crisis into a full-blown financial crisis. Credit could seize up from internal and external sources, which would compound losses.

The Fed may be running out of ways to contain the damage; its balance sheet is already bloated and its ability to cut rates limited, unless it were to go negative on short-term rates. That would raise a whole new set of challenges. (Understatement.)

Alarm bells rang at the Kansas City Federal Reserve’s Jackson Hole Symposium. The fear was that we could be on the precipice of another financial crisis. That would amplify the downside risks to the economy associated with more aggressive 2022 rate hikes.

Does that mean we should abandon efforts to upgrade our infrastructure and back off efforts to deal with the existential threat of climate change? No. We have already kicked the can down the road for too long and done what is easy instead of what is necessary. The losses triggered by extreme weather events are already mounting.

Ultra-low rates now have provided us with a rare window of opportunity to address infrastructure investments. I would issue longer term debt — something much longer term than 10-year Treasury bonds — to finance those investments while the window is still open. That includes investments in addressing climate change, including work to repair the damage already done.

Infrastructure investment has larger, known payoffs in terms of productivity growth over time than spending programs do. Dilapidated roads and bridges are compounding bottlenecks and delivery delays, while extreme weather events are further disrupting supply chains. The Treasury and the Fed are getting increasingly concerned about how climate change could destabilize the financial system and the broader economy.

I would use “pay-fors” — tax hikes and spending cuts — to fund the increases the administration is seeking via budget reconciliation. The White House’s wish list includes a broad spectrum of programs that span child tax credits, child care and universal pre-K, parental leave, enhanced Pell grants for college, expansions to Medicare, subsidies to encourage the adoption of cleaner technologies and immigration reform. The $3.5 trillion package intended to narrow inequalities is a virtual kitchen sink.

Why finance infrastructure and pay for the rest via tax hikes or spending cuts elsewhere? Because much of the increase in the administration’s budget would expand existing government programs. Those programs are inefficient at the best of times. Add the need to issue direct transfers to individuals to implement many of the proposals and we could unwittingly stoke inflation when it is already running hot.

Separately, the Fed has weighed its options should Congress fail to lift the debt limit, which applies to debt we already owe. Transcripts from an October 2013 call revealed a potential game plan should Congress fail to lift the debt ceiling and default on U.S. debt obligations. Among the options discussed was a move to buy any debt that Congress defaults on, while selling Treasuries from the Fed’s bloated balance sheet.

Then Governor Jay Powell argued such measures would be “loathsome” and “repugnant” but would not rule them out. Fed Vice Chair Janet Yellen reluctantly agreed: “I wouldn’t say never.” The economic Armageddon such a default on our debt would trigger would be even worse.

That is no guarantee about how Fed Chairman Powell and Treasury Secretary Yellen would work together to handle such a crisis today but provides us with a clue. Of course, it would be better for all of us if Congress stopped treating the debt limit as a political piñata, given the enormous risks associated with not raising it, but I am not holding my breath. Imposing a ceiling does nothing to rein in deficits.

Even interventions by the Fed may not be enough to stem more permanent damage to the U.S. economy. The reserve currency status of the U.S. dollar would be most directly affected, which could dramatically raise our borrowing costs.

It is worth noting that the Fed was forced to intervene during the 2011 standoff over the debt ceiling, which brought us within days of defaulting. The rating agency Standard & Poors downgraded the investment status of Treasury debt, which could have forced banks to hoard cash. Instead, the Fed issued a statement saying that all Treasury debt still qualified as the highest grade for bank capital purposes to prevent a hoarding of cash.

The pandemic pushed us through the looking glass. We discovered that investors were more than willing to absorb the debt needed to deal with the crisis. They were willing to accept negative inflation adjusted returns on that debt rather than risk the larger and more permanent losses associated with contagion. They were responding to a once-in-a century phenomenon. It would be a mistake to assume that investors will be as eager to finance our debts indefinitely, especially if inflation persists. Deficits and debts don’t matter until they do; then, it can get ugly.

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About the Author

Diane Swonk is one of the most respected macroeconomists, who maintains a unique perspective on the inner workings of Main Street as well as Wall Street. She is an expert on the economics of the labor market, monetary policy and structural changes that are distinct from economic cycles. Her global network includes economists, industry leaders and geopolitical experts, which amplifies the breadth and reach of her analysis. She advises policy makers at all levels of government, including central bankers. Diane’s uniquely accessible approach to macroeconomic shifts has made her a highly sought-after expert quoted by local, national and international newspapers and broadcasters. For her outstanding contributions in the field of economics, Diane has been named a Fellow of the National Association for Business Economics (NABE). She is a member of the Council on Foreign Relations, serves on the Sitting Committee to the Booth School of Business at the University of Chicago and advises the economics department at the University of Michigan. She has testified before Congress to improve the quality of economic data and on the causes and consequences of income inequalities. Diane has won many awards for excellence in forecasting and leadership in economics and the business community. She is deeply involved in nonprofit organizations focused on expanding access to education and increasing the quality and diversity of our country’s leadership. She earned her B.A. and M.A. degrees in economics with top honors from the University of Michigan. She received an MBA in finance from the University of Chicago’s Booth School of Business, also with top honors.


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