The fiscal equivalent of war

Stuff keeps happening

When I look at the fiscal situation around the world, it increasingly seems like what you’d expect in a world at war. Yet while there are wars going on in Ukraine, Gaza, Yemen, Sudan, Burma, Libya, and many other places, most developed economies are now at peace.

Photo by Jp Valery on Unsplash

I see three factors that are making global debt markets increasingly resemble wartime conditions:

1. The end of mutual defense pacts.

2. The end of globalization.

3. The end of American fiscal responsibility.

Thus far, the media has largely treated these as independent stories. But the debt markets increasingly see a link, as do some of our more astute observers. Here is Joe Weisenthal and Tracy Alloway:

Here in the short term, one thing that you can’t help but notice is that rates at the long end of the yield curve are rising all over the world. . . .

But to my mind, deglobalization is part of the story here as well, and I see that working in two ways.

The first is, again, in a world where trading (and national security) partners are perceived as being less open and reliable, countries are required to spend more on building up their own industry. The most obvious example of this already — the one where we can draw the clearest line between geopolitics and rates — is Germany, which is opening up the fiscal taps in order to spend more money on defense. If you kind of squint and look at the blue line, you see a sharp move up in early March, right when we started getting the headlines about fiscal expansion.

Technically, Nato still exists. But as a practical matter it has been abolished by the Trump administration. Now it’s every country for themselves. That means a lot more defense spending (including in the US), which is economically wasteful and fiscally challenging. This is a pity, as mutual defense pacts are a wonderful way of economizing on defense spending. A Russia that cannot beat Ukraine would not dare attack Nato. But that security is gone now. Tossed away like a petulant child breaks a toy they don’t like.

Another story discusses the way that global debt markets are linked:

From the US to Japan, long-term borrowing costs for the world’s biggest economies have surged as investors question the ability of governments to cover massive budget deficits. . . .

While Germany’s traditional adherence to fiscal discipline means it has more capacity to ramp up borrowing than many other governments, the challenge is that it will be competing against higher long-end supply around the globe.

“There’s clearly a lack of demand for long end duration everywhere,” said Shaniel Ramjee, co-head of multi-asset in London at Pictet Asset Management.

Japan is facing a similar problem. Here’s the FT:

The Japanese government bond market was already having a bit of a springtime nightmare, but a poor auction of 20-year debt earlier this week has sent long-end yields soaring to their highest levels ever.

The article provides this frightening graph:

During the 2010s, I was criticized for supporting the Japanese policy of increasing sales tax rates to reduce the budget deficits. We were told there was no reason to worry about deficits in a world of zero interest rates. But contrary to the predictions of my critics, Japanese NGDP growth actually increased due to monetary stimulus, despite the fiscal “austerity”.

Just imagine if the Japanese had taken the advice of Keynesians and continued running massive fiscal deficits throughout the 2010s. Their debt to GDP ratio would be even higher today, and the effect of rising interest rates on the budget situation would be even more frightening.

The article discusses three factors contributing to Japan’s fiscal problems:

First is inflation. Headline CPI in Japan is now 3.6 per cent, and has been above 2 per cent for over three years. That means that a 30-year bond yield at 3.15 per cent is still below inflation, or negative in real terms.

Second, Japanese insurers have virtually stopped purchasing very long-term bonds, to satisfy new economic solvency ratios introduced recently.

Third, long-term fiscal concerns are rising. The US is pressuring Japan to spend 3 per cent of GDP on defence (from the current 1.6 per cent). The ruling coalition is considering a supplementary budget, while the opposition is pushing for a consumption tax cut. No one seems to be talking about less spending and raising more tax revenues.

In addition to the global military build-up, we also have a trade war—initiated by the Trump administration. At one point during April, the trade war began to unsettle the US market for long term Treasuries. This was the factor that led Trump to back off from his original proposal for extremely high tariff rates.

In my view, the trade war and the breakdown in mutual defense pacts are not separate issues—rather they are both linked to a global rise in authoritarian nationalism. Nationalists tend to be both populist and xenophobic. That doesn’t bode well for an international economic and security system that was built on cooperation.

Trade wars reduce economic growth, which increases stress on the budget. Populism leads to big budget deficits. When Juan Peron combined protectionism with fiscal irresponsibility, it wrecked Argentina. Trump’s adoption of the same policy mix is a threat to the entire global economy.

The recent House negotiations over the budget is almost a textbook example of what can go wrong under populism, when there are no “adults in the room.”

Consider the case of the Congresswoman Young Kim, who represents California’s 40th district (where I live). Wikipedia describes her as a moderately conservative Republican:

NBC News reported that the issues important to Kim included "creating jobs and keeping taxes low", "beef[ing] up education funding in science, technology, engineering and math", and reforming the immigration system to "ensure those brought to the U.S. 'as children without legal documentation are treated fairly and with compassion.'" She supports student loan forgiveness if the borrower is on the verge of bankruptcy. Kim favors reduced regulations and increased trade. She is a fiscal conservative.

A Mitt Romney Republican. And yet given the dynamics of the budget negotiations, she ended up being one of a handful of GOP House members that blew up the deficit by ending the $10,000 limit on SALT deductions.

In a normal country where the president didn’t have a personality cult, congressional leaders might have worked out a compromise that put the budget on a somewhat sustainable path. You want the SALT deduction? OK, then we keep taxing tips and overtime, and no extra deduction for seniors or increased child tax credit. No cut in pass-through business taxes.

Instead, we have the worst of both worlds. Congress is afraid to go against the President’s wish list, and can be held hostage by a handful of House members representing special interests. The budget becomes the GOP version of an “everything bagel”.

The CBO forecast is very bad, but the actual budget situation is far worse. The CBO is forced to adopt the administration’s rosy assumptions of tax cuts expiring on a specified date. Recall the 2017 corporate tax cut was scheduled to expire this year. Did it? Do you believe future Congresses will take away the SALT deduction and start taxing tips and overtime? Will they reverse the child tax credit increase?

This tweet caught my eye:

In addition, if interest rates stay at current levels, then budget deficits will be far larger than the CBO forecasts.

Even worse, the CBO forecasts assume that peace and prosperity will continue indefinitely. When has that ever happened?

I recently saw someone on CNBC claim that the debt to GDP ratio stabilized during the late 2010s. That’s actually not quite true, but even if it were true it would have meant that the deficit was completely unsustainable. I cannot emphasize this point strongly enough:

A stable debt/GDP ratio during an economic expansion is an unsustainable fiscal policy.

In order for fiscal policy to be sustainable, the debt to GDP ratio must fall during expansions, so that it can rise during recessions.

This tax bill is almost unimaginably bad. If you are a progressive it’s bad because there are massive tax cuts for the rich while the poor are hit by tariffs and benefit cuts. If you are a supply-sider the bill is bad because it reduces economic efficiency. The SALT deduction alone is an engine for massive wasteful spending in high tax states. If you like simplicity the bill is bad because it makes the tax system far more complex—we are back to itemizing deductions. I don’t think even Kamala Harris would have produced something quite this bad, and any other GOP president would have delivered a far better bill.

One thing I’ve noticed during the nearly 50 years I’ve been a macroeconomist is that stuff happens. I don’t know what will happen, and I don’t know when it will happen. But if history is any guide, then stuff will continue happening. Maybe it will be a bird flu pandemic. Maybe it will be a war. Maybe it will be a recession. Maybe it will be a massive bank bailout (given that Trump is also deregulating banking but keeping deposit insurance and TBTF.) All of us (even me) live in a fantasy world where we subconsciously expect the future to be like the past. But it isn’t. Stuff keeps happening.

Our budget situation is not even sustainable if nothing bad happens going forward. I suppose it’s possible that some sort of AI miracle will rescue us, just as its theoretically possible for someone drunk and high on cocaine to put on a blindfold and drive 90 mph down the highway without hitting another car. But I don’t think it makes sense to assume that we’ll be as lucky as the Indiana Pacers.

Sorry to be a downer, but does it make sense to be optimistic when we are blowing up the framework of global trade that underpinned the greatest period of prosperity in world history, and simultaneously blowing up the mutual defense treaties than have underpinned world peace since 1945, and simultaneously running a historically irresponsible fiscal policy?

I’m tempted to say that a deficit of 6% of GDP is what you’d expect during wartime, not peace. But Lyndon Johnson actually raised taxes during the peak of the Vietnam War, which led to a budget surplus during 1968. That’s what I mean by “grown-ups in the room.” We’ve never had a budget this unbalanced during a period of peace and prosperity.

Oh, and the Senate bill may well be even worse.

I very much hope I’m wrong. One sliver of hope is that Trump backed away from the more extreme tariffs when there was pushback from the markets. Perhaps the bond vigilantes will eventually force Congress to cut spending and raise taxes.

But hope is not a plan.

PS. I still believe Trump might be opening the door to a future VAT. The Dems have refused to go there because they worry that high sales taxes are unpopular. But if everything imported is to be hit with a 10% tax, then a VAT suddenly seems like much less of a dramatic change. A fiscal “Nixon to China”.

PPS. On the plus side, Trump’s policy on higher education is only 27% as bad as Chairman Mao’s.

Say what you will about my TDS, on one point I’ve been completely, 100% vindicated:

Donald Trump = Viktor Orbán

Trump’s first 4 months are pure Orbanism.

PPPS. People impersonating me occasionally leave comments here—one clue is that my name is spelled incorrectly. Another clue is that they are even sillier than my comments.