Global Economics and Management

The Prospect of a US Fiscal Crisis

At our last Global Trends class, I was asked what major risk factors afflict the US economy. My answer was: the possibility of a fiscal crisis. Indeed, in the aftermath of the Great Recession and more recently during the COVID pandemic, there was an explosion of fiscal spending. More fundamental factors like the ageing of the population are also putting long-term strain on public finances, at both the federal, state and local levels, as entitlement spending is expected to rise steeply. And the recent increase in interest rates (initiated by the Fed to fight inflation) is raising the fiscal cost of public deficits, because interest payments on US public debt are rising on the portion of the debt with low maturity (for longer maturity debt, low rates were locked in, and the cost won't change until these bonds need to be rolled over). These various developments largely explain the recent downgrade of US public debt by Fitch.

Recently the Wall Street Journal ran a short feature on this situation. This includes an interesting graph projecting the amount of interest owed by the Federal government under various interest rate scenarios. What the article does not say is that this problem is almost entirely political. Indeed, a fiscal consolidation would entail either cutting spending growth (including entitlement spending growth) or raising taxes. The political will for either simply does not exist on either side of the political spectrum: within the Republican Party, there is disagreement on what is needed on the fiscal front, which may lead to yet another government shutdown (also at the WSJ, the great economist Alan Blinder tells this story effectively). As for the Democratic Party and the Biden Administration, they do not support reforming entitlement spending, and have set a very high income threshold for tax increases (it will be impossible to meaningfully address the fiscal situation simply by raising taxes on those making more than $400,000 - because there are too few of those).

If I could waive a magic wand, I would implement something along the lines of the 2010 Simpson-Bowles bipartisan report. That is, I would work on the spending side (for instance by indexing the retirement age to life expectancy and by working more aggressively to cut healthcare spending), and on the revenue side (for example by moving to a carbon tax and by implementing a consumption tax that could replace the current income tax). But there is simply zero prospect that this could happen in the polarized political environment that prevails now. When countries with big fiscal imbalances cannot get their act together, what often happens is that a fiscal crisis forces the reform upon them: lenders become reluctant to lend, borrowing costs rise, a recession follows, requiring deep structural reforms. For decades, the US has been protected from such a scenario because it was considered a safe haven and the dollar reigned king: the US government had not trouble selling and rolling over its debt, and was issuing this debt in its own currency. How long this can continue is anyone's guess, and it is true that fiscal doomsayers have been proven wrong time and time again. But that does not mean they will be wrong forever...

What Happened at SVB?

We just finished a session on risks and imbalances - and what do you know? - a risky imbalance just manifested itself! The collapse of Silicon Valley Bank today is the second largest bank collapse in US history (after the meltdown of Washington Mutual in 2008). What happened?

The best resource I found on this subject is this Bloomberg article (this New York Times article is not bad either). In a nutshell: startups and VC funds all over Silicon Valley were parking their cash at SVB. SVB was taking these deposits and buying bonds. When the Fed started to raise interest rates, there were huge notional losses on these bond holdings. This led depositors to worry the bank would not be able to honor its liabilities (the deposits) in case of a sudden withdrawal. This very fear made the sudden withdrawal happen (in a classic bank run fashion).

Ordinarily, a bank run would not happen because deposits are insured by the FDIC up to $250,000. This covers most depositors against the risk that a bank could not meet its obligations. But not SVB's depositors, because these were cash-rich firms with deposits far in excess of the FDIC limits. According to the Bloomberg article above, up to 93% of SVB's domestic deposits were uninsured. In such circumstances, a bank run becomes possible.

The issue of bank runs led to a famous paper by Diamond and Dybvig (1983) which earned its two authors a Nobel Prize last year (along with Ben Bernanke who also has some familiarity with financial crises).

The trillion dollar question now is: what happens next? The rise in interest rates has already felled the entire crypto industry, is responsible for many of the tech sector's woes, and had now engulfed the 16th largest bank in the US. Will the new monetary policy continue to wreak havoc? Will this bank collapse lead the Fed to reevaluate its interest rate hikes? If so, will we have to live with high inflation? If you know the answers to these questions, you can become very rich in the next few weeks!

Where Are Interest Rates Headed?

A debate is currently raging in economics as to whether interest rates will go back to the very low levels that had prevailed since the Great Recession and through the COVID era - and that started to fade when the FED raised rates recently to fight inflation.

Some scholars like Olivier Blanchard, a former IMF chief economist, argue that the fundamental forces that explained the zero-rate regime, namely low productivity growth and deflationary tendencies (often dubbed "secular stagnation") are with us to stay. Others, like economist Charles Goodhart, argue that slowing demographics and the retrenchment from globalization will imply higher interest rates and higher inflation.

Over at Bloomberg, the wonderful Allison Schrager does a great job at summarizing the arguments on both sides of this vibrant debate, falling squarely on Goodhart's side of the debate. As Yogi Berra said, it is very hard to make predictions, especially about the future. But if I had to guess, I would think that Schrager is right: the fiscal strain imposed by aging, unfunded entitlements and the unwillingness of politicians and electorates around the world to engage in fiscal belt-tightening will most likely lead to a scarcity of savings (i.e. more expensive money) and inflationary pressures - as governments look to inflation as a convenient way to erode the real value of the public debt.

This is a debate of huge importance whatever sector you work in - or simply if you are interested in knowing how much you will pay for a mortgage in coming years!

UPDATE: Here is Larry Summers (on February 10) discussing the continued situation of high inflation and the risk of becoming complacent when it comes to interest rates increases - this view consistent with the idea that interest rates will have to remain elevated for a while:

Jeffrey Sachs on the Global Economy

This interview by my former professor, Jeffrey Sachs (now at Columbia University), is well worth the 24 minutes it will take to watch it. It discusses many of the themes we recently discussed in Global Trends: the current economic situation in the world, the issue of inflation, of debt overhang, etc.

Niall Ferguson on Conflict and Asset Prices

Over at Bloomberg, Professor Ferguson warns us not to ignore the lessons of history when it comes to the possible conflict in Ukraine. Large-scale conflicts historically have led to higher interest rates and higher gold prices. The article draws useful parallels between the situation that we face now and the situation that prevailed both in 1815 at the end of Napoleon's run, and in the immediate period before the First World War. It is both a great lesson in history as well as a thought-provoking reflection on the current situation. Money quote: "As an investor, you may not be interested in war, but war is interested in you".

There will be important implications for investors from a Russian invasion of Ukraine. The heightened tension will lead investors to seek safe havens. This could have ambiguous effects on interest rates but my guess is that, in the context of tightening monetary policy and rampant inflation, we won't see the usual downward trend in Treasury yields that tends to accompany flights to safety. Sanctions against Russia are likely to be biting, especially when it comes to hydrocarbons, implying spikes in the prices of oil and gas. Stock markets have yet to fully price a full-fledged invasion, since there is residual uncertainty on whether one will take place - volatility is almost surely assured. How the Fed and ECB will handle this shock as they are about to raise rates to fight inflation will be very interesting to watch: in a context like this, releasing more liquidity is the usual reaction, but this may not be desirable with inflation where it is now. A combination of heightened geopolitical risk and rampant inflation looks a lot like the 1970s.

The Surge in Inflation

The big news this week is that inflation is up, big time. Year-over-year CPI inflation is at 5.4%. This vindicates the fears that economists like Larry Summers have been voicing for a while now. I blogged intensively on this issue in the past, for instance here. On one level, having some inflation can be a good thing, as it erodes the real value of debt and therefore alleviates at least in part the burden faced by debtors (not least the Federal government): it's a form of default. Indeed, some of the excess inflation that we are witnessing is the result of an avowed policy goal of the FED to favor growth at the cost of a little overheating. However, inflation dynamics can quickly get out of control. 5.4% seems like more than what the FED had been ready to accept, so we had better hope that they know what they are doing and can rein it in in time. If the bout of inflation that we are witnessing forces the FED to raise interest rates, this may actually defeat the purpose of having moderate inflation - namely the cost of debt may rise rather than decline. I blogged about this too, in the more distant past... back in August of 2020. People  then thought I was a bit crazy to be worrying about rising interest rates (we were still at the height of the pandemic). Now, I am not sure this view is so far outside the mainstream...

What Caught my Attention this Weekend?

1) The WSJ featured an article on how the COVID crisis is accelerating the decline of cash as a method of payment. It is worth clicking on the links embedded in the story. It is closely related to what we discussed last Thursday, and also very much in line with a general theme we will repeatedly see in Global Trends: the COVID crisis is most likely to accelerate trends that were already in motion before its occurrence, rather than to represent a reversal. This is the case for income inequality, social strife, political polarization, the retreat from globalization, the mounting tension with China, the trend toward automation, the generalization of easy money policies, and the decline of cash...

2) Also in the WSJ, Greg Ip opines on the role of easy money in fueling, at once, record stock valuations and mounting government debt. Both worry me greatly - more than they seem to worry other economists. That is especially the case for mounting government deficits and debt, as we will discuss in Module 9. If the massive injections of liquidity that we have witnessed ever lead to inflationary pressures, the FED may have to start raising rates. A huge stock of public debt could make this very expensive for the government. The very demand for loanable funds that emanates from the public sector may in itself put upward pressure on rates, ultimately. Remember - interest rates have nowhere to go but up. I expressed these concerns last August. My concerns have not eased since, though the scenario I described could be quite removed from us in time. 

UPDATE: People from both sides of the political spectrum seem to be voicing the same concerns as I have on the possible inflationary effects of current US macroeconomic policies: Michael Bordo and Mickey Levy do so over on the Wall Street Journal opinion page, while Larry Summers expresses similar worries in the pages of the Washington Post.

The GameStop Saga

I have been following with great interest the gyrations of the GameStop stock. It is one of the big financial sector stories of the new year, and it features several dimensions of financial innovation that we will touch upon in tomorrow's class.

If you wish to get a primer on the issue, you can hardly do better than to read this excellent summary from Vox. The links embedded in the story are almost more interesting than the story itself, if you want to dig deeper. This Bloomberg column by John Authers is also recommended, and I agree broadly with its message.

I find the tug of war between short selling hedge funds and small-scale investors quite fascinating. But on the merits of the issue, it is hard to see a compelling case that the current valuations of GameStop are justified by the fundamentals. I am glad I am not on either side of this game (for this is a game), but if I were, I'd feel more comfortable on the bearish side than on the bullish side. Of course, I am a cranky old economist, not a hopeful young investor!

UPDATE: GameStop's value seems to have come back down to earth even more quickly than I expected. Bloomberg has the details. The Lombard economist cited at the end of the article strikes me as spot-on.

Are Interest Rates About to Rise?

It is hard to read the tea leaves when it comes to interest rates. But I was struck by two recent news items, both in Bloomberg, that seem to show that interest rates may face upward pressures. 

The first was an article on how France and Germany have huge borrowing requirements, to finance the fiscal expenditures that were instituted to fight the COVID-related depression. These huge borrowing requirements are putting upward pressure on yields. You will note that even though yields there have risen in the last two months, they are still extremely low by historical standards. It is not the magnitude of the rise that causes me to report on this, rather it is the cause of the rise, which seems linked to unusually high borrowing requirements. This is likely to continue, and to put pressure on yields.

The second was a similar item, related to the Reserve Bank of India. It seems that in India too, yields have been rising, for slightly different reasons. Here it seems policymakers are worried about inflation, and may be letting yields rise rather than printing more money to keep them down.

When I was learning economics in the 1990s, a very popular story for why public deficits were bad for growth had to do with crowding out. Crowding out was a story based on supply and demand. The story was that when the borrowing requirements of the public sector were high, interest rates would tend to rise as a result of the demand for loanable funds emanating from the government. In turn, these rising rates would raise the cost of capital to the private sector, depressing private investment. In this manner, public spending would "crowd out" private investment, reducing growth.

The crowding out story kind of disappeared from the economics lexicon in the 2000s. During the Great Recession, central banks injected massive amounts of liquidity to shore up the banking sector and avert a depression. New terms like quantitative easing, whereby central banks would purchase all sorts of assets besides government debt, in exchange for newly-created money balances, meant that interest rates could fall all the way to the lower bound (zero) even in the presence of large public deficits. Inflationary pressures were tame, so central banks could do this without fear of igniting generalized increases in the price level. But with the COVID pandemic, we are testing the limits of this process. The borrowing requirements are so huge, and the amounts of injected liquidity so enormous, that we may get either inflation or rising interest rates.

Of course, we are not there yet, and it could take months, maybe years, for this to become a serious concern. But I am flagging it now because we are possibly seeing some early signs of the reemergence of crowding out. This is not yet the case in the US, and in most countries. But it is showing up a bit in Europe, in India... and the economic mechanisms that make these concerns valid there make them potentially valid elsewhere, because governments everywhere are running unprecedented deficits. I doubt that we will continue to be able to monetize massive amounts of public debt without paying - at some point - the consequences in terms of growth and inflation.

UPDATE: A few days after I posted this, the Fed made an announcement that they would likely keep rates near zero for the next 5 years, and that they would relax their stance toward inflation. This seems to go counter to the two articles I linked to above. I have some observations: if growth resumes and inflationary pressures appear again during the recovery, the Fed may not be able to maintain their new stance: if inflation rises, the Fed will have to do something about it, and that something may involve a departure from zero rates. In that case, the policy will have proven to be time-inconsistent, leading to a loss of credibility for the Fed. But if the Fed fails to convince firms and consumers that they are committed to low rates for a while, people may not act to restart the economic engine by consuming and investing: the Fed is between a rock and a hard place (as it usually is!). There is also the possibility that if rates elsewhere rise, the Fed may face the prospect of a dollar depreciation, and consequently may be forced to soften its stance on low rates. The Fed typically does not target the exchange rate, so this may be a weak channel for rising rates, but if combined with domestic inflation, it may contribute to a departure from the announced policy stance. I'm not saying this will necessarily happen or that rates will rise for sure, I'm only thinking through one possible scenario. And by making this announcement, the Fed sure is indicating that they believe we will be in this slump for a long time - if anything I take this as an indication of the seriousness of our current economic predicament.

Where Has All the Cash Gone?

In Module 4 of Global Trends we will be discussing monetary innovations. For instance, we will study the unprecedented monetary policy tools that the FED (and other Central Banks) developed in response to the 2008 Global Financial Crisis. During that event, the FED not only brought interest rates close to zero, but in tandem it made very large amounts of liquidity available to the financial system and to the economy. These injections of liquidity took sometimes unconventional forms, such as purchases of many kinds of assets (beyond Treasuries) that the FED previously did not purchase. For instance, the FED ended up with large quantities of mortgage-based securities on its balance sheet. The result of all this was a massive expansion in the FED's balance sheet, from about $870 billion in August 2007 to $4.5 trillion in early 2015 (source). In the aftermath of the crisis the FED tried to shrink its balance sheet, but all it ever managed was to bring it down to $3.8 trillion (August 2019) - still much higher than pre-crisis levels.

As soon as September of 2019, the FED started to expand its balance sheet again. In the aftermath of the COVID-19 crisis it exploded, and now stands at over $7 trillion. Where is all this money?

One answer can be found on the FED's own website. If you go here, and choose the chart entitled "selected liabilities of the Federal Reserve", you will see that there has been a recent jump in deposits of depository institutions at the FED. These are the reserves that the banking system holds at the FED. Bank are required to hold a certain percentage of their deposits as reserves at the FED, but they can choose to hold more than the legally required percentage. This, clearly, is what they have been doing - not just recently, but also during the aftermath of the 2008 financial crisis. Instead of loaning out the extra cash that the FED created through its asset purchases, they chose to hold it at the FED, so that these money balances were never actually put in circulation. Banks wanted to do this because, since October of 2008, the FED started to pay interest on bank reserves. This is a major new tool that allows monetary policymakers to fine-tune cash in circulation. Banks still have a cushion of cash they can use if they need to lend or if they get in trouble, but with the FED paying reserves they don't feel a strong urge to lend (especially when the interest they would earn on these loans is so low). And if they do, which could result in inflation, the FED can always pay a higher rate of interest, to rein banks in.

(Another category that seems to have increased steeply are the balances that the US Treasury holds at the FED. I don't want to dwell on this here, but you can find a clear explanation of what is going on at this link).

On the same chart you will see a steeper-than-usual recent increase in currency in circulation (which is a liability of the FED because anyone with dollars can redeem them for real goods and services). It pales in comparison to the near doubling of the FED's balance sheet since September 2019, but still - it does represent an increase. Combined with a steep rise in the the private sector's savings rate, it means that US firms and households are cash rich.

This is where a great recent article in Bloomberg comes in. The article explains that Americans are hoarding much of the excess cash that has actually been put in circulation. Here is one of the stunning charts in the article:

In other words, not only are banks holding excess cash reserves at the FED, but households (and some firms) themselves are flush with cash that they are not spending. Of course, they can't really spend it, since they are either under forced or voluntary lockdowns due to COVID.

In this context, should we worry about inflation? I don't. The cash balances that households have can be mobilized when the health crisis abates, to fuel a recovery in demand. We are not there yet, and when we are, this could create inflationary pressures. But the FED knows quite well how to manage the amount of money that is actually in circulation. They can cool things down if they get overheated. But we are no where near that point now. Indeed inflation expectations are at an all time low.

In general, the above-referenced Bloomberg article is a truly excellent (and short) way to gain a good understanding of where the US economy stands, and of the main trade-offs that economic policy-makers face. Recommended.