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Implications of fiscal dominance in the US and likely options going forward.
Posted on 8/26/23 at 5:54 pm
Posted on 8/26/23 at 5:54 pm
This will be a hell of a first post, fair warning. Been lurking here for years, sometimes for recruiting info but mostly for coaching scandals and searches gone awry, lol,...RTR btw. My wife is sick of discussing macro so perhaps this is a cry for help, or at least some friendly banter. Fiscal discussions can be political but hopefully the mods won't boot this to the poli board as I think it'll be better served here as the topic will increasingly affect our finances. And the truth is each side of our current duopoly shoulders approx 50% of the blame. This goes for past admins as well as the recent fiscal firehose which was unleashed in two stages by two different admins.
US debt/gdp is currently around 120% after briefly scrapping 130% during covid before the resultant inflation compressed it. Since 1820 51 countries have hit 130% and 50 have defaulted in one shape or form. Japan (260% debt/gdp) is the lone exception and they are currently having to choose between saving their currency or their bond market. Can't do both. They also have some unique attributes that allow them (for a time) to defy monetary gravity such as a high personal savings rate and their status as a net exporter.
The US, on the other hand, is incapable of kicking the can down the road anywhere near as long as Japan has. We're a twin deficit nation. We only export airplanes, bombs and bullets, some medical equipment and debt, truckloads of debt. I see a lot of comparisons between today and the 1970s but that is a false parallel. The inflation of the 70s was primarily driven by bank lending as boomers entered the housing market en masse. Kissinger needing the oil price to triple so he could back the dollar with it with it after Bretton Woods failed was a contributor as well.
In contrast, today's inflation is fiscal driven and as such the closest parallel is the 1940s when the Fed was effectively merged with the Treasury for a few years so the WW2 debt balloon could be inflated down to a manageable level by employing yield curve control. Japan has been in ycc since I believe 2016. It is the Hotel California of monetary policy. You can check in anytime you like but you can never leave (or at least until debt/gdp is shrunk back to 65 or 70%).
There are two primary levers a modern government can use to inflate their debt away (that don't involve war) and I believe both will be used in the not too distant future. The first method was test driven during covid. Those stimmies, the ppp "loans" and other assorted programs were imo, the govt test driving UBI. Checks went out, debt/gdp briefly spiked and was compressed lower a year or two later when the ensuing inflation began working its way through the economy offering a nice spike in nominal gdp.
LINK
The reason I believe this was a test drive is because of this^ paper authored by Stan Fischer and published, coincidently, just before the repo spike of Sept '19 which foreshadowed the "covid crash" of March '20. Stan Fischer was an economist with the Bank of Israel in the 80s when they engineered a very successful mild hyperinflation which shrunk their debt/gdp to a manageable level and allowed them to normalize policy. The "going direct" method cited in the paper=stimmy checks or ubi. Fischer later worked at the Fed before taking an advisory position at Blackrock.
The second method I believe will be employed in conjunction with a form of ubi will be the return of mandatory zero interest banking reserves. Note, reserve requirements at commercial banks have been set at zero since Mar '20. By requiring banks to hold large reserves without paying interest reported inflation can be damped when the effects of the ubi hits the economy.
LINK
Here's a paper^ published this summer outlining exactly how to do it complete with very complicated math projections about how much cpi can be compressed during an inflate the debt away campaign. Note, Charles Calamiris is an academic who does not work at the Fed. The fact that the St Louis Fed published this is significant. This, while JPow continues to deny that fiscal dominance will ever play a role in his policy, uh...ok.
TLDR: We are running wartime deficits in peacetime, deficits are approx 7% of gdp currently and will spike to 8-10% or higher when tax receipts nosedive in the recession currently being engineered by the Fed. With no road left for can kicking, the math is increasingly leading us into fiscal dominance. The more successful Powell is in shrinking inflation the worse off our fiscal situation gets. Debt shrinkage shenanigans are coming, likely in one, or both the forms described here. You might want to start thinking about it now.
US debt/gdp is currently around 120% after briefly scrapping 130% during covid before the resultant inflation compressed it. Since 1820 51 countries have hit 130% and 50 have defaulted in one shape or form. Japan (260% debt/gdp) is the lone exception and they are currently having to choose between saving their currency or their bond market. Can't do both. They also have some unique attributes that allow them (for a time) to defy monetary gravity such as a high personal savings rate and their status as a net exporter.
The US, on the other hand, is incapable of kicking the can down the road anywhere near as long as Japan has. We're a twin deficit nation. We only export airplanes, bombs and bullets, some medical equipment and debt, truckloads of debt. I see a lot of comparisons between today and the 1970s but that is a false parallel. The inflation of the 70s was primarily driven by bank lending as boomers entered the housing market en masse. Kissinger needing the oil price to triple so he could back the dollar with it with it after Bretton Woods failed was a contributor as well.
In contrast, today's inflation is fiscal driven and as such the closest parallel is the 1940s when the Fed was effectively merged with the Treasury for a few years so the WW2 debt balloon could be inflated down to a manageable level by employing yield curve control. Japan has been in ycc since I believe 2016. It is the Hotel California of monetary policy. You can check in anytime you like but you can never leave (or at least until debt/gdp is shrunk back to 65 or 70%).
There are two primary levers a modern government can use to inflate their debt away (that don't involve war) and I believe both will be used in the not too distant future. The first method was test driven during covid. Those stimmies, the ppp "loans" and other assorted programs were imo, the govt test driving UBI. Checks went out, debt/gdp briefly spiked and was compressed lower a year or two later when the ensuing inflation began working its way through the economy offering a nice spike in nominal gdp.
LINK
The reason I believe this was a test drive is because of this^ paper authored by Stan Fischer and published, coincidently, just before the repo spike of Sept '19 which foreshadowed the "covid crash" of March '20. Stan Fischer was an economist with the Bank of Israel in the 80s when they engineered a very successful mild hyperinflation which shrunk their debt/gdp to a manageable level and allowed them to normalize policy. The "going direct" method cited in the paper=stimmy checks or ubi. Fischer later worked at the Fed before taking an advisory position at Blackrock.
The second method I believe will be employed in conjunction with a form of ubi will be the return of mandatory zero interest banking reserves. Note, reserve requirements at commercial banks have been set at zero since Mar '20. By requiring banks to hold large reserves without paying interest reported inflation can be damped when the effects of the ubi hits the economy.
LINK
Here's a paper^ published this summer outlining exactly how to do it complete with very complicated math projections about how much cpi can be compressed during an inflate the debt away campaign. Note, Charles Calamiris is an academic who does not work at the Fed. The fact that the St Louis Fed published this is significant. This, while JPow continues to deny that fiscal dominance will ever play a role in his policy, uh...ok.
TLDR: We are running wartime deficits in peacetime, deficits are approx 7% of gdp currently and will spike to 8-10% or higher when tax receipts nosedive in the recession currently being engineered by the Fed. With no road left for can kicking, the math is increasingly leading us into fiscal dominance. The more successful Powell is in shrinking inflation the worse off our fiscal situation gets. Debt shrinkage shenanigans are coming, likely in one, or both the forms described here. You might want to start thinking about it now.
This post was edited on 8/27/23 at 9:02 am
15
Posted on 8/26/23 at 6:23 pm to Art Blakey
Can you dumb it down for me?
Good thing?
Bad thing?
What should we as citizenry do/prepare for?
China should be exporting their devaluation soon. Will that impact your thesis?
Good thing?
Bad thing?
What should we as citizenry do/prepare for?
China should be exporting their devaluation soon. Will that impact your thesis?
Posted on 8/26/23 at 6:36 pm to Art Blakey
Hell of a first post. You make a fair argument. I think “kicking the can down the road” continues until there is a viable candidate to replace the USD though.
As bad as it is right now, the entire world relies on us and trust us more so than their own governments.
As bad as it is right now, the entire world relies on us and trust us more so than their own governments.
Posted on 8/26/23 at 6:44 pm to BamaCoaster
Bamacoaster,
Fiscal dominance means the Fed essentially loses its independence. In the 1940s it was basically folded into the US Treasury. The reason is interest expense becomes so great that positive real rates, i.e., above the inflation rate, are impossible to pay for the govt in question. So, regardless of inflation, the hands of monetary policy are tied.
You don't want to be holding long bonds if you want to earn a positive yield. The math on a traditional 60/40 won't work. It eventually pushes everyone further out the risk curve. Bad news for banks, pensions and insurance companies. But especially banks, since the govt is likely to suppress consumer inflation by making the banks eat zero interest reserves.
Fiscal dominance means the Fed essentially loses its independence. In the 1940s it was basically folded into the US Treasury. The reason is interest expense becomes so great that positive real rates, i.e., above the inflation rate, are impossible to pay for the govt in question. So, regardless of inflation, the hands of monetary policy are tied.
You don't want to be holding long bonds if you want to earn a positive yield. The math on a traditional 60/40 won't work. It eventually pushes everyone further out the risk curve. Bad news for banks, pensions and insurance companies. But especially banks, since the govt is likely to suppress consumer inflation by making the banks eat zero interest reserves.
This post was edited on 8/26/23 at 6:46 pm
Posted on 8/26/23 at 7:31 pm to Art Blakey
Thanks for this, very informative and well thought out. Question. So if you are holding cash, as I am, will this devalue the crap out of it? If so, what do you suggest? I'm retiring in October and am at a loss of what I should do. So darn much uncertainty.
Posted on 8/26/23 at 9:03 pm to Topisawtiger
Topisawtiger,
I'm a few years younger than you so my risk tolerance is greater. I'm not a financial advisor nor is this investment advice but you can't go wrong with t bills yielding 5%, no duration risk and you can roll them over for as long as you like. That or a money market yielding 5% is the best option for money on the sidelines that you want to preserve imo. If inflation surges again, say to high single digits over that 5%, you're taking a small haircut but not as much as mattress cash.
I'm torn on equities. If/when they really start inflating the debt away equities will probably go nuts, especially as the bond market wises up and migrates in. We will probably see more insane valuations than today. However, I'd be very surprised if there's not a decent correction coming from these rate hikes in the more immediate term. Rates are now about where they were pre GFC with twice the debt levels.
Will they pull out the firehose like they did in Mar of 20 creating a very narrow deep V dip and recovery? My guess is Powell just lowers rates, doesn't print and lets it bleed if the bond market is functional. I don't think he'll QE again until he sees a treasury auction fail or near fail.
I'm a few years younger than you so my risk tolerance is greater. I'm not a financial advisor nor is this investment advice but you can't go wrong with t bills yielding 5%, no duration risk and you can roll them over for as long as you like. That or a money market yielding 5% is the best option for money on the sidelines that you want to preserve imo. If inflation surges again, say to high single digits over that 5%, you're taking a small haircut but not as much as mattress cash.
I'm torn on equities. If/when they really start inflating the debt away equities will probably go nuts, especially as the bond market wises up and migrates in. We will probably see more insane valuations than today. However, I'd be very surprised if there's not a decent correction coming from these rate hikes in the more immediate term. Rates are now about where they were pre GFC with twice the debt levels.
Will they pull out the firehose like they did in Mar of 20 creating a very narrow deep V dip and recovery? My guess is Powell just lowers rates, doesn't print and lets it bleed if the bond market is functional. I don't think he'll QE again until he sees a treasury auction fail or near fail.
Posted on 8/26/23 at 9:24 pm to Art Blakey
(no message)
This post was edited on 10/21/23 at 11:20 am
Posted on 8/26/23 at 9:56 pm to Art Blakey
quote:
But especially banks, since the govt is likely to suppress consumer inflation by making the banks eat zero interest reserves.
At what point do they stop issuing new credit, then? I mean, I know that's their business, but if it is all risk, no reward, what is their (the bankers) exit strategy from the industry?
You make a lot of sound points, but we're in a completely novel economy relative to the 1940s. Fiscal hawks (of which I am one since a teenager) have been screeching about this since Reagan (or before). Frankly, I think we hit the tipping point under Obama and there isn't a clear recovery procedure. We can either do a planned crash landing or an unplanned one. Making the runway is no longer an option.
Posted on 8/27/23 at 4:23 am to Art Blakey
I like you
Posted on 8/27/23 at 7:52 am to Ace Midnight
quote:
At what point do they stop issuing new credit, then? I mean, I know that's their business, but if it is all risk, no reward, what is their (the bankers) exit strategy from the industry?
You make a lot of sound points, but we're in a completely novel economy relative to the 1940s. Fiscal hawks (of which I am one since a teenager) have been screeching about this since Reagan (or before). Frankly, I think we hit the tipping point under Obama and there isn't a clear recovery procedure. We can either do a planned crash landing or an unplanned one. Making the runway is no longer an option.
Banks have already tightened lending standards considerably. Some industry specific non banks are trying to fill the void, ex: Zillow's lending arm just introduced 1% down home loans. Lol, what could go wrong?
Re: the 1940s comparison, yes, the economies differ at scale. Most notably, we have since exported our manufacturing base to defend usd hegemony leaving a highly financialized services and consumption based economy in its wake. However, at the base level, inflation can only really come from two sources, either banks lending money into existence or government printing it into existence. The 70s were primarily bank lending and the 40s and present are primarily fiscal driven.
Fiscal hawks are like goldbugs. Yes, they've technically been right for 40 years but it takes a long time for these things to come to a head and sometimes demographic shifts can lull people into thinking the math doesn't matter. Dick Cheney once famously said "Reagan proved deficits don't matter", lol.
A few years before Cheney said that we had a surplus for a couple years despite profligate govt spending. Both Clinton and Gingrich took credit for it, pretending like they were budgetary savants but the truth was that was just a brief window of favorable demographics, boomers were in their prime earning years, there were a lot of them, and the WW2 generation who were drawing on entitlements were a smaller demographic. Now boomers are retiring, there are still a lot of them, and gen X and millennials aren't making nearly enough for their taxes to support boomer retirements. The math on the New Deal and Great Society programs is fundamentally broken. Those gaps will get printed.
Posted on 8/27/23 at 8:29 am to Art Blakey
quote:
we had a surplus for a couple years despite profligate govt spending.
I hate this myth. The budget was in near balance for a single yearly cycle, but since the actual debt actually went up (slightly) I continue to argue that it was no surplus at all and perverts the very nature of the word.
Regardless, it was, as you say, more the result of timing than any policy pushed by either party at the time.
Posted on 8/27/23 at 9:18 am to Art Blakey
This is the type of discussion I like to see on this board. Very interesting to read.
One thing I've started to notice is the diminishing power of the dollar around the world. Went to Mexico a few months ago and the exchange rate kind of shocked me.
One thing I've started to notice is the diminishing power of the dollar around the world. Went to Mexico a few months ago and the exchange rate kind of shocked me.
Posted on 8/27/23 at 9:26 am to Art Blakey
Also a question, I see you say the fed is engineering a recession to tame inflation and other things. Am I wrong to think that needs to happen? I mean it's going to suck in the short term but long term it seems to my elementary economics brain that it would help
Posted on 8/27/23 at 10:17 am to Civildawg
quote:
Also a question, I see you say the fed is engineering a recession to tame inflation and other things. Am I wrong to think that needs to happen? I mean it's going to suck in the short term but long term it seems to my elementary economics brain that it would help
Isolated in a vacuum, you are correct. Inflation is undesirable, it hurts the lower and middle income earners the most. But let's break down the second and third order effects given the US fiscal position. US tax receipts are currently down about 8% year over year. In a run of the mill recession tax receipts drop about 20%. In a severe recession it's worse. Any drop in receipts will show up in the following year's deficit. Let's be honest, this govt isn't cutting any spending. The vast majority of spending is interest, defense and entitlements. Entitlements with an election coming up? No. Defense with tensions in Asia rising? No. Hard default on interest? Not happening.
We have about a 25T gdp and govt spending accounts for 6T of that or roughly 25% of gdp. Cut govt spending and you cut gdp and exacerbate any recession. If Powell is successful in squashing inflation via demand destruction current deficits will blow out in the ensuing recession as tax receipts fall and safety net payments to individuals increase with unemployment. This will drive a new wave of inflation.
The Fed is boxxed in. They're damned if they do, damned if they don't. Unlike Yellen and Bernanke, I think Powell is smart enough to understand the position he's in and that's why I'm surprised he even wanted a second term. If he holds his ground as unemployment creeps up in a recession this fall or next year the admin and MMTers in Congress will come for his head.
Posted on 8/27/23 at 1:29 pm to Art Blakey
good first post, and much I agree with.
It is useful to remember that with UBI, the US Government will subsequently have the ability to use negative interest rates as an incremental “tax” to remove assets directly from a participant’s account.
With massive layoffs on the near horizon, and complete destruction of the commercial credit availability, I suspect the only possible avenue remaining for JPow is to cut rates and potentially begin another round of QE as the economy “augers in.”
IMO, the real answer is to resurrect the economy through energy independence and to put spending controls into the US budget. Energy costs permeate inflation in many hidden ways.
I wanted to remain is cash, but the 5%+ return on treasuries made it attractive enough to move a portion of it there (TBIL and TLT for me)
It is useful to remember that with UBI, the US Government will subsequently have the ability to use negative interest rates as an incremental “tax” to remove assets directly from a participant’s account.
With massive layoffs on the near horizon, and complete destruction of the commercial credit availability, I suspect the only possible avenue remaining for JPow is to cut rates and potentially begin another round of QE as the economy “augers in.”
IMO, the real answer is to resurrect the economy through energy independence and to put spending controls into the US budget. Energy costs permeate inflation in many hidden ways.
I wanted to remain is cash, but the 5%+ return on treasuries made it attractive enough to move a portion of it there (TBIL and TLT for me)
Posted on 8/27/23 at 2:15 pm to cadillacattack
quote:
good first post, and much I agree with.
It is useful to remember that with UBI, the US Government will subsequently have the ability to use negative interest rates as an incremental “tax” to remove assets directly from a participant’s account.
With massive layoffs on the near horizon, and complete destruction of the commercial credit availability, I suspect the only possible avenue remaining for JPow is to cut rates and potentially begin another round of QE as the economy “augers in.”
IMO, the real answer is to resurrect the economy through energy independence and to put spending controls into the US budget. Energy costs permeate inflation in many hidden ways.
I wanted to remain is cash, but the 5%+ return on treasuries made it attractive enough to move a portion of it there (TBIL and TLT for me)
Great point, energy independence, or its potential I should say, is our not so secret weapon. Gas probably needs to hit about $7 for it to become politically feasible, given the current nature of the CO2 politics. That is a luxury Europe and Japan don't have and both are in worse fiscal shape than we are.
I started studying the crude markets when the current admin starting draining the spr and here are some fun facts. US shale has been 90% of global production growth for the last decade which essentially meant we exercised some control over the price of oil as the largest marginal producer. Horizontal drilling obviously takes a lot more upfront investment and generally demands a higher price to be profitable compared to much of the vertical drilling in the mid east. By draining the spr we effectively capped horizontal exploration because it didn't pencil out at those price levels.
Instead of investing in exploration companies began returning profits to investors by raising dividends. All this came on the heels of negative oil in spring 2020. Domestic shale is now on the verge of rolling over which has huge implications going forward. This effectively grants MBS and Putin more control over price. The current admin also published their refill price and now Putin and MBS are taking turns cutting production everytime WTI gets near that window. Oof.
The good news is we could achieve independence if we had to, and we will, but due to questionable decisions we will likely have to endure some pain to get there. The spr can't just be refilled in 6 months like it was drained. It will take years to refill, hopefully we won't need it before then.
This post was edited on 8/27/23 at 2:16 pm
Posted on 8/27/23 at 6:22 pm to Art Blakey
quote:
The spr can't just be refilled in 6 months like it was drained. It will take years to refill, hopefully we won't need it before then.
Although I don’t agree with the reasoning for which Biden emptied the SPR, I also don’t really see the point of it anymore. We all know that the US is now capable of meeting domestic demand with domestic production so what exactly does the SPR accomplish? Even when it’s full, it’s still like only days worth of demand. With Shale oil, the US is only constrained by refining capacity, so having a couple days worth of oil sitting in storage seems useless
Posted on 8/28/23 at 9:40 am to Captain Crackysack
quote:
We all know that the US is now capable of meeting domestic demand with domestic production so what exactly does the SPR accomplish?
If there was an outbreak of a major theater war involving the U.S. and/or any major NATO ally (e.g. UK, France, Germany), supplies of jet fuel, diesel and gasoline would figuratively evaporate overnight.
It was always supposed to be for that reason with a secondary objective to allow for economic activity during a short-term shortage (functioning like a buffer in case of emergency).
This economic/political lever it has been used for is silly and counterproductive.
Posted on 8/28/23 at 11:00 am to Ace Midnight
quote:
If there was an outbreak of a major theater war involving the U.S. and/or any major NATO ally (e.g. UK, France, Germany), supplies of jet fuel, diesel and gasoline would figuratively evaporate overnight.
It was always supposed to be for that reason with a secondary objective to allow for economic activity during a short-term shortage (functioning like a buffer in case of emergency).
This economic/political lever it has been used for is silly and counterproductive.
That's kind of where I'm at. It's for emergencies, food/supply distribution in a crisis etc...
This post was edited on 8/28/23 at 11:01 am
Posted on 8/28/23 at 12:37 pm to Ace Midnight
quote:
supplies of jet fuel, diesel and gasoline would figuratively evaporate overnight.
Right but the SPR doesn’t store refined products. It stores crude oil. So even if WW3 starts, we’re constrained by refining capacity, not available crude.
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