The Capital Note

The Capital Note: Debt, Windfalls, and Disaster

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Welcome to the Capital Note, a newsletter about finance and economics. On the abbreviated — Daniel Tenreiro is caught up in other projects — menu today: Debt and the waste of windfalls, the lockdown reflex, oil tankers as warehouses, green protectionism, and the (partial) vindication of October.

Debt and Complacency
When I read stories such as this, I begin to feel very uneasy.

The Wall Street Journal

The cost of servicing the nation’s growing debt load is shrinking despite a historic rise in government red ink this year, suggesting the U.S. still has room to borrow to fight the coronavirus pandemic.

Demand for safe Treasury assets has kept interest rates near historic lows this year, pushing net interest costs down by 10% from October through August, the Treasury Department said Friday. . . .

The Congressional Budget Office last week said debt as a share of economic output is set to approach 100% for fiscal year 2020, compared with 79.2% last year, and hit 108.9% by the end of the next decade.

Despite the rising red ink, however, CBO lowered its projections for interest costs over the next decade by $2.2 trillion from its forecast in March, reflecting lower-than-expected interest rates.

“The idea that we’ve done all this spending and our debt service is actually lower than it was in the pre-pandemic baseline is a remarkable testament to, in my view, how much more fiscal space you get when you have really low interest rates,” said Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities, a Washington think tank.

Don’t get me wrong, the fact that we can fund all the spending that is currently taking place in order to help manage the effects of COVID-19 and — let’s be honest about this — the measures taken to combat it is welcome. The alternative does not bear thinking about. Its consequences would be political as well as economic and they would be dire.

That the U.S. has been able to do this is a testimony both to the strong deflationary impulses evident since the financial crisis as well, in the background, to the advantages of the dollar’s status as the reserve currency, a status enhanced by the less-than-compelling fiscal position of many other major economies. To twist an old quotation, there is something to be said for being one of the healthier horses in the glue factory.

That said, it is hard not to think that these low rates are (to borrowers) something of a windfall, and windfalls are — to put it gently — not always used as wisely as they might be by governments.

The sad saga of the euro zone provides an example of this. Many of the countries that signed up for the single currency saw a dramatic fall in borrowing costs, which could, at least in theory, either have been used to pare back existing accumulated borrowing or, where the fiscal balance was already in decent shape, been treated as a windfall rather than a license to let rip. That’s not what happened (for a number of reasons), and the result, for some countries, was catastrophe, made infinitely worse by the fact that each country’s borrowing was now in the euro, a “foreign” currency (a problem that the U.S., a borrower in dollars, does not have). To oversimplify, they could not print their way out of trouble.

But in the end, no country can print its way out of trouble indefinitely.

So, on that cheery note, let’s turn to Arnold Kling, writing in Law & Liberty.

Kling cites IMF economists Carmen M. Reinhart and M. Belen Sbrancia, who have written:

Throughout history, debt/GDP ratios have been reduced by (i) economic growth; (ii) substantive fiscal adjustment/austerity plans; (iii) explicit default or restructuring of private and/or public debt; (iv) a surprise burst in inflation; and (v) a steady dosage of financial repression accompanied by an equally steady dosage of inflation.

Kling also quotes “the grumpy economist,” John Cochrane, who, displaying remarkable powers of understatement, has this to say:

The US grew out of WWII debt by not borrowing any more, by decades of fiscal probity, and by strong supply-side growth in a deregulated economy. We have none of these reassurances going forward.

Nope.

Kling:

The prospects for a repeat of the post-World War II experience of falling debt/GDP ratios are poor. Economic growth over the past 50 years has remained well below the levels achieved in the 1950s and 1960s. Social Security no longer contributes to the surplus, because the ratio of beneficiaries to workers is much higher than it was back then. Also, Medicare has become another large strain on fiscal resources. Finally, the willingness of leaders in Washington to forego current desires in order to maintain fiscal discipline has evaporated.

Yup.

Kling:

If neither economic growth nor primary surpluses are likely to emerge to bring down the debt/GDP ratio, that leaves the other options discussed by Reinhart and Sbrancia: hard default; soft default via surprise inflation; and financial repression with well-anticipated inflation.

In Kling’s view, which (to repeat myself) is well worth reading, the most likely outcome is inflation. As he observes, that is not what’s in the forecasts, but:

In my view, all attempts to predict inflation using mechanical rules fail. They fail because inflation depends on the habits, norms, and expectations of the public at large. If people are habituated to low inflation, then attempts by the Fed to nudge up the inflation rate will not work. In fact, over the last decade, inflation has almost always come in under the Fed’s announced targets. Conversely, if people believe that inflation will be high and variable, then they try their best to protect against this: they shorten the term of agreements; they incorporate cost-of-living escalators into labor bargains; they minimize their holdings of currency or other non-interest-bearing assets. In the United States, we last saw these behaviors in the high-inflation era of the 1970s. They served to reinforce the high-inflation regime, and it took the entire decade of the 1980s to return to an era of low and stable inflation.

Because of the importance of expectations of inflation that are embedded in habits and norms, an economy will tend to gravitate toward one of two regimes: a low-inflation regime, in which inflation is low and steady; or a high-inflation regime, in which inflation is high and variable.

A scenario that I find plausible is that by 2030 the United States will have transitioned to a high-inflation regime. The Federal Reserve will be powerless to prevent such a transition. If it attempts contractionary policies, the interest rate on government debt will go up. With the debt/GDP ratio as high as it is, this would threaten a fiscal crisis by sharply raising the amount of tax revenue that has to be devoted to making interest payments. If instead, the Fed seeks to hold down the government’s interest costs, it will have to do so by making massive new purchases of government bonds, thereby putting more monetary fuel onto the inflationary fire.

Time will tell whether Kling is right, but however this all spins out, it is hard to see how (in his words) “the debt/GDP ratio is going to come down in a benign fashion.”

One final thought on borrowing costs. I have never forgotten attending a talk given by a (now deceased) Wall Street titan a decade or so ago. The topic was U.S. government debt, and although he made no predictions as to when investors would lose patience, he did predict that when they did, it would be very sudden and very sharp.

Depressed, I talked to the titan’s stepson a day or so later.

“Ah, you’ve heard ‘the talk,’ as we call it in the family.”

“Yes, I have. Not good.”

“No.”

Happy Monday!

— A.S.

Around the Web
Wolfgang Münchau in the Financial Times:

The infection rate in Sweden also showed strong geographical variation. Most of the Swedish cases were concentrated in two regions, including Stockholm. Meanwhile, the southern Swedish city Malmö is close to the Danish capital, Copenhagen, separated by the narrow Oresund Strait. Malmö’s rates look good by comparison with Copenhagen, even though the two operated under different lockdown regimes.

I don’t know why regional gaps were so strong, and my interlocutors in Sweden do not either. If you want to make grand pronouncements about Swedish lockdown policies and infection rates, you should probably make an effort to understand this first.

Policy in times of Covid-19 amounts to decision-making under extreme uncertainty. The latest Swedish numbers do not prove or disprove anything. But before policymakers order something as extreme as another lockdown, they should have had incontrovertible statistical evidence, not just a bunch of numbers that feed their confirmation bias. As long as statistical doubt persists, we certainly do not want to do this twice.

A lockdown is an extreme policy measure and its consequences will not become apparent for some time. I have no doubt that it will end up increasing inequality. Unemployment and corporate insolvencies will rise once the support measures are withdrawn. Although stock market indices have fallen and recovered, these are just averages. Behind them stand huge shifts of capital from old to new sectors. If people continue to work from home, this will boost residential and rural areas at the expense of city centres and shift resources from commercial to residential property.

I consider the lockdown reflex as currently the biggest threat to western capitalist democracies . . .

The “lockdown reflex” is a very good phrase indeed.

Oil tankers as warehouses…

Bloomberg:

Some of the world’s biggest oil traders are gearing up for a possible resurgence of a coronavirus-induced glut of crude and fuels, snapping up giant tankers for months-long charters so that they can be ready to store excess barrels if necessary.

The chartering spree is likely to alarm Saudi Arabia, Russia and their allies as it indicates that the oil traders believe the crude market is moving into a surplus after OPEC+ managed to create a deficit earlier this summer with its output cuts.

Trafigura Group, the world’s second-largest independent oil trader, in recent days booked about a dozen supertankers that can hold a total of 24 million barrels of oil, according to people familiar with the matter. All in, about 18 similar charters have been arranged with Royal Dutch Shell Plc, Vitol Group and Lukoil among those also hiring the vessels, according to shipbrokers’ lists of bookings seen by Bloomberg. State-controlled China National Chemical Corporation Ltd, known as ChemChina, has also joined, the lists show.

EURACTIV:

The European Union will press China to aim for climate neutrality by 2060 or eventually face punitive carbon tariffs during a summit on Monday (14 September) aimed at concluding a bilateral trade agreement by the end of the year.

At the summit, Europeans will also push Beijing to peak its global warming emissions by 2025 and commit to stop all investments in new coal-fired power stations, whether at home or abroad, EU officials said.

The climate talks are part of a wider bilateral trade and investment agenda that Brussels hopes will help restore a level playing field between EU companies and state-owned Chinese firms that are not subject to the same CO2 emission obligations…

“China has committed to peak its emissions by 2030,” a senior EU official remarked. “We think it’s far too late, we suggest 2025.”

Failing to do so would eventually push the EU side to impose punitive carbon tariffs on Chinese firms in order to restore a level playing field with European companies, which will face ever-stricter emission standards in the coming years because of the bloc’s increased level of ambition, EU officials explained.

“We’ve already had this discussion with our Chinese friends” as well as other nations, the official said in reference to the EU’s planned border adjustment mechanism, or carbon border tax.

Although there is no decision yet on the shape or features of the tax, the official said that “some parameters” were already clear: first, the Commission “will make a proposal” and “it will be aimed at putting imported products on the same level as domestic products” with a view to restoring fair competition between EU and foreign manufacturers.

China may or may not talk a good game (we will see), but I doubt that it will blink. Green can be a good color for camouflage, not least for protectionism, and that, clearly, is the direction in which the EU is going.

And as the EURACTIV report makes clear, it won’t only be directed at Brussels’ “Chinese friends.”

Random Walk
October acquitted (but there’s a catch).

From Investopedia:

The October effect is a perceived market anomaly that stocks tend to decline during the month of October. The October effect is considered mainly to be a psychological expectation rather than an actual phenomenon as most statistics go against the theory. Some investors may be nervous during October because the dates of some large historical market crashes occurred during this month.

The magic word there is “perceived.”

Brian Sozzi, writing for Yahoo!Finance at the end of August:

September tends to be a weak month for stocks historically. In fact, according to LPL Financial, September has been the worst-performing month for markets, on average, since 1950. The S&P 500 has dropped about 1% on average that month since 1950, LPL Financial data shows. The only other month to notch a drop on average (and a minuscule one at that) going back to 1950 is August.

On the other hand, October is not entirely in the clear:

LPL Financial says the S&P 500 has dropped nearly 1% in election years [in October] dating back to 1950. That makes October the worst month for markets in an election year.

Once again, happy Monday!

A.S.

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