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The US Congress has passed President Joe Biden’s $1.9 trillion coronavirus relief package and the president is expected to sign it today. It is a triumphant moment for the ruling Democrats early into Biden’s term. And it also amounts to a significant moment in the history of the US. For it will be the start of a big political gamble which, if it succeeds, will guarantee another age of US prosperity but, if it fails, could overturn most of our current strategic assumptions.
It is over 40 years since Paul Volcker took office as chairman of the Board of Governors of the Federal Reserve. At the time, stagflation – a combination of high inflation and unemployment and slow economic growth – ravaged the US economy: inflation was 12% and subsequently peaked at over 14%. After implementing dramatic interest rate increases, Volcker was able to arrest the double-digit inflation. Ultimately, this paved the way for a quarter century of great prosperity.
Until recently, seeking or tolerating higher inflation was anathema to the so-called Washington Consensus, the policy prescriptions generated by Washington-based institutions such as the International Monetary Fund, the World Bank and the US Department of the Treasury. However, the consequences of the financial crisis of 2007/08 and of the coronavirus pandemic have stretched policymakers’ attention well beyond that singular focus. Uneven prosperity growth for the asset-rich compared to those left behind have forced the debate on policy measures to address societal inequalities and previously untapped labour resources. The questions of why a defined rate of unemployment is necessary, or why going below it is dangerous, have been posed. Janet Yellen, former chair of the Federal Reserve, now Treasury Secretary, summed up her conclusion to the debate during a recent appearance on CNN:
I have spent many years studying inflation and worrying about inflation… But we face a huge economic challenge here and tremendous suffering in the country. We have got to address that. That’s the biggest risk.
Avoiding the Errors of the Past
In striking contrast to the Volcker years, the desired objective now is maximum employment, even if this means higher inflation, if only because policymakers believe they have the foresight and tools to prevent runaway inflation. The shift is as exciting today as it was terrifying four decades ago, and the outcome holds profound global consequences.
Before focusing on the consequences of reflation, of stimulating the economy so that it picks up growth, it is worth asking why sustainably higher inflation is a plausible outcome. After all, the so-called quantitative easing (QE) policies designed to increase money supply to boost lending and investment, generated none of the sort after the financial crisis in 2007/08. But everything is different today, compared to 12 years ago.
First and foremost, the fiscal response to the financial crisis at that time – amounting to 6% of GDP over three years – was inadequate relative to the shock. This underwhelming response was partly due to insufficient information (the contraction in the second half of 2008 turned out to be almost three times greater than initially reported) and partly attributable to political preferences. This time, Washington has deployed fiscal policy in ways unheard of outside of major wars. Since March 2020, fiscal support has amounted to 17% of GDP, with a further 9% about to be enacted, and another 10% or so in a multi-year infrastructure package likely later this year. As a result, the US growth shortfall relative to the previous baseline (the so-called output gap) could well be closed this year, with a huge ongoing stimulus beyond. The fiscal deficit is forecast to be $3.5 trillion in 2021 and $1.5 trillion in 2022.
Monetary policy, with the benefit of lessons learned during the 2007/08 crisis, has also been more aggressive. In March 2020 alone, QE was $786 billion – more than the entire QE2 programme. By the end of 2021, post-pandemic QE will amount to more than $4 trillion, or close to 20% of US GDP. Because of monetary actions, money supply growth (an indicator which has fallen out of fashion since the 1980s) – runs at +26% year on year. This is a post-Second World War high, and 2.5 times the pace that followed the 2007/08 crisis.
Prospective monetary policy will be different too, and profoundly so. Scarred by persistent shortfalls, the Federal Reserve published an updated statement of goals and objectives. Flexible Average Inflation Targeting will replace the former rigid inflation targets. Overshoots of 2% will not just be tolerated, but sought, to compensate for past undershoots. Inflation expectations must be raised. Crucially, the achievement of full employment takes precedence over all other objectives.
Because of the sheer nature of the coronavirus pandemic shock and the outsized policy response, this is the only recovery of our times not characterised by pressures on the finances of the private sector. Instead, households and corporates have hoarded savings since they often had nothing to spend it on. Households’ excess savings grew by over $1.5 trillion last year, with another $0.5–1 trillion to be added this year. Liquid assets on corporate balance sheets expanded by $1.1 trillion. At 16%, it is the highest share of total assets in half a century. The banking system, a principal lightning rod for the great financial crisis of 2007/08, is now in rude health.
Opportunities and Risks
If the US reflation experiment succeeds, then the US unemployment rate should fall below 3% for the first time since the 1950s. Inflation would rise to 2.5% or so, with interest rates rising in a measured manner commensurate with that level. US exceptionalism will once more be the order of the day.
Yet the forecasts are uncertain. If the domestic savings rate were to undershoot previous levels, as it did in the years following the Second World War with confidence rebounding, then growth will likely significantly exceed expectations. Repeated double-digit quarterly GDP growth rates are possible. With the output gap closed, inflationary pressure would build, and the current account deficit widen. All other things being equal, this will pressure bond yields higher and the dollar initially lower.
In a globalised world, everything is relative. In contrast to the scenario above, China is on a steadier economic course. China’s growth should decelerate to around 5% in the next couple of years, followed by 4–4.5% over the medium term. Money supply growth – the total value of money available in an economy at a point of time – is only 9% year on year in China, strikingly different from the US. Beijing’s underlying goal is transition to a consumption-led economy with less reliance on exports, real estate or government infrastructure spending.
Additionally, Beijing is finally pursuing a strong renminbi (RMB) policy. This facilitates the desired economic rebalancing and, importantly, the use of RMB as a reserve asset. Part of this process is the opening of financial markets to foreign capital. During the 12 months to September 2020, $290 billion flowed into the bond and equity market, with more to come as weightings of Chinese markets in Western financial indices expand further. Non-Chinese Asian foreign exchange reserves climbed $400 billion in the past year, to reach $3 trillion. Central bank reserves held in RMB have increased only 2.1% to $245 billion, leaving enormous room for growth amid diplomatic encouragement.
The deepening of China’s markets presents a medium-term challenge to the US. The US’s ability to undertake the reflation experiment is founded entirely on maintaining low interest rates. Washington’s actual debt service costs are low at just 1.6% of GDP, almost unchanged from five years ago despite escalating deficits. Nevertheless, the US is vulnerable and exposed to higher rates, given that the average maturity of US government debt is less than six years. The US government’s annual funding needs will remain at the upper end of a trillion dollars when QE ends, according to the Congressional Budget Office. By comparison, last year’s funding need was less than half a trillion dollars. China, meanwhile, holds $1.1 trillion of US Treasury securities. Will China continue to fund Washington’s largesse, particularly if it enables US exceptionalism, or will the stronger RMB policy limit accumulation of foreign exchange reserves?
Previous US or global crises and ensuing market adjustments have been associated with US dollar strength, causing acute pain at times for emerging markets – the ‘taper tantrum’ in 2013, the collective reactionary panic after investors learned that the Federal Reserve was slowly putting the brakes on its QE, is one such example. When the current cycle ends, a crucial question will be China’s tolerance for capital outflows from its markets as others before it have suffered. Might capital controls be imposed, or might China liquidate US Treasury holdings to repatriate the monies and offset the outflows? The ensuing tightening in US financial conditions could be a catastrophic differentiator from past crises and require ever-larger QE programmes.
The threat of capital controls between regions of the world’s market is undoubtedly causing some global money managers to consider matching assets and liabilities within regions to avoid stranded assets.
A failure of US reflation will be defined by inflation rising alarmingly before unemployment falls significantly, or spiralling US Treasury yields that crowd out domestic growth and endanger passage of the infrastructure programme. The domestic political consequences of such will be long felt. For China, this would do far more than validate the shortcomings of Western democracy.
Chinese growth would then be set to outperform for the foreseeable future and would allow for, and indeed promote, a broader fulfilment of their geopolitical objectives. In short, a mirror image of what the US achieved in confronting and ‘burying’ the Soviet Union at the conclusion of the Cold War.
Today, Biden is entitled to rejoice: he has achieved his key political objective in the management of the US economy well within his first 100 days in office. But economics can dictate realpolitik outcomes. And the stakes now are very high indeed.
Andrew Law is chairman and chief executive officer of Caxton Associates, a 37-year-old US hedge fund that he manages from London. He writes in a personal capacity.
The views expressed in this Commentary are the author's, and do not represent those of RUSI or any other institution.
BANNER IMAGE: President Joe Biden at a roundtable on the American Rescue Plan at the White House, 5 March 2021. Courtesy of UPI/Alamy Live News.