Morning Commentary: There’s No Such Thing as a Free Lunch
A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.
There’s No Such Thing as a Free Lunch
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Andrew Kositkun Senior FX Advisor
By almost any measure, the U.S. is unveiling remarkably aggressive fiscal policies. Here’s a snapshot of how U.S. fiscal spending compares to spending in other countries.
Actual and planned stimulus, as a share of GDP, is three to four times bigger in the U.S. than in most countries.
The latest double dose of stimulus — $900 billion in December and another $1.9 trillion on the table — is as big as the packages passed when the economy was collapsing last spring. These two packages are more than what we saw in any prior recession even though unemployment has fallen to 6.7%, lower than in most recessions.
Even with the U.S. “outperforming” other countries on fiscal policy, more spending is likely to come. Given resistance to broad-based tax increases or cuts to entitlement spending, new programs should be mainly deficit-financed. From a growth perspective, this is a good thing, but from a sustainability perspective, high levels of spending raise the questions of whether or not deficits matter and what the downside risk is to the unprecedented debt levels the U.S. will find itself in. Based on recent actions, it appears that there has been a trend of deterioration in budget discipline, with both political parties leaning toward a “free lunch” view of fiscal policy.
On the Republican side, the 2017 tax cuts were originally proposed by Paul Ryan to be deficit neutral by closing enough tax loopholes to offset most of the lost taxes due to lower marginal tax rates. This was consistent with the idea of avoiding pro-cyclical fiscal policy that pumped up demand in an economy already at full employment. It was also consistent with President Reagan’s 1986 tax reform during another period of full employment. However, the final compromise between Democrats and Republicans not only led to deficit-financed tax cuts but also increased spending. As a result, the deficit grew by $321 billion over the next two years.
On the Democratic side, there appears to be a similar lack of fiscal discipline. During recessions, deficits are a good thing, as increased government spending offsets a collapse in private spending. With the worst quarter of GDP contraction last spring, it made sense to also have the largest fiscal offset ever. However, a year later, the unemployment rate has been cut in half, vaccines continue to roll out, a reopening of the economy should be coming in a few months’ time, and household savings accounts are already higher with stimulus money from last year. Furthermore, the Congressional Budget Office released a study showing the U.S. economy will return to pre-pandemic levels even without another round of stimulus. Does it then make sense to pass stimulus of essentially the same size as when the economy was going through its worst quarter on record?
Despite all of this, there doesn’t appear to be a debt crisis on the horizon or risks of dollar debasement. The U.S. remains the center of global capital markets, and the U.S. dollar is the undisputed reserve currency with a lack of viable replacements. The euro suffers from the lack of full fiscal integration and long-run risks to the union. The Chinese yuan is also a poor alternative due to China’s opaque legal system and restrictions on capital flow.
But there still are costs to loose fiscal spending that are more subtle and depend on how long these budget deficits persist and how large they grow. The first cost is how difficult persistent deficits make it to raise money to counter recessions and raise the deficit when needed. The second cost is that super-aggressive policy could shorten the business cycle as the unemployment rate is pushed rapidly below full employment. This could mean earlier-than-expected inflation and earlier-than-expected Fed tightening. The third cost is upward pressure on yields that could increase volatility in risk assets that have become used to “permanently” low discount rates. Finally, there is the issue of debt burdens on future generations. Simply put, the bigger the party, the bigger the hangover.
HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT:
President Biden met with the group of 10 GOP senators that drew up the $618 billion alternative fiscal support plan. Both sides reported that talks went well, but no substantial progress has been made.
The eurozone reported stronger-than-expected fourth-quarter GDP, with the economy contracting 0.7% quarter over quarter against expectations for a 0.9% contraction. Going forward, the issue facing the eurozone is the possibility of prolonged lockdowns amid vaccine rollout issues that should lead to further economic underperformance.
News reports indicate that U.K. Chancellor Rishi Sunak will not increase taxes in his March budget. It is understandable why all countries desire to begin normalizing fiscal balances, but any sort of fiscal tightening would damage the fragile recovery. As such, the expectation is for the U.K. government to extend its support program while acknowledging the need to control fiscal budgets.
Japan has extended the state of emergency in 10 of the 11 prefectures by a month. These measures were set to expire on Feb. 7. The prefectures under the state of emergency order account for 60% of GDP meaning the state of emergency order should lead to continued growth and inflation headwinds that should see the Bank of Japan continue its accommodative stance.
The Reserve Bank of Australia kept its cash rate and three-year government bond target yield unchanged as expected. The central bank also announced an extension to its QE program, with risks for another extension, with slower purchases, after the new program expires. The bank did acknowledge a stronger-than-expected recovery but reiterated that rates will not be increased until 2024 at the earliest. Overall the statement took on a very dovish tone and should put to bed any talks of tapering in the near term.
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