Just when most of us thought it might be over, the horror show that is the US state of the union continues, notwithstanding a decisive presidential election verdict.
Whether it is Secretary of State Pompeo upending US foreign policy in Europe and the Middle East, former New York City mayor Giuliani destroying his last ounce of credibility on baseless allegations of voter fraud, Republican leaders cowing before President Trump, or ordinary citizens forgoing their Thanksgiving holidays, America looks decidedly ‘un-great’ as 2020 draws to a close.
Investors, however, figured they could count on non-partisan, technocratic economic policy leadership from Washington, DC.
At least until last Thursday. That’s when US Treasury Secretary Mnuchin unilaterally yanked credit-stabilization funding from the Federal Reserve, prompting an unprecedented rebuke from the central bank.
Considering the latest signs of dysfunction from the executive branch, it is remarkable that markets weren’t more rattled by week’s end. To be sure, bond yields and the dollar dipped, while equities finished marginally lower.
Most probably, investors are looking past current spats, chronic incompetence and presidential subterfuge, confident that matters will improve with new leadership next year.
Indeed, the shenanigans of the outgoing administration matter less than whether policy makers and politicians in Washington – but also in Berlin, Brussels, London and Tokyo – have learned from mistakes made after the global financial crisis. If they have, investors have reason to cheer. If not, things could get worse.
One might be tempted to ask, what could be worse than an outgoing president attempting a coup?
The answer: Conventional (fiscal) wisdom in unconventional times.
Orthodox fiscal thinking begins with the inescapable observation that government budget deficits and debt burdens are unsustainable. The logical conclusion is that tax hikes and spending cuts are mandatory. Orthodoxy gains credence with the arrival of promising Covid-19 vaccines that, if widely administered, will allow a rapid restoration of economic activity.
If that sounds far-fetched, think again. Even before the elections, Mitch McConnell steadfastly resisted calls for a second large US fiscal stimulus package. Assuming that the Georgia Senate runoff elections in early January do not flip the US Senate, it is difficult to see why McConnell will compromise on much, including fiscal stimulus, given that the end of the pandemic and economic recovery will boost the political fortunes of Democrats and the Biden Administration in two and four years. Why give a winning hand even more?
In short, the Washington script looks familiar – just as in Obama’s tenure, expect stonewall Republican opposition.
That’s a big problem, given that millions of Americans remain unemployed and that effective wide-spread vaccination of the population is months away. Without extended unemployment benefits and fiscal transfers, an already slowing economy could tip back into recession. Indeed, several major financial institutions have forecasted a double-dip recession commencing in Q1 2021.
Bad as that may sound, however, the more significant long-term risk is posed by Democrats, not Republicans. That’s because since the early 1990s Democrats have been the party of fiscal responsibility, cleaning up after Republicans. That kind of fiscal orthodoxy must stop in a Biden Administration.
Just like Bill Clinton in 1992 or Barack Obama in 2008, President-elect Biden will inherit an economic recession and a huge fiscal deficit from an outgoing Republican administration. But unlike Clinton, Biden is unlikely to benefit from powerful productivity and globalization tailwinds, which enabled Clinton to turn a federal budget deficit of nearly 4% of GDP in 1993 into a small surplus by 2000, while simultaneously overseeing rapid economic growth.
Instead, Biden, like Obama, will be confronted by a massive deficit (structurally estimated by the IMF at 13% of GDP in 2020), while facing enormous economic headwinds, including tepid productivity growth, de-globalization and economic weakness abroad. (Obama faced the collapse of the financial sector, but at least he could count on China as a powerful global growth locomotive.)
Seduced by the economic success of the Clinton Administration, and facing harsh opposition from Republicans in Congress, by 2011 Obama had embarked on a policy of fiscal retrenchment. Between 2011 and 2014, the US federal government’s structural budget deficit fell by nearly 4 percentage points. By the time Obama left office, the overall deficit had been more than halved in his eight years from 10% to 4.4% of GDP, an even bigger fiscal adjustment than achieved under Clinton.
Yet Obama’s fiscal orthodoxy came at high economic and political cost. Much-needed public investment in education, health and infrastructure was postponed. Real living standards for average Americans stagnated. The income and wealth divides between the few and the many widened. That was fodder for Trump and Trump-ism.
Fiscal orthodoxy in Europe after 2010 was, if anything, more aggressive, and also came with severe economic consequences. The Eurozone financial crises sapped countries of access to credit, brought their banking systems to the brink of failure and prompted draconian fiscal tightening. The result, unsurprisingly, was soaring unemployment and the rise of populist parties. In just over one year (2011-2012), for example, Greece implemented austerity measures worth 6.3% of GDP, swinging a structural budget deficit into surplus, while simultaneously sending the unemployment rate soaring from 18% to 24%.
Today, all advanced economies are beset by pandemic-induced recessions, while also experiencing inflation well below central bank targets – given the ability to borrow at historically low interest rates, fiscal orthodoxy would be a serious mistake. Central bank purchases of government debt (ranging from 50% of 2020 issuance in the UK, over 60% for the US and 70-75% for the Eurozone or Japan) allow governments to borrow heavily without increasing debt servicing burdens. Sluggish inflation and, in the case of the Fed, a central bank commitment to inflation overshooting, suggest that low government borrowing rates will endure for much longer.
The policy conclusions are clear. Promoting recovery with all tools – monetary, fiscal and public health – should be the sole macroeconomic priority of the Biden Administration, as well as for governments in Europe and Japan.
For too long, Democratic administrations have had to clean up the economic, financial and fiscal messes left behind by Republicans. One day, Democrats may have to revisit the budget disarray left behind by the Trump Administration. But if Democrats are interested in sustainable economic improvement for all Americans, they must jettison fiscal orthodoxy, whether voiced from within their own ranks or by Republicans.
The time for unconventional action is long overdue.