Unconventional Wisdom

by | November 23, 2020

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.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides commentary and analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior business leader with two decades of experience growing and transforming businesses in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the Secretary of Defense. He is a member of the Council on Foreign Relations and the Chairman of the Advisory Board of Project Syndicate, the non-profit opinion page that provides world-class commentary to over 500 newspapers globally. In addition, he is a board member of the American Alpine Club and the Jackson Hole Community Housing Trust, and has served on the boards of the Gates-Cambridge Trust, the Seattle Art Museum, and a number of other non-profits. Friedman is a regular contributor to several newspapers and thought leadership groups and has published numerous opinion editorials on topics including economics, finance, philanthropy, and politics in Project Syndicate, Bloomberg, The Wall Street Journal, The Financial Times, The Guardian, CNBC, The South China Morning Post, The Chronicle of Philanthropy, and other news outlets. He is also the author of Babu’s Bindi, and The Big Thing, both children’s book. An avid mountaineer and rock climber for 30 years, Friedman has climbed some of the world’s highest mountains and led the first major climb to raise money for charity through an ascent of Mt. McKinley. He holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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