The Daily Update - PART IV: The Role of Initial Conditions & Policy Blunders and Expectations

Extract from Bob Gay’s piece ‘Policy Blunders and Currencies’

The Near-Term View – A Shrinking Supply of US Dollars

Herein lies the Fed’s current dilemma. A monetary regime of negative real policy rates and asset purchases is not sustainable. Pressures to exit these policies are growing in the US now that economy has reached full employment with the attendant risks for inflation. Those conditions call for a neutral monetary stance or perhaps something sterner. That means the Fed has little choice but to continue normalise rates and to unwind its bloated balance sheet. In doing so, however, the Fed is unintentionally constricting the global supply of US dollars.

That poses a problem for non-dollar currencies. Over the past ten years of ultra-low interest rates, governments and companies in emerging countries have issued a massive $60 trillion in new debt, much of which is denominated in US dollars. Since the Fed’s shifted toward normalising policy in 2015, the shortage in the global supply of US dollars has gaining momentum. If you add the shaky finances of Turkey and Argentina and Venezuela -- all which have high US-dollar denominated debt, the possibility of an emerging market debt crisis this year has increased sharply. Turkey owes $275 billion in euro and USD-denominated debt, or 56% of all their government and corporate debt; Argentina has 60% of its debt denominated in US dollars. Both of those currencies have collapsed, thereby doubling their exposures. The bottom line is that the US dollar is catching a bid as a safe haven in world where the supply of US dollars is shrinking, leaving the Fed with an uncomfortable choice between the exigency presented by the domestic economy and the possible collateral damage to debtors abroad who are dependent on access to US dollars.

The Role of Initial Conditions

On a longer view, the policy decisions made at full employment set the stage for economic performance for many years ahead. In the vernacular, the time has come to ‘remove the punch bowl before the party gets out of hand’. Unfortunately, the US is doing the opposite on several fronts.

Full employment demarcates a critical tipping point for assessing both inflation risks and the likely consequences of public policy actions. What might be appropriate at less than full employment can become a serious policy blunder at full employment. Fiscal stimulus serves as the classic example. In simple Keynesian terms, public spending complements private spending at less than full employment, thereby raising aggregate demand and encouraging private investment. By contrast, at full employment, public and private spending increasingly become substitutes as public spending crowds out private demand and investment by raising prices more than output. We have not quite reached that point yet but will within the next year. In short, whereas growth in excess of the US long-term potential of about 2%, would have been welcome when resources were underutilised, it now is a mixed and fleeting blessing that sets the stage for the next recession.

Policy Blunders and Expectations:

In that context, nearly all recent initiatives of the Trump administration will prove to be macroeconomic blunders because the long-term cost will far outweigh any illusive short-term benefits. Consider the massive tax cut and spending bills passed by Congress. Apart from a host of technical errors that have left companies uncertain about their tax liability, the outsized tax cuts hurriedly passed in December will widen inequality, which is inversely correlated with long-term growth. The same criticism holds for the massive $1.3 trillion spending bill, which doubles down on the ill-timed stimulus, does not include funding for much needed infrastructure that might benefit potential GDP, and puts the US on an unsustainable trajectory of debt and deficits. According to estimates by Goldman Sachs, US deficits will climb to almost 6% of GDP by 2020 under the new and tax spending bills, which would represent an unprecedented shortfall for the economy at full employment during peacetime. Moreover, those deficits will put the US on an unsustainable trajectory for debt and interest payments. Federal debt, as estimated by Congressional Budget Office, will soar beyond 150% of GDP as soon as 2042.

Likewise, self-inflicted trade disputes are unambiguous macroeconomic blunders. Contrary to President Trump’s bluster, there are no winners in trade wars, only losers. The OECD recently simulated the impact of an increase in trade costs of 10% on imports, exports and real GDP of major countries based on detail data on the composition of their international trade flows. Not surprisingly, the big loser is the United States, whose exports would decline almost 15% while imports would fall only half as much. This net loss from trade disputes arises in large part from the collateral damage to international supply chains of domestic companies. Note that harmful trade measures have been on the rise since 2013, according to data from the Global Trade Alert. The latest spat of tariffs imposed by the US and China’s retaliation are ramping up a dangerous trend that will undermine potential GDP growth at home and abroad.

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