Politics driving fiscal space, populists winning in Europe, and the meaning of a crushing euro external balance
1 Big Thing: Politics are the driving force in fiscal debates
The conventional wisdom is that Donald Trump is irresponsible for running up trillion dollar deficits which will limit fiscal space in the next downturn. In a good piece on how a recession could take hold in 2020, Nouriel Roubini gave voice to this concern in passing.
My view as stated in the past: the politics are the only constraints here. Though I agree with Nouriel’s conclusion and believe the zero lower bound constraint on monetary policy is real, I believe the fiscal constraints are self-imposed.
Here’s how I put it in July:
So when the Fed cuts to zero, there won’t be a bevy of fiscal measures coming — irrespective of how government funds itself. On the fiscal front, the political obstacles are too high to overcome, especially given the existing deficit levels created by Trump’s tax cuts.
The Sanders position on using fiscal policy to increase the social safety net of the US middle class through deficit spending has been met with contempt by the Democratic Party. Hillary Clinton disavowed these ideas in 2016. Nancy Pelosi has gone one further, promising to bring back Paygo if the Democrats win the House of Representatives. Unless the Democratic Party shifts leftward, you can forget about large fiscal stimulus anytime soon.
Trump did get his tax cuts through a Republican Congress in 2017. But now there is little appetite for more deficit spending in the Republican Party. Were we to fall into recession, nothing I see in the Republican Party shows any likelihood of stimulus.
Why this matters: It doesn’t matter who’s right whether the constraints are self-imposed political constraints or real constraints dictated by inflation and currency revulsion. What matters is economic and market outcomes. And what I am saying is that I agree with Roubini that a recession in the US will be met with monetary and fiscal constraints. That’s a prediction that will be either proved true or false. Personally, I tire of the back and forth on the economics. What I care about are outcomes.
Mitt Romney is one of only a few visible Republican politicians talking this way. But were Trump a Democrat, surely Republicans would be excoriating him for fiscal irresponsibility.
Deeper dive: Roubini makes a recession prediction for 2020 based on 10 points grounded in specific economic principles he finds credible. You may disagree with his economics. But he is making a prediction. What other mainstream academic economists are predicting a recession in 2019 or 2020? None that I know of
Roubini’s is a very important piece in my view, as a result.
2 – Questions about monetary space
Just briefly here, let me mention the monetary side of things because the economic paradigm we live in calls for monetary policy as the active lever. Fiscal policy is only used in extremis.
I wrote the following in March:
- In July 1981, federal funds went from 19% to 12 3/8% in that cycle (6 5/8%)
- In April 1982, federal funds went from 15% to 8 1/2% in that cycle (6 1/2%)
- federal funds went from 9.75% in May 1989 to 3% in November 1982 (6 3/4%)
- From November 2000, federal funds went from 6.50% to 1% in July 2003 (5 1/2%)
- federal funds went from 5.50% in July 2007 to 0% by the end of 2008 (5 1/2%)
Why this matters: unless rate policy shifts have larger impacts on the real economy when rates are low, we have a problem. Rates are 2%. And maybe they can get to 3 or 4% by the time a recession takes hold in 2019 or 2020. That’s significantly less monetary policy space than at any time in the last 40 years.
Deeper dive: The Fed is banking on the concept that
- either recession will hit later than 2019 or 2020, or that
- policy cuts are more impactful per basis point when rates are low, or
- unconventional policy like QE will fill the gap, or
- fiscal agents will step in when the Fed runs out of bullets
That’s how to think about where this is headed. And then the question becomes, if we run out of monetary and fiscal [political] policy space, what happens to the economy, the markets, and the populace’s politics?
Forget about the back and forth on the economics of all of this and focus on likely outcomes.
3 – The populists are winning in Italy
Italy, Lorien poll:
Approval ratings (party leaders)
Salvini (LEGA-ENF): 50% (+8)
Di Maio (M5S-EFDD): 46% (+6)
Meloni (FdI-*): 22% (-1)
Berlusconi (FI-EPP): 17% (-4)
Martina (PD-S&D): 17% (-2)
Grasso (LeU-S&D): 16%
+/- vs. May ’18 pic.twitter.com/RP129602Iz
— Europe Elects (@EuropeElects) September 13, 2018
Why this matters: In France, we saw change when Emmanuel Macron was elected. And Macron, using the standard neoliberal methods of governance, is now more unpopular than he has ever been. By contrast, the change agents in Italy are gaining in popularity. That speaks to the mood right across Europe (and in the US).
I don’t think Macron will have any success, not least because his claim to being a change agent depends on the willingness of the EU to make fundamental architectural changes. I don’t think that’s going to happen. And so, Macron will be left looking like a standard neoliberal state head who tried and failed to get change at the EU level. Populists will benefit.
4 – Meanwhile the ECB is ready to normalize
Societé Generale: We still cling confidently to a view that #ECB policy normalisation will get going again and as it does, the euro’s revaluation will resume. #forex #fx #currencies #EUR #euro #EURUSD $EURUSD
— Francesc Riverola – FXStreet.com 🎗 (@Francesc_Forex) September 14, 2018
Why this matters: If the European economy holds, we are going to see the ECB normalize rates. It bears noting that the ECB raised rates in July 2008 on the eve of the Lehman Brothers collapse. And it raised rates again in July 2011 in the midst of the European sovereign debt crisis. Are we to think the ECB under Mario Draghi is much different? Who comes after Draghi next year?
The ECB, along with other major central banks, is desperate to follow the Fed in normalizing rates. And it will use any excuse it can to do so. The key is the state of the economy. Right now it has gone through as good a patch as any since the crisis. And that means we should expect the ECB to look to normalize.
5 – The euro area current account shows a massive imbalance
Look at these two charts from Trading Economics, framed over different time periods. First, there’s the euro areas trade balance over the past year, showing relatively steady surpluses.
But, if you zoom out to ten years, you then see that the euro area has moved to surplus from a relatively neutral position.
Why this matters: What’s going on here is what Paul McNamara identified when looking at Turkey the other day:
Turkey looks to be confirming the lesson that “the trope of countries being able to “export out of crisis” is essentially imaginary” @M_PaulMcNamara The adjustment in current account comes from crisis -> collapse in domestic demand -> falling importshttps://t.co/iGNcOMXDh3 pic.twitter.com/9mAGxRngsG
— Adam Tooze (@adam_tooze) September 12, 2018
The euro area had a crisis that it solved by suppressing internal demand. This led to a marked improvement in the external balance, even in the face of weak GDP growth. But it also leaves the euro area extremely vulnerable to external shortfalls in demand. If we have a global recession, the euro area will be hit harder than other economies because it is limiting spending to repair government balance sheets and effectively relying on external demand for growth.
Deeper dive: More than the US, the EU will face a problem because the fiscal constraints there are real. The euro area periphery borrows in a foreign currency, the euro. And if the external demand shortfall combines with an uptick in deficits as recession takes hold, this will lead to problems in government bond markets. Italy will be the country to watch, particularly given the radicalization of the electorate and its large government debt burden.