Why I am more worried about Europe than the US

Is the fiscal debate political or market-driven?

The eponymous debate in the US over government spending, debt and deficits is whether the issues are fundamentally market-driven or politically-motivated. For example, recently Trump economic advisor Larry Kudlow told the Economic Club of New York that “We have to be tougher on spending” and went on to make the case for cutting Social Security and Medicare in order to get tougher on spending.

Now, is Kudlow making the case for the bond market vigilantes stepping in and creating a sovereign debt crisis in the US? If so, he’s flat out wrong. The currency is the release valve. Or maybe he’s talking about the potential for inflation due to the trillion dollar deficits his administration is creating. Though I doubt it, there is a case to be made there. But more likely, he’s making a politically-motivated case to cut entitlement spending to ‘pay for’ the tax cuts the Republicans handed corporations and wealthy Americans.

Irrespective of the politics though, it’s clear that the US has a lot more policy space than some would have you believe. For one, the US has its own currency. And what that means is that the Fed, as monopoly supplier of reserves, can hold rates down below the rate of inflation for as long as it wants with the only constraints being potential inflation and currency depreciation. The same is true for other major central banks too. Look at the real yields in this chart, for example.

Real 10-year government yields.png

Source: Charlie Bilello, Pension Partners

The real yields in the US, Canada, Japan and Europe are all negative for 10-year bonds, except in the European periphery. That’s a consequence of so-called financial repression, where the central bank holds rates below the rate of inflation. And this has depressed real yields right across the curve, to the point where 10-year yields are universally negative in real terms.

Who’s going to stop the central banks – bond market vigilantes? How? They won’t because they can’t. It’s a misunderstanding of the power of central banks over a currency they can manufacture in unlimited quantities.

And in the US, the trillion-dollar deficits are having zero impact. 10-year yileds are still negative in real terms while the currency is relatively strong against America’s trading partners.

Europe is where you have to be concerned

So the policy space on the monetary policy front to support fiscal expansion is basically unlimited. Any constraints are self-imposed.

The real problem is in Europe. And it’s on the fiscal front, because European governments do not use a currency their national central bank can create. They have no backstop for their deficit spending. And so there is a legitimate reason to fear default as investors learned with Greece.

In a global economic downturn, that’s a big concern because it means European governments have to act pro-cyclically, cutting spending just when the private sector is forced to do so.

For example, Italy, which has a government debt load of 132% of Italian GDP is the most indebted country in the eurozone. Notice that real yields there in the chart above are 1.29%, whereas in Germany they are -1.54%, where government debt has just crossed below the 60% Maastricht threshold. That’s a huge penalty that Italy is paying for its government debt load. And it’s a direct result of the fear of default or redenomination.

If we have a global recession as Nouriel Roubini predicts or a financial crisis as Ann Pettifor predicts, Italy is in big trouble. Yields will spike and the country will be forced to make deep cuts to spending in order to avoid defaulting. In essence, it will become the next Greece – unless some drastic changes are made to the ECB’s or Italy’s policy latitude. Will the Italian electorate stand for this? It’s unknown. We do know that the populists there are winning though. In a recession scenario, anything is possible including an exit from the eurozone.

Final thoughts

So I would heavily discount the politically-motivated talk about fiscal Armageddon in the US. The US is sovereign monetarily and that gives it unlimited space for fiscal action with the negative consequences falling on the currency via elevated inflation and inflation expectations.

If we really wanted to test the fiscal Armageddon scenario, we should look first to the UK where all of the macro considerations are the same as they are for the US. You have a high deficit, a negative external imbalance and lower interest rates, meaning less space for rate cuts.

At the same time, the UK lacks the same reserve currency status the US has and it is facing a potentially calamitous exit from the eurozone. Nevertheless, in a worst case scenario, the UK could maintain financial repression and increase deficit spending while the central bank embarks on QE. And the so-called bond market vigilantes could do nothing about it except cell Sterling, something that would automatically help Britain’s current account.

By contrast, in Europe, the ECB still has rates at zero, is still penalizing banks for holding excess reserves, and is still engaged in quantitative easing. They basically have no room for more expansive monetary except to the degree it finances deficit spending. And the CB is forbidden by law from doing just that. When the next downturn hits, Europe is where the fireworks will be, not in the US or the UK.

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