“We didn’t blow up the global financial system. That hardly constitutes a great accomplishment.”
So said Doug Holtz-Eakin, a former adviser to George HW Bush, when the House of Representatives finally voted this week to raise the US debt ceiling for two years in return for a cap on government spending beyond the election next year (albeit one that has allowances for extra spending on defence and areas of health and welfare: question ‘when is a cap not a cap?’; answer, ‘when it’s a colander’). Not wanting to sink the ship, the Senate nodded its agreement with a two-thirds majority.

The heavily modified rapture in Holtz-Eakin’s sentiment is obvious. The US government has avoided default on its bonds with a day to spare: relief all round, financial Armageddon averted. On the other hand, at $31 trillion of debt (129% of GDP in 2022, estimated north of 130% currently) with further qualified extensions where the annual cost of financing has risen many multiples in little more than a year, and where the government’s budget deficit at 5.8% continues an unbroken series of shortfalls stretching back to the Millennium, is hardly any cause for breaking out the champagne and bunting. While both sides are claiming political victory, the reality is that it is hollow for both: aside from avoiding running out of cash by being allowed to borrow more, nobody is fundamentally happy. In context, both the deficit of 5.8% and the debt/GDP (gross domestic product) of 129% are almost exactly double the maximum permissible for a country to be eligible to join the European Union (not that America is planning on doing that, even if Australia thinks that residing in the Southern Hemisphere and on the other side of the world, it qualifies for Eurovision).

While deficits have been an annual habit for a quarter of a century, it is only the decade-and-a-half since the Global Financial Crisis (GFC) that the US government balance sheet has been consistently more than 100% geared in terms of debt/GDP, propelled to over 120% in 2020 and now at least 10 points higher still. The step-changes were all the direct result of a systemic shock: in the case of the GFC, through the failure of regulatory oversight to manage risk in an environment in which investment banks and hedge funds developing immensely complex and increasingly exotic derivative instruments were far ahead of the authorities’ ability to keep pace with ensuring the foundations of the financial system were still robust (ultimately many products were too clever by half, defying the ability even of their creators fully to understand the consequences); latterly, the shock has been a pandemic and a war in Europe.

Monetary smoke and mirrors

Introduced to re-boot the financial system in the GFC melt-down, Quantitative Easing (QE) has been an economic phenomenon. Colloquially and slightly lazily referred to as ‘central bank money printing’ it was once upon a time considered monetary heresy: illiterate economics, the type likely to lead to spiralling inflation, a plummeting currency and public penury. Think the Weimar Republic and wheelbarrows of cash to buy a box of matches. The subtlety and intent of QE was that the central bank would not directly finance the government; the government would only be able to issue debt to the markets to the limit of their natural appetite and capacity; some of those bonds would in turn be bid for by the central bank. However, once central banks began to use QE regularly as a policy mechanism for influencing bond yields in tandem with lower interest rates, those market capacity constraints became irrelevant if the markets perceived that every government bond they bought at auction from the Treasury would have a virtually guaranteed buyer for it at the central bank: in effect it became central bank money printing one step removed.
Getting paid to borrow
Backed by the fact of the central bank being a repeat if not permanent buyer, as demand for bonds grew, so prices rose and yields tumbled, eventually tending to zero (or in the case of the eurozone, to sub-zero, the European Central Bank buying multiples of the number of bonds compared with what was being issued). It drove down government financing costs to ultra-low levels (again in the eurozone, governments were paid to borrow, however crackers a concept, one which many grown-up people in the economic and financial community tried to justify with ever more tenuous arguments merely giving the game away that they didn’t really understand the logic either). We can argue until the cows come home as to whether generationally low inflation was controlled by the central banks using QE, as the deluded former Governor of the Bank of England Mark Carney claimed, or whether thanks to other macroeconomic, technological and societal factors inflation was coming down anyway.
Fiscal incontinence: heart for a change of direction in the US?
But the real point is that with that easy access to cheap borrowing and a growing belief that inflation was as good as dead, aided and abetted by their central banks, governments of all hues lost their fiscal discipline. Unless the times demand it (usually too late), few governments are elected under a parsimonious manifesto of hair shirts and austerity. No, for politicians working the hustings and, on the stump, spending money is good! Spending money is fun! Spending money wins (i.e. buys) votes. But unless it creates sustainable growth, and if it remains unfunded (i.e. by tax receipts), government expenditure with few constraints allows the debt levels to creep up inexorably.

It is when, such as now, that the economic backdrop alters adversely, the pratfalls become painfully real. We have been through a period of sharp policy reversal, a switchback from Quantitative Easing to Quantitative Tightening. Central banks were late in the day to realise the threats posed by runaway inflation; but they got there in the end and took the appropriate action. Governments, on the other hand, are still blithely carrying on with fiscal policies with little bearing to today’s conditions. The US debt ceiling breach is the manifestation of the problem. But even now, as we discussed last week, senior economists such as former Bank of England Chief Economist Andy Haldane, think that self-imposed debt and deficit limits are an irrelevance and a hindrance to economic progress. Surely, the logic behind that is no more secure than offering an alcoholic more booze to make him feel better.
Political brinksmanship
With 17 months to go, the 2024 Presidential race is already warming up. This recent display of political brinkmanship about the budget deficit (little reported in the UK, regular readers of these columns will know the saga had been running since mid-January, including in its closing stages last week a thwarted plot by ultra-conservatives to unseat their own Republican Speaker, Kevin McCarthy, in a display of no-confidence in his leadership) has been an important prelude towards the primaries being contested early next year, followed by the main event for the White House in November.

Back in 2016, ahead of the Presidential election, both protagonists promised big state funding: Donald Trump under the banner of “America First!” with his infrastructure plans; Hilary Clinton on health care reform and welfare. It was merely the order of magnitude of how much to spend and where that separated them, not the principle itself of committing to the increased expenditure and debt. With Joe Biden promising “We’re gonna go big! Go BIG!” in 2020, the situation had been made more complex by the economic measures required to deal with the pandemic and its aftereffects.
Challenging the groupthink
It was James Carville, an adviser to Bill Clinton, who summed up the essence of US elections: “It’s the economy, stupid!”. Clinton was a Democrat. His Democrat successors seem to have forgotten Carville, otherwise there would have been no debt ceiling fiasco in the first place. The economic backdrop may be very different in 17 months’ time, however, it will be fascinating to see if a genuine ideological dividing line on fiscal policy, specifically managing government borrowings, becomes a feature of the election. Bidding for a second term, Biden will be almost guaranteed not to deviate from his course (he is still under immense pressure from the radical wing of his party to move further leftwards); realistically, it is only the Republicans who have that card to play. What they agreed this week in the relatively minor tinkering at the edges “hardly constitutes an achievement”; the acid test will be whether there is a real political will next year to start challenging the lazy, Keynesian groupthink which pervades virtually all western governments, mainstream political parties and institutions. Time will tell; but first, the Republicans need a leader, and one with a little bit of intellectual gravitas would not go amiss.

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