Blain’s Morning Porridge Jan 30th 2024: Government Spending, Austerity and Inflation.
“Defence is always the easiest to cut, and the hardest to get back going and sustain.”
The nations of the West face crisis: how to fund vital infrastructure and critical defence spending without upsetting bond markets? They are worrying about the wrong things. Time to rethink government spending and how to do it.
Every single government across the West faces the same four body problem:
- How to prioritise and pay for the multiple functions of the state?
- How to address recession and growth?
- How to address inflation?
And the critical variable:
- How to pay for it?
That, is rather in the hands of the markets.
Every sovereign funding manager I have ever met is haunted by the fear investors may go on bond strike if their overall quantum of debt looks too high. I told them to relax – investors are as keen to buy as you are to sell. Demonstrate that debt is well managed, competitively priced, and repayable. In the case of developed nations its simple: demonstrate the Virtuous Sovereign Trinity (VST) of a Stable Currency, a Sustainable Bond Market, and Political Competency in the affairs of state – and the right priced deal will find buyers.
The positive reaction in US bonds y’day after the US quarterly refunding estimate came in surprisingly lower at $760 bln vs its previous October estimate of $816 bln, highlights the market is paying close attention to debt quantums. (I remember when quarterly re-fundings were shocking at $30 bln!)
Lower US Bond yields boosted stocks, and lots of market analysts are terribly excited this week’s combination of big tech earnings, positive data and the prospect “unnecessarily” restrictive interest rates will shortly be eased, will drive markets higher..… Markets love nothing more than talking themselves higher.
Treasury gains y’day were a predictable short-term rally on lower than expected supply, but long-term the issues that might destabilise US Bonds are VST related; geopolitical shifts, isolationism, and changing trade-alliances weakening the dollar-case, or a budget impasse triggering a technical default on bonds, or polarised US politics causing investors to seriously doubt Treasuries as the ultimate safe haven. What if a president made a comment about not repaying Bonds held by nations perceived to be hostile to the US? There is precedent – Lis Truss nearly overturned 300 years of the Gilt Market with her political foolishness.
At its simplest it’s all about interest rates – which we are told are dependent on getting inflation down. UK premier Rishi Sunak made cutting inflation one his 5 (or was it seven?) promises to the British electorate. The Bank of England hiked rates, he talked a lot about the need for wage-restraint, and inflation fell because the supply shocks that caused it eased… giving Sunak the satisfaction of a 20% success rate. He thinks he did it by holding government wages down, and preaching the virtues of austerity. It was schoolchild 101 economics…
My base case is simple – higher interest rates are painful, but economies adjust. Normal interest rates are not 1-2%, but higher and positive (above inflation). Abnormally low interest rates are unnatural – and dangerous. In the case of the USA, why ease rates significantly when the economy, earnings and employment are strong and robust? The result would not be corporates spending billions on new plant or creating jobs, but borrowing money to buy back stocks to further juice their equity, and bigger bonuses for the board!
Overly low rates are great for markets and the wealthy, but bad for the economy and workers. The multiple distorting consequences of low rates will likely outweigh any economic good they might do. (The situation in Europe, where economies (like France y’day) are bouncing along the cusp of recession, is different. A little bit of stimulus might help.) Interest rates should be applied like a precision tool rather than a sledgehammer.
Its probably time we changed our unnecessarily blinkered response to inflation. It is based on conventional monetary wisdoms like: “inflation is always and everywhere a monetary phenomenon.” It is monetarist dogma that government spending drives the quantity of money, therefore to cut inflation all you must do is cut government spending. Hence, the standard inflationary playbook – which has barely changed since the 1970s – is Austerity.
Austerity. Starving a malnourished child is not an option, but apparently hiking interest rates to slow down stuttering economic activity by making workers redundant is? If they can’t consume, recession becomes inevitable.
And… pulling out my hammer to batter in the nails to the coffin-lid of monetarism – recent experience shows the inflation spike was nothing to do with excessive demand, but all about Supply Chain Shocks – and has had zero to do with government spending. Russia’s invasion of Ukraine triggered the energy shock. Global supply chains remain sub-optimal post the pandemic. Lesser factors like increased extreme climate events have triggered more micro-level inflation hot-spots in specific goods or sectors.
Stagflation is a reality – low level inflation of 3% in an economy stuttering along at 1% growth is stagflationary. The traditional policy response – as it is to any economic malaise, the equivalent of a medieval course of leaches – will again be austerity – causing stalled economies to flatline.
That inflation is due to money is Flat-Earthism.
For 13 years, from 2009-2022, governments around the globe created the conditions for the single biggest inflationary shock of all time in the wake of the Global Financial Crisis – the Age of Zero Interest Rates and Quantitative Easing – but guess what? Inflation in the real world remained stubbornly low. Its difficult to argue Covid spending across economies drove inflation – it was an economic intervention (with mixed success), but again was not the inflationary trigger. (There was inflation during the last decade. It was all hidden in financial assets – the strongest bond and stock rally of all time – tellingly accompanied by declining real wages!)
Supply Chain and Energy Shocks are only going to get more frequent in the rapidly evolving new geopolitical landscape. The World’s is no longer a US-centric-bloc priced in dollars. Competing Asia, the Middle East, China, Europe, BRICS – are the new realities. Biden’s recent decision to hold back on new LNG delivery contracts comes at a difficult time for Europe, where Germany is now acutely reliant on spot gas pricing for a significant portion of the energy driving Europe’s core economy..
When the facts change, I change my mind….
Inflation is driven by events, (events dear boy). The quantum of money is a concern, but how it is used to address events is the main issue.
The biggest failure of the West over the past 50-years – visible in the appaling state of American road networks, collapsing bridges in Italy, or the general absolutely nothing works in the UK- has been underinvestment by government to infrastructure and the public goods of state. The delays and inefficiencies of the planning process that makes it so expensive to repair/replace is an example of political incompetency. Time to change.
All of which brings us back to my original question: how to fund nations?
Stop regarding government spending as a function of Mrs Thatcher’s housewife’s purse. Fix the system, demonstrate competency to manage and deliver the projects, and present firm, workable plans. There isn’t really a choice: governments will have to use market funding to rebuilt national soft and hard infrastructure – or watch their countries sink into obscurity. If the system needs reform.. reform it. It’s an investment decision: but at the moment the UK’s Labour party is in a dither about the optics of how to justify borrowing a modest £28 bln for renewable energy and grid upgrades without looking like a spendthrift..
The biggest crisis is reversing the long-term under-investment in Defence – the Primary Duty of any State. As Europe wakes up to the perceived Russian threat, it faces a massive 1938-scale defence spending challenge. We simply don’t have the industrial capacity, skillsets, or engineering talent to make it happen in less than a decade. So forget tanks and F-35s. I am looking for firms that can churn out 100,000 drones with the Tech to Swarm, per month… as that is new reality of conflict.
More on this to come…
Out of time..
Bill Blain
Strategist
This morning’s photo from the Telegraph.
6 Comments
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Bill, I wonder if a proper municipal bond market might help the UK. The central control of local government spending by Mrs Thatcher has never really been unwound. If I bought £10k of 5 year bonds to fix the roads around me, ( which are in a dreadful state) I would have some civic pride and a coupon of 4% would be fine…lots of advantages all round.?
Interesting idea. However, that would mean yet another layer of bureaucracy on spending/planning/delivery at local level. Experience shows some English councils were very poor investors – witness Thurock giving an Irish shyster millions to not deliver solar farms. Also, the US Muni experience – tax advantaged but no guarantee of wise investment.
The bottom line is we need better decision making – better politics.
Bill, This looks like we could be heading for a rehash of government selling bonds or shares in GB power to raise the 28 bpm per year
Not neccessarily a problem selling bonds. Showing the govt is competent enough to repay them is the issue – ie: fix the system. That said the FT is warning today that demand for Gilts is dropping. If that is so… problem.
Bill, your use of the Virtuous Sovereign Trinity appears to imply that a sustainable bond market depends on a sustainable bond market. That suggests to me either that this formulation does not work or that the stable exchange rate and government competency are the only requirements. And then, does not a stable exchange rate require government competency?
I am only an oil and gas project economist and tax regime consultant. I am not in any sense a general or academic economist. Most of my life I have wondered why instead of one quarter percentage point changes in a reference interest rate we do not get used to one or more quarter percentage point changes in the rates of broadly based taxes such as VAT, income tax and corporation tax. Then the whole impact would not be focused on the housing market and ripple out in a limited way to a few sectors such as construction and home furnishing. This would result in a more stable and equitable (between buyers and renters as well as between sectors) economy. Small tax rises would also give the government the fire power to provide the next required stimulus through small tax cuts. The current system puts that potential fire power into the hands of the banks, who use rising interest rates as cover for raising profit margins.
Is not the independence of a central bank illusory? Are not the central bank and the Treasury like a single income married couple? There is a net spending department and a net earning department.
I suspect that my suggestion would fail on the “we cannot/will not do it if other countries do not do it” argument. That is like the self perpetuating urban “myth” that “it all goes to landfill or incineration anyway” which means that except for a few recycling stalwarts like me it all goes to landfill or incineration anyway. I suppose there may be a grain of truth in that though, considering that if the UK had a relatively stable real terms value of its currency and others did not follow us we would not have a stable exchange rate. Do you think the consequences would be fatal to my scheme or not?
The virtous sovereign trinity is a three-legged stool. Each leg relies on the others to support it.
A sustainable bond market will be in crisis if the currency is unstable and/or there is political incompetency.
A stable currency will wobble if poor governments start printing money to repay unsustainable debt..
And with a crashing currency, and bond yields shooting higher, any government is bound to falter.
Keep them in balance.. and all is fine.. ish.