Across many developed economies, the prevailing economic and financial policy framework – what we’ll call the Box – is failing to deliver for much of the adult population. The mood is ripe for a policy revolution, a new monetary settlement. When the Box is blown up, inflation objectives will lose their privileged position. Fiscal orthodoxy will be abandoned. This will demolish the pillars on which so many investment strategies are built.
In 1965, US President Lyndon B Johnson, imagining himself as the heir to Franklin Roosevelt, embarked on his Great Society.
It embraced Medicare and Medicaid – government health insurance for the elderly and poor – a war on poverty, urban regeneration, upgraded transport systems and much more. However, there was a problem: the war in Vietnam flared up, threatening Johnson’s ambitions. The US troop count rose from 23,000 at the end of 1964 to more than 500,000 by early 19681. Escalating war spending competed with Johnson’s domestic ambitions.
Fifty years on, the tension between peacetime and wartime spending priorities has resurfaced, not only in the US, but in the UK and other developed economies, tempting a new generation of politicians to play poker with inflation.
For the past decade, most of these countries have been battling to repair their public finances after the devastation of the global financial crisis. As well as the automatic stabilisers – such as higher welfare spending – that kicked in as the global economy slumped, governments supported imperilled financial institutions and loss-making strategic industries, and provided regional aid. This drove budget deficits towards 10% of GDP. To all intents and purposes, governments and central banks were on a war footing after September 2008. While the word austerity has been over-used – for the most part, government spending programmes have been frozen rather than shrunk – a groundswell of opposition to austerity has developed.
Electorates in the US, UK and southern Europe are now fed up with being told there is no extra money available for hospitals, schools, social care, policing, prisons and so on. Most mature economies suffer from creaking infrastructure and under-funded public services. Their provision has not kept pace with additional demand, nor with technology driven expectations. To make matters worse, domestic security services are struggling to combat the evolving threat of lone-wolf terrorism. The armed forces are stretched. And climate change has vaulted up the policy agenda.
Now, as in Lyndon Johnson’s day, the prevailing economic and financial policy framework – what we’ll call the Box – is failing to deliver positive outcomes for a large majority of the adult population.
If we cast our minds back to the early 1960s, the policy framework consisted of: the Bretton Woods system of fixed exchange rates; the convertibility of US dollars into gold at a fixed price; the virtue of balanced government budgets; and post-war controls on the free movement of labour, goods and capital. Armed with the newly-minted Phillips curve, economists such as Paul Samuelson and Robert Solow claimed the US unemployment rate could be halved, from 6% to 3%, if only the authorities would accept a moderately higher annual inflation rate of around 4% to 5%, rather than 1% to 2%2.
Walter Heller, the chair of John F Kennedy’s Council of Economic Advisors, summed up the frustration with the prevailing economic orthodoxy: “Men’s minds had to be conditioned to accept new thinking, new symbols, and new and broader concepts of the public interest.”
Kennedy was sceptical of this way of thinking and it was not until Johnson replaced him that the policy revolution started to take hold. US consumer price inflation (excluding food and energy) rose from 1.5% in December 1965, to 3.8% in December 1967, to 6.6% in December 19703. America’s reflationary splurge blew apart Bretton Woods and the gold standard. A decade of monetary instability and even higher inflation ensued.
Could this, or something eerily similar, happen again?
The Box that was designed to lock-in low inflation, uphold fiscal discipline and rebuff political interference is in mortal danger, not only, but not least, in the US. We stand at the threshold of a policy revolution that will blow up the Box, over-riding the primacy of the inflation objective and abandoning fiscal orthodoxy into the bargain.
A play in two acts
In 2019, a volte face by the US Federal Reserve helped shape the dominant market narrative. In a sudden policy shift, the Fed curtailed its quantitative tightening programme and, in a neat twist, deployed the proceeds of its sales of mortgage-backed securities to purchase additional US Treasuries. We should see this as a retrograde lurch towards the policies of financial repression – policies still pursued in various guises by the European Central Bank and the Bank of Japan.
During both world wars, successful financial repression caused a great deal of discomfort for European bondholders. There is now a clear risk of a World War III for bondholders, given the similarity between the coordinated expansion of central bank balance sheets in recent years with that during World War II.
Suppressing interest rates (and controlling yield curves) artificially lowers the cost of servicing debt for households, non-financial companies and, of course, governments. By contrast, a normalisation of interest rates – which can be led by policymakers or credit markets – implies rising debt service costs and painful debt dynamics for those who have grown used to bargain-basement borrowing. Moreover, rising debt service ratios in the private sector put downward pressure on the government’s tax take – lower disposable income for households leads to lower spending and therefore lower revenues from consumption and other indirect taxes.
There is dual fiscal stress, arising from rising public sector debt service costs and lessened scope for tax collection. This creates the potential for an explosion in the budget deficit.
Financial repression is a two-act play. Act One is interest rate suppression, but this is not – and can never become – a settled state. What some have called a “new normal” is nothing of the sort. Rather, it describes an interim state of disequilibrium. When Act One ends, perhaps there is an intermission – enough time for a quick gin and tonic and a trip to the facilities – but Act Two soon begins. And Act Two is unanticipated inflation. Unanticipated inflation, by definition, is an unpriced risk.
The Box emerges
Out of the chaos of the post-Bretton-Woods world, the Box emerged.
After a decade of high inflation, high unemployment and poor growth in the 1970s, there eventually came an effective response. This involved an increasing commitment to liberal economic policies: freer trade, abolition of capital controls, floating exchange rates and freedom of movement across national borders. In time, this developed into a coherent – but never watertight – policy framework. This is the Box represented in Figure 1.
Before the financial crisis in 2008, the Box had four supporting columns: budgetary discipline in the public sector, over a defined time horizon; a neutral funding policy; a defined inflation objective, delegated to a central bank; and adherence to the principle of free and open markets for goods and services, labour, capital and money.
For the most part, macro policy was delegated to technocrats. Deprived of the traditional tools to manipulate the economic cycle for electoral gain – spending increases, tax reductions and cuts in interest rates. Politicians evolved alternative strategies to win votes, while still declaring their allegiance to fiscal rules and to the monetary independence of the central bank. These alternative strategies included promoting financial liberalisations that would widen and deepen access to credit in the private sector; moving the cost of financing infrastructure investment off the public sector balance sheet; not addressing mounting demographic pressures on the provision of public services; and multiplying public pension entitlements and other financial promises stretching far into the future.
When private sector debt exploded in 2007-08, politicians endorsed rescue packages that caused the budget deficit to soar. They also gave their approval for central banks to embark on large scale purchases of government bonds and other assets, while maintaining near-zero short-term interest rates. While tighter bank regulation disabled many traditional lending channels, cheap credit was supplied to the private sector through unregulated shadow banks. The private sector debt bomb has been re-engineered and repositioned in the corporate sector.
Political economy becomes toxic
Plainly, the design of the Box was not perfect. If it was, there would not have been a financial crisis. However, the crisis brought about the arbitrary redesign of the policy framework, skewing monetary policy easier and fiscal policy tighter, and blurring the boundaries between the two.
This hastily redesigned Box, shown in Figure 2, retains a commitment to capping inflation. But it turns out to have some very different properties from the original, including serious flaws, such as locking in gains and losses between different age segments of the population.
Over the past decade, the political economy of this skewed Box has become toxic. Fiscal constraints frustrate infrastructure and environmental plans. Funding constraints frustrate reflation plans, including healthcare reform, ‘living wage’ aspirations and job guarantees. Inflation targets carry a permanent background threat of policy tightening. Free trade allows a national stimulus to leak; an open capital account permits capital flight.
Increasingly, is it becoming clear that national policy agendas – of the political right and left – cannot be reconciled with the Box.
Consider the scope for fiscal redistribution. If new spending priorities are to be afforded within existing budgetary constraints, then significant new taxes must be raised. The incomes of the compliant rich – especially in the US – are already heavily taxed. And wealth taxes are difficult to assess and collect. It could take three years to bring in the revenues from a new wealth tax, a long time in the context of, say, a four-year presidential term.
End of consensus
The bi-partisan political consensus that has upheld the Box since the financial crisis is dead. Our destination? An exploded Box. The 2020 US presidential election is the key context.
President Trump has already unleashed waves of chaotic dislocation in the policy arena, shaking the columns of the Box. Trump has been seeking more quantitative easing, unbalancing the budget, undermining both the independence and legitimacy of the US Federal Reserve, erecting tariff barriers to levels last seen in the 1970s and discouraging economic migration, mostly notably with plans for a Mexican wall.
Trump resembles a modern-day Samson in his final show of strength – shackled, blind and a source of public entertainment, yet strong enough to dislodge the pillars of the house and bring the roof down on the Philistines. If Trump is re-elected in 2020, it is reasonable to assume that he would seek to demolish what remains of the Box – a structure on which so many investment strategies depend.
What of the Democrats, should their candidate be successful in 2020? The policy messages are every bit as revolutionary as those of the president. Modern Monetary Theory is covered elsewhere in this Review, from the perspective of Stephanie Kelton, an economic adviser to Bernie Sanders.
Across the US political spectrum, the voices of fiscal conservatism are mute. And the voices of economic nationalism are growing louder.
Four critical trends
Jack Goldstone, in his book Revolution and Rebellion in the Early Modern World, analysed periodic breakdowns of governance in Europe, China and the Middle East from 1500 to 1850. He concluded that “population growth, in the context of relatively inflexible economic and social structures, led to changes in prices, shifts in resources, and increasing social demands with which agrarian-bureaucratic states could not successfully cope”.
Goldstone discovered four critical trends at work in every episode of breakdown. First, government fiscal distress. Second, intra-elite conflicts. Third, a heightened potential for mass mobilisation. Fourth, the increased salience of utopian ideologies of rectification and social organisation.
Significantly, population growth is associated with price inflation, while the demands of an ageing population are linked to fiscal distress. Revolution and rebellion, Goldstone finds, were not caused by “excessively high taxation by rulers, or a simple lack of social mobility, or chiefly by class conflict, or general impoverishment of society”.
For fiscal crises, his consistent finding is that these were caused by under-taxation, as elites systematically evaded taxes. This meant government revenues struggled to keep pace with inflation and so lagged increases in the real wealth of society.
High social mobility – high rates of turnover and displacement – preceded crises, while low social mobility was associated with times of stability. Finally, elites were effective at shifting the burden of taxation onto the middle classes. As Goldstone writes, “the conditions of the working classes and peasants declined while elites and commercial classes grew richer”. In the generation preceding a crisis, the polarisation of wealth was a consistent theme.
Today, Goldstone’s four conditions for revolution and rebellion seem amply satisfied in the US.
Despite a trend of falling unemployment, the US budget deficit, as a proportion of national income, has worsened over the past two years and the tax proportion is falling. Political polarisation has increased and bipartisan compromise has become rare. For Goldstone’s ‘mass mobilisation’, see campaigns organised on social media, in support of Medicare for All or a Green New Deal, for example. For utopian ideologies, see Modern Monetary Theory, with its clear repudiation of fiscal norms.
Towards the triggers
The explosion of the Box could be triggered by a pronounced global economic downturn. This would overlay cyclical and structural fiscal burdens on the existing unsustainable fiscal path. In this scenario, what happens to the cost of servicing debt is a wild card.
Other triggers include another financial crisis, or an old-fashioned fiscal splurge.
A global financial crisis that deflates the equity and credit markets would prompt calls for another massive rescue package. More likely is an attempt to deliver ‘people’s quantitative easing’, whereby private investors are compensated for their losses, or private borrowers are given the means to settle their debts. This could be presented in a framework of Modern Monetary Theory.
An old-fashioned fiscal boost, accompanied by loose monetary policy, would have a powerful liquidity impact. It could be presented as a pre-emptive strike against growing disinflationary pressures and an associated concern that the public’s inflation expectations had drifted unacceptably lower.
Moving the fulcrum
Central bank independence, and the primacy of the inflation objective, represent plum targets for the new revolutionaries.
Without relaxing the inflation constraint, it will be hard to reduce income inequality significantly. While inflation-targeting regimes are ubiquitous – covering over 90 countries worldwide – they have failed on numerous occasions. Turkey, Vietnam and Russia offer recent examples.
Back in the 1970s, the surge of US inflation was not associated with rising income inequality. The stagnation of real incomes in the bottom quintile of the income distribution, and the surging prosperity of the top decile, have occurred while the inflation rate was low. Inflation, long viewed as an ancient peril to be eradicated, has been re-cast as the agent, probably the only viable agent, of income and wealth redistribution.
Now, as with Roosevelt in 1933 and the breakdown of Bretton Woods in 1971, the mood is ripe for a policy revolution.
In Money: The Unauthorised Biography Felix Martin argues there is nothing intrinsically wrong with “moving the fulcrum of the scales of justice”. The purpose of these scales “is not to achieve accuracy – a notion without meaning in the social world – but fairness and prosperity. On the alternative view of money, keeping the fulcrum fixed while shifting weight from one scale to the other via fiscal redistribution is certainly one way of doing things – and quite rightly the usual way in normal times. But the nature of monetary society is such that unsustainable inequalities that cannot easily be corrected in this way will inevitably occur from time to time. When that happens, it is time to move the fulcrum to restore balance.”
Towards Act Two
Bond markets are anticipating the next global economic downturn, and a move by policymakers to extreme settings in the search for effective remedies.
Yet the next downturn bears an existential risk for the Box, and for the economic and financial policies on which so many investment strategies rest.
As political economy overrides the ‘New Normal’, the Box will explode and priorities will be reordered. To meet new objectives, central banks will likely be reassigned to the defence of sovereign credit in the context of ambitious public spending programmes and the continued repression of nominal interest rates. It will be the end of central bank independence as we have come to know it. The inflation objective will be disregarded. The inflation rate will find a new level, opening the door to a new monetary settlement, as Act One gives way to Act Two.
Notes: 1. Samuelson (2010), The Great Inflation and Its Aftermath. 2. Ibid. 3. Ibid.
This article was originally published in the Ruffer Review 2020.
The views expressed in this article are not intended as an offer or solicitation for the purchase or sale of any investment. The information is fact based and does not constitute investment research, investment advice or a personal recommendation, and should not be used as the basis for any investment decision. Ruffer LLP is authorised and regulated by the Financial Conduct Authority.