As a class, investors have enjoyed the fruits of the Trump presidency. From the day of his election through this past January, the Dow Jones rose 48%, from 17,888 to 26,616. That is a rally of unheard of proportions for a large cap market index. After it hit that high in late January, the market corrected by 10%. Despite those who feared the worst, the pullback was a healthy – and needed – correction for a market that has been careening upward. Over the past week, the economic momentum encapsulated in the stock market's advance has been shaken by Donald Trump's apparent eager embrace of a trade war, and his willingness to threaten the myriad advantages that the United States has enjoyed as the architect of the post-World War II international order.
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The threat posed by Trump's continuing flirtations with economic nationalism goes well beyond the tit-for-tat consequences that we might face should he go forward with imposing tariffs on one industry or another. It is easy to forget how dependent upon the rest of the world we have become, not just with respect to confronting global issues like the terrorism or climate change, but in the more mundane issue of how we pay our bills from one month to the next.
Talking about debt and deficits has gone out of fashion, and for good reason: after a decade of zero and near-zero interest rate policies by central bankers around the world, the annual interest cost on the federal debt has remained artificially low, assuring that the financial cost of federal deficits has been far lower than the political cost of doing anything about them (i.e. raising taxes or cutting spending). While total outstanding federal debt held by the public has grown ten-fold since Ronald Reagan was president – from $1.2 trillion in 1984 to $11.7 trillion in 2016 – the net interest cost in the federal budget has barely doubled, rising from $111 billion to $240 billion, as the average interest rate paid on the national debt plummeted from over 8% to under 2%.
In a world where borrowed money costs so little, Congress finally decided that yelling and screaming about deficits isn't worth it; a new consensus emerged: deficits don't matter. The moment of capitulation came when Republicans – including members of the formerly anti-debt Freedom Caucus – embraced tax cuts estimated to cost $2.2 trillion. After that, the budget deal costing $300 billion was a cakewalk.
The result of that capitulation is projected to be trillion-dollar deficits for years to come. That, in turn, means that the United States will be depending on the good will of the international community for years to come – a consideration that does not appear to factor into Trump's view of the international landscape.
Our ability to fund massive budget deficits year after year without feeling much pain has not been just because of zero interest rate policies that have been in effect since the 2008 collapse, but also because for the past half-century the U.S. dollar has been the reserve currency of the world. Both of these circumstances are now at risk, and both suggest that the future may not be as accommodating as the past.
As the global reserve currency, foreign countries have a number of reasons to invest their currency reserves in dollars. It is an advantage that French President ValĂ©ry Giscard d'Estaing famously described as an "exorbitant privilege" granted to the United States as the overseer of the post-World War II international order. As illustrated in this graph from the St. Louis Federal Reserve Bank, foreign investment in federal debt – shown here in blue –has increased substantially as the amount of U.S. federal debt has grown. The other areas illustrated in the graph are domestic private investors in green, and holdings by the Federal Reserve Bank in red. As of 2016, foreign investors held 53% of the $11.7 trillion of publicly-held federal debt, with China and Japan together holding $3.3 trillion, or one-third of the total.
Interest rates are already heading upward as the world economy is picking up steam, just as the Congress and the President have committed to a path of massive increases in annual borrowing. We are now dependent on the international community to assure adequate demand for our bonds, and minimize the interest costs we are forced to pay. Should rates rise to where they were in 2007 just before the global financial collapse – around 4.5% – the net interest costs in the federal budget would nearly triple from the current $220 billion to $650 billion per year. Should rates rise to where they were when Bill Clinton was president – 6.5% – interest costs would rise nearly four-fold to $850 billion. That would represent a cost increase of $630 billion, or more than the entire cost of the budget for the Department of Defense last year. And those numbers are based on the debt outstanding as of 2016, and therefore understate the risk posed by rising rates.
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In these circumstances, the last thing we need is the President antagonizing the rest of the world for his own momentary political advantage. Right now, those same countries he is antagonizing are the ones that he is assuming will buy the trillions of dollars of bonds that will fund his tax cuts. They don't have to do that if they don't want to. If they decide to turn their backs on him, we are going to learn very quickly that federal deficits do matter after all.
Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit: Why Federalism is Not Just For Racists Anymore."
Artwork by Jay Duret. Check out his political cartooning at www.jayduret.com. Follow him on Twitter @jayduret or Instagram at @joefaces.
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