It's the Bond Market, not Biden, That's Giving Trump the Willies.

As Democrats take to the debate stage, Donald Trump is preparing an onslaught of real-time tweeting to define whomever his adversary might turn out to be eighteen months from now. It used to be a matter of courtesy and decorum that political parties stood aside as their counterparts had their largely unfettered moments in the public eye. Democrats tended to remain out of the limelight during Republican debates and conventions, and vice versa.

That might have been the way things used to be; but, of course, it is no longer the way things are. It is inconceivable that Democrats will be able to enjoy two evenings of primetime coverage without Donald Trump doing his best to steal the headlines; to assert himself onto center stage. To allow them to do so would violate every fiber of his being. Perhaps he will tweet punchy new nicknames. Perhaps he will rail against their socialist ways. Or perhaps Trump will go ahead and bomb Iran, and blow them out of the media cycle altogether.

Trump's real enemy, however – the one that is keeping him up at night – will not be at the debates this week. His real enemy is a tougher one to troll or malign, or to dismiss with sandbox antics or adolescent ridicule. The enemy that keeps him up at night is the bond market, or, more precisely, the yield curve. If there is a single factor that looms to dictate the outcome of the 2020 election, it is the economy; and, traditionally, the time-tested harbinger that economic adversity lies just around the corner is an inverted yield curve. Right now, Donald Trump is presiding over the perfect economic situation from which to seek reelection – unemployment continues to fall to previously unheard of levels and the stock market continues to reach new heights – but the bond market is predicting that it won't last.

The yield curve is something many people have an understanding of, even if they have never heard the term. They know that a fifteen-year mortgage has a lower interest rate than a thirty-year mortgage. Or they know that the interest rate on a thirty-day bank certificate of deposit pays a lower interest rate than a one-year certificate of deposit. That is to say, many people who have never heard the term "yield curve" generally understand that in the world of finance, the longer the period of time, the higher the interest rate. That is the normal shape of the yield curve: it is upward sloping.

From time to time, however, the yield curve flattens and, at extreme moments, it inverts, as short-term interest rates rise to become higher than long-term rates. This can happen because short-term rates are pushed up by Federal Reserve Bank, as it seeks to manage economic growth and keep inflation under control; or it can happen because investors become "risk averse" and put more money into long-term treasuries, which pushes long-term rates down. Or, as illustrated in the first graph here, it can happen when both of those things happen simultaneously, as has been the case over the past year and a half, as the Fed has been pushing short-term rates up, and increasingly defensive investors have been pushing long-term rates down.

This graph here sums up why the recent inversion of the yield curve has grabbed attention in the media. This graph presents the "slope" of the Treasury yield curve, as calculated by the difference between the yield on the 30-day Treasury and the yield on the ten-year Treasury. When the number is higher, the slope of the yield curve is positive and steep, when the number dips below zero, the short-term rate is higher than the long-term rate, and the yield curve is inverted. As shown here, over the past forty years, each time the yield curve has inverted (highlighted by the periods circled in red) a recession (shaded in gray) followed shortly thereafter.

This is what is keeping Donald Trump up at night. None of the Democrats on stage this week scare him, but the inverted yield curve is giving him the willies. It is why he has been lashing out at Fed Chairman Jay Powell – someone 95% of Americans have never heard of – more than he has at anyone since Jeff Sessions. In Trump's view, Powell created this mess by raising interest rates to begin with. It is the Fed's actions that have distorted the slope of the yield curve and that now threaten to undermine both the economy and Trump's reelection chances, and he is doing is best to force the Fed to reverse course.

It remains to be seen, however, if the current yield curve inversion is as meaningful as many presume it to be. The world of economic theory has been in turmoil since the 2008 financial collapse, as one economic truism after another has fallen to the wayside. For example, macroeconomic theory presumes that there is a direct trade-off between economic growth and inflation. This fundamental rule is encapsulated in something called the Phillips Curve – shown here – which plots the relationship between unemployment and inflation, and suggests that as unemployment declines, inflation must begin to rise. The relationship makes sense: as the unemployment rate declines and the labor market tightens, employers are forced to increase wages to attract and retain workers. This increased cost is passed on to consumers, pushing prices upward.

The experience of the past decade, however, has defied the Phillips Curve. As illustrated here, since the dark days of the Great Recession, when the Dow Jones Industrial Average bottomed out at 6,469.95 – marking a 54% decline from its pre-crisis peak – and unemployment reached 10%, the Dow has risen by 240% and the unemployment rate now sits solidly below the magical 4% level that economists have long viewed as constituting "full employment." All the while, as illustrated by the green dotted line, even as the economy has gathered steam, and the Fed has flooded the global financial system with dollars, inflation has remained stubbornly in the range of 2%. For all intents and purposes, the Phillips Curve has ceased to matter.

The collapse of long-term interest rates over the past several months represents a similar economic quandary. For years now, critics of the Fed have warned that once the Fed started to reverse its zero interest rate and quantitative easing policies, long-term interest rates were sure to spike upwards; the term hyperinflation was bandied about. Should foreign governments – notably China – taper off their own purchases of Treasuries at the same time, the rise in interest rates would surely be exacerbated, as the federal government struggled to find buyers to fund its massive deficits. Toward the end of last year, the bond market was gripped with fear as this scenario seemed to be unfolding. As the Fed began to taper off its holdings of treasuries, and China cut back its bond purchases, the rate on the ten-year Treasury bond jumped by more than 1% to 3.25%. Yet in this instance as well, conventional economic wisdom has been turned on its head. Despite both China and the Fed continuing to reduce their holdings of Treasuries – and with federal deficits ballooning past $1 trillion – the bond market has rallied and the yield on the ten-year Treasury has dropped to 2.00%.

It may be that the yield curve no longer predicts the future, as many economic commentators are now suggesting. Things are different today, some argue, as they point to the death of the Phillips Curve and a ten-year Treasury bond yield heading back toward historically low levels; while others simply suggest that the sample size makes the historical track record meaningless. But Donald Trump has his own evidence in mind, as he continues to badger his Fed Chairman to do whatever he has to do to give the economy a push and make the yield curve upward sloping again. His gripping fear of the inversion of the yield curve recalls the 1993 comments by Bill Clinton's political strategist James Carville. “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Clinton had just toppled the incumbent President George H.W. Bush, in large measure because an economic recession had overshadowed Bush's successful prosecution of the first Gulf War.

Donald Trump's evidence is George H.W. Bush and Jimmy Carter. They are the only presidents in the modern era to lose their bid for a second term. Each were brought down by economic adversity. They were weak men with failed presidencies, as Trump sees it, and to become the third member of that club would be the ultimate humiliation and defeat.

Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free."

Artwork by Joe Dworetzky. Check out Joe's political cartooning at www.jayduret.com. Follow him on Twitter @jayduret or Instagram at @joefaces.

Dick Cheney brings religion to the Democrat left.

Texas Republican Congressman Kevin Brady was doing a soft-shoe last week at the 2019 Fiscal Summit sponsored by the Peter G. Peterson Foundation. He was trying to defend the massive package of tax cuts passed in December 2017 – of which he was a principal architect – in the wake of a new analysis from the Congressional Budget Office showing that those tax cuts were ballooning federal deficits back toward $1 trillion a year.

The Peter G. Peterson Foundation was the creation of Pete Peterson, a prominent Wall Street financier, Nixon administration official and GOP wise man who famously sounded the alarm about growing federal deficits back when people cared about such things. Most recently, in the months before he died, Peterson opposed the 2017 tax cuts, arguing at the time that "Mortgaging our fiscal future for trillions in temporary tax cuts will hurt our economy over time, and every C.E.O. should know that. True business patriots need to advocate for their country as well as their company."

Brady – by Peterson's test less patriot than self-serving partisan – argued vociferously at the time that the tax cuts would pay for themselves. The truth is, his argument had less to do with economics than pure politics, as since the Reagan years, the notion that tax cuts pay for themselves has become a Republican shibboleth, whatever the data or circumstances might suggest. Forty years ago, in the post-Vietnam War stagflation years, when the top federal tax bracket was 90%, the unemployment rate was nearing double digits, and factory underutilization was rampant, one could make the argument for tax cuts with a straight face. As the Laffer Curve suggested, communities with high, confiscatory tax rates may be able to increase tax collections by reducing tax rates, due to the combination of increased economic activity and reduced tax avoidance that might result.

As top income tax rates were dropped from 90% to 35% or so, supply side economics and cutting taxes morphed from economic theory to political strategy, and – along with guns and abortion – became a cornerstone of the GOP coalition. As Reagan ally and GOP strategist Grover Norquist has argued for decades, if Republicans promise tax cuts, they will win most elections most of the time, and it makes no difference if they bother to cut spending along the way. No one, Norquist liked to explain, cares about deficits, other than a few old bankers sipping scotch in the Metropolitan Club. And now, a few decades later, most of those bankers are dead.

If there was a single moment when supply side economics was transformed into a political mantra, it was when Vice President Dick Cheney effectively fired George W. Bush's Treasury Secretary Paul O'Neill. O'Neill – an old school Republican of the Peterson mold – opposed the Bush tax cuts for exactly the reasons Peterson suggested. At a pivotal moment, in the wake of the 2002 mid-term elections, when O'Neill was arguing that proposed income tax cuts would turn projected federal surpluses that Bush had inherited into deficits that would damage the economy, Cheney retorted with words that would come to encapsulate Republican fiscal policy and political strategy: "You know, Paul, Reagan proved that deficits don't matter. We won the mid-term elections, this is our due." 

Democrats have chafed for decades at watching Republicans cut taxes, knowing that fixing the ensuing fiscal mess would inevitably fall to them. Tax-cutting, budget-busting, new age Republicans describe themselves as 'fiscal conservatives' to this day, yet one Republican administration after another has left behind a fiscal catastrophe that has required "tax and spend" Democrats to do the fiscally responsible thing and seek to put things back in order. As newly elected Bill Clinton explained to his budget team as to why their panoply of new policy ideas would have to wait, "We are all Eisenhower Republicans now."

Seeing a new deficit crisis looming, and the possibility that if they win in 2020, they will once again find their policy ambitions frustrated, Democrats are finally getting religion. Republican rarely talk about the Laffer Curve anymore, but Art Laffer's spirit remains critical, as it provides a penumbra of justification for their tax-cut religion. A number of Democratic hopefuls have now found their own Art Laffer: Bernie Sanders' economic advisor Stephanie Kelton.

Kelton is the most visible proponent of Modern Monetary Theory (MMT). MMT suggests that new social spending can be proposed without having to answer the age-old gotcha question, 'how are you going to pay for it.' It offers a theoretical construct for Dick Cheney's hectoring of Paul O'Neill years ago: deficits don't matter.

For someone trained in traditional economics – think Paul Krugman, an MMT skeptic who has been engaged in an ongoing debate with Kelton – the problem may be with the word “theory.” A more apt term might be “observation.” After all, Modern Monetary Theory is built around the observation that for decades now the United States – and MMT poster child Japan – have been piling up deficits and debt, with no discernible adverse consequences.

Traditional economic theory suggests that massive deficit spending should create domestic inflation, as new money is infused into the economy driving up demand and increasing the money supply. The funding of deficits with increased public debt would, in turn, drive up long-term interest rates to lure investors to purchase the increased supply of bonds, and squeeze out the supply of capital available to the private sector. There have been myriad examples of countries that have gone through these cycles of overspending, growing debt and ensuing financial crisis, most notably in Latin America, and to a certain extent Greece.

But this has not been the experience in Japan, where despite decades of massive deficit spending and a piling on of public debt, long-term interest rates remain near zero and inflation is non-existent. The US experience has been similar. Even as we have run up massive deficits, inflation has remained low for decades, and interest rates on US Treasuries are near historically low levels.

Much has been made of the expectation that long-term interest rates would spike upwards should China and other countries stop purchasing new debt, and the Fed stop its quantitative easing and begin to reduce its own holdings of Treasury securities. Yet, over the past year, as deficits have continued to grow and interest rates have declined, China has reduced its investment in Treasuries by about 10% or close to $100 billion. Perhaps more significant, but less reported, the country whose central bank has trimmed its Treasury holdings the most has been ours, as the US Federal Reserve Bank has reduced its holdings of Treasuries by $300 billion over the same timeframe. These steps – China selling Treasuries and the Fed shrinking its balance sheet – were supposed to signal a coming economic armageddon. Now they both begun to happen, and the result... nothing; long-term interest rates have continued to slide downward and the private sector is awash in capital. As shown in the graphic here, in contrast with the widely held view that foreign governments and the Fed have been funding our deficits, holdings of Treasuries by foreign investors and central banks has been flat since 2014, and holdings by the Fed are trending down. Our deficits are being funded not by foreigners, but primarily by private investors here at home.

It may be that the phenomenon of growing debt and flat interest rates in Japan and the US is explained by demographics. The Japanese population is aging rapidly, with 20% of the population now 70 years old or older. As this graphic illustrates, the aging of Japan is coming more quickly than in other countries, though it is a global phenomenon. Older people buy bonds, and they hold them. The population in the US is aging as well – a factor that has argued for substantial growth in immigration, though that is not the direction our politics are heading right now – and that may partially explain the steady increases in private holdings of Treasuries.

The problem with the observations that underpin MMT and the rush by Democrats on the left to embrace Dick Cheney's political economic world view, is that as much as the post-2008 economic universe has strained economic central wisdom, that wisdom will, ultimately, rear its ugly head. They don't call economics "the dismal science" for nothing. Deficits may not have mattered for a while now, but give it time.

Data source: CBO 10-year Budget Projections, May 2019

This was the dirty secret buried in recent CBO data. Private investors may continue to buy up Treasuries and fund our deficits, but that funding comes at a cost, illustrated in this graphic. In the CBO's 10-year budget projections, the interest cost on the federal debt – shown here as the blue dotted line – nearly triples from $325 billion per year to $921 billion. This means that by 2029, interest on the federal debt will be larger than the defense budget and larger than all non-defense discretionary spending.

And this is the optimistic projection. The CBO numbers suggest a very rosy view of interest rates, projecting that the average interest rate on Treasury securities will barely rise over the next decade – nudging upward by 15 basis points a year (0.15%) from 2.3% to 3.5% in 2029 – even as the public debt as a percent of GDP continues to grow. Should one be slightly more pessimistic, and project instead that the average interest rate on Treasury bonds rises to 5% – a level that approximates the level prior to the 2008 financial crisis – the annual interest cost on the federal debt grows four-fold, to over $1.3 trillion annually. At that point, as illustrated by the orange dotted line, interest on the accumulated debt would cost almost as much as defense and non-defense discretionary spending combined, and approach Medicare as the largest single area of federal spending. If there is a single chart that explains why millennials are skeptical about the self-serving nature of our politics, perhaps this sums it up.

It used to be axiomatic that mortgaging our fiscal future through massive deficit spending is bad economics and a crime against the citizenry of the future – particularly to Pete Peterson and the Republican Party, before the deconstruction of the GOP began under Ronald Reagan. It isn't anymore. Stephanie Kelton is far from being a Dick Cheney acolyte, but her thumbnail argument is the same: deficits don't matter because – so far – they haven't seemed to matter. That is music to the ears of those on the left who advocate for every manner of new federal spending – and to Democrats who loathe the prospect of economic circumstances once again forcing them to assume the mantle of Eisenhower Republicanism. But just because deficits haven't mattered for a while doesn't mean they won't matter in the future.

We have been down this path before in the economic realm, where conventional wisdom is cast aside in favor of a 'new paradigm,' only to see those old truths rear their ugly heads with a vengeance. In the last 1990s, after decades of steady shortening of periods of economic contraction, economists began to suggest that the business cycle – the inevitable economic cycle of growth and recession – had become a thing of the past. That fleeting moment of euphoria came crashing down with the 2008 global financial collapse, and the worst recession in nearly a century. The notion that deficits don't matter is politically attractive, but is similarly unlikely to stand the test of time. Just because most of the people who believed that deficits matter are dead, doesn't mean that it isn't true.


Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free."

Artwork by Joe Dworetzky. Check out Joe's political cartooning at www.jayduret.com. Follow him on Twitter @jayduret or Instagram at @joefaces.

The Lombardi Rule.

Bernie Sanders has good reason to be pissed off. Three years ago, he ran against Hillary Clinton as the avatar of a rigged system. Clinton was the paragon of the Democrat establishment and had spent her career catering to Wall Street and the globalist agenda of corporate leaders. That is to say, she stood for everything Sanders has stood against. He may have swallowed his pride and endorsed Hillary's candidacy, but deep inside he had to feel vindicated when Donald Trump, running against that same rigged system, won the day.

Today, at home and abroad, the United States as we long imagined it to be – the global leader of the alliance of advanced democracies – is in tatters, and for all the reasons Bernie predicted. All of the policies that he railed against over the years – free trade, outsourcing, financial deregulation, the wars – have come home to roost. While it is fashionable to blame Trump for all that ails us, he is a product of our decline and discontent rather than the cause. If one were to put names to the architects of our dysfunction, they would surely include Bush and Clinton, while harkening back to many who came before them.

The Georges Bush and Bill Clinton brought the world the entry of China into the World Trade Organization, financial deregulation, and the wars in Iraq and Afghanistan. While intended to promote freedom and democracy in China, and expand economic prosperity and opportunity across the globe, those actions, in turn, eroded the middle classes in the United States and Europe; laid the groundwork for a global financial collapse that eviscerated family savings, pensions and security; and led to the wave of immigration that is shaking the political stability of Europe. Not only has liberal democracy failed to make headway in Russia, China and the Arab world, but it is under severe assault across Europe and at home.

There is a reason that 20% of Bernie supporters polled recently indicated that they would vote for Trump rather than another Democrat, and it is the same reason that Bernie is pissed off. Everything he predicted has come true – free trade and financial deregulation turned out to be a disaster for many American workers – and yet once again Democrat voters appear to be turning to an establishmentarian centrist rather than him. Joe Biden is Hillary Clinton all over again: he voted for the wars, he is closely aligned with the banks, and he never met a trade deal he didn't like. He's just better at pitching the guys at the union hall and American Legion post.

That, however, is the point. Democrat optimism about the prospects of winning back the White House next year has ebbed. According to a CNN poll published this week, one-third of Democrats now believe that Trump is likely to win reelection next year, a share that has grown from just one-in-five six months ago. Among all voters, the CNN poll suggests that a majority of Americans now expect Trump to win a second term. Day after day, week after week, Trump reminds Democrats of what is at stake, and why this it not the year to let the perfect be the enemy of the good. In the words of the Green Bay Packers legendary coach Vince Lombardi – for Democrats looking ahead to 2020, winning isn't everything; it's the only thing.

Against that backdrop, it is little wonder that Joe Biden continues to double up Bernie in the national polls – somewhere in the range of 35% to 18% – with no one else breaking out of single digits. Biden is widely viewed as capable of beating Trump in a national context, a view that was given more credence by a Texas Q Poll published this week showing Biden beating Trump head-to-head in Texas by four points, with Trump beating each of the other Democrat candidates named. Additionally, according to the most recent national Q Poll, among the prospective Democrats, Joe Biden has the most positive favorable-unfavorable score – long considered a significant metric of electability – where he was viewed favorably by 49% of those polled, compared to unfavorably by 39%. This is referred to as a 'plus ten' in political jargon. This compared to a 'minus seven' for Sanders, with 41% positive vs. 48% negative. Among the rest of the Democrat field tested by the Q Poll, only South Bend Mayor Pete Buttigieg had a positive score.

I count myself among those who fully expected that Joe Biden would peak in the polls on the day he announced his campaign, and that his poll numbers would then regress steadily, ultimately leading to a tight contest among a handful of top-tier candidates. We have seen this pattern before, when political parties waited for a designated savior to enter the race, only to see that candidate savaged once they actually entered the fray.

Biden's ability to sustain his position well ahead of the rest of the field has been surprising. He has largely avoided entangling himself in the intra-party policy debates that have embroiled other aspiring candidates by essentially running a general election campaign against Donald Trump. So far, that strategy has played into Democrat anxiety, as by running against Trump, he reinforces his appeal to Democrats nervous about the ability of their nominee to do that which Biden is already doing.

Biden's standing has been buttressed by a couple of other factors. Polling suggests that his relatively centrist stances on issues are aligned with a large share of Democrats, and, thus far, with no other relative moderate among the top-tier of candidates, he has not faced competition in the moderate "lane." In addition, according to the Q Poll, progressive/liberal Democrats have thus far been paying more attention to the nomination campaign than moderate and conservative Democrats, and, accordingly, much of the media coverage has focused on intra-party debates over progressive issues. While this has shown Biden to be out of step with Democrat activists, it has at the same time supported his strategy of presenting himself as the candidate focused on and capable of beating Trump.

Even as Biden has benefitted from having the moderate lane to himself, Bernie's candidacy is suffering from the range of choices that progressive Democrats now have to choose from. If Bernie has seen his support in the polls drifting downward, that shift certainly has less to do with Joe Biden than with Elizabeth Warren, and to some extent Kamala Harris. Warren, in particular, has worked diligently to put meat on on the bare bones of Bernie's revolution. Unlike Sanders, whose themes of Medicare-for-All and free college tuition have been around for a while, with little specificity beyond that they will be paid for by the 1%, Warren has taken it upon herself to craft a full array of policy proposals for fixing the American capitalist system and addressing the growing problem of income inequality.

The structure of the early primaries is also skewed to Biden's advantage. These advantages are not a function of machinations by the Democratic National Committee, but rather the combination of the benefit of name recognition – which Biden and Sanders share – and the fact that Biden is the only arguably center-left candidate in a top tier that loosely comprises Biden, Sanders, Harris, Warren and Buddigieg. When Iowa voters show up to caucus, those whose priority is to nominate a progressive or woman candidate will likely find themselves splitting their loyalties among a number of strong candidates, while Biden will stand alone – presuming that Coloradans Michael Bennet and John Hickenlooper, John Delaney or other relatively centrist candidates you have never heard of are not able to make a dent in the polls in the coming months. Biden should hold similar advantages in the other early states of New Hampshire and South Carolina.

If he doesn't mess up. I continue to expect that Biden will come down to earth before all is said and done, though for no particular reason beyond the fact that frontrunners never seem to make it, and Biden, in particular, is a gaff machine. Biden's central argument that he is uniquely capable of beating Trump in a general election belies the fact that he has failed dramatically in his previous campaigns for the presidency. It may well be that other candidates might do as well or better; the problem is that in an historical moment when Democrat voters are looking for a sure thing, there really is no way to make the case that one can run successfully against Donald Trump, until one runs successfully against Donald Trump.

And there is the age thing. It is hard to look at Biden and Bernie and not take note of the fact that should one of them become president, he will be older than any president who has ever served. Either one of them, the day he walks into the Oval Office, would be older than Ronald Reagan – our oldest President – on the day he walked out.

Right now, however, the Lombardi rule is looming to trump everything else. According to the Des Moines Register/CNN poll, 65% of those polled who plan to attend the Iowa caucuses said that beating Trump will be their highest priority, compared to 31% who indicated that it will be more important to support someone who shares their views on major issues. A Monmouth University poll of New Hampshire voters mirrored the same sentiment, preferring by 68% to 25% a candidate who they disagree with on issues but they believe to be stronger against Trump over one who supports their issues but who they think may have a harder time winning. Bernie – and many progressive Democrats who share his view of the world – may believe that he has been proven right, and that time and again Joe Biden was on the wrong side of history. His problem, and that facing other candidates hoping to break through, is that it appears that many Democrats may not care about all of that this time around.


Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free."

Artwork by Joe Dworetzky. Check out Joe's political cartooning at www.jayduret.com. Follow him on Twitter @jayduret or Instagram at @joefaces.