Fiscal Dominance -- So Far It's A Choice

A review of Charles Calomiris' paper on Fiscal Dominance and the Return of Zero Rates on Reserves

Summary:

• Calomiris' paper on the risks of U.S. fiscal dominance is important, but is receiving uncritical acceptance due to current price action in bond markets

• The assumptions, particularly its pessimistic view of Congress' future fiscal behavior and the underestimation of the dollar's role as the global reserve currency, are unlikely to be borne out

• The paper overlooks nuanced policy options for entitlement reform and revenue-raising, and does not consider the impact of human ingenuity, such as medical breakthroughs, on fiscal projections.

• Overall while Calomiris' paper raises important questions about U.S. fiscal policy, it falls short in offering a comprehensive and balanced view, neglecting to consider alternative scenarios and policy tools that could mitigate fiscal risks

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Quote of the Week:

Remember one thing. Crashes are never caused by poor earnings or lower economic growth. Those things cause recessions, but they do not cause crashes. One thing, and one thing only, can cause a crash: forced selling. — Matt Maley, Miller Tabak (on the Crash of ‘87)

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What I’ve Been Reading

The Rise and Sudden Decline of North Carolina Furniture Making — a fascinating read on the impact of China trade on the long-established North Carolina furniture industry from the Richmond Fed. Importantly, any analysis of the impact needs to consider that the industry was decimated NOT by competition from Chinese producers, but by the pro-active decamping of production facilities (and jobs) by US producers in advance of the WTO admission of China. Prior to the 1999 GATT agreements that set the clear stage for China’s joining the WTO, North Carolina had consistently experienced unemployment well below the US national average. During the 2000-2006 housing boom, a period when we would have expected furniture manufacturers to benefit, North Carolina unemployment surged to well above the US average.

As noted by the Richmond Fed:

One of the story's wrinkles is that the influx of Chinese imports had not been initiated by Chinese industrialists but rather by the North Carolina industry's own leaders, who had sought cost advantages that could put them ahead in what has historically been, and remains to this day, a highly competitive industry. Another wrinkle is that, by undercutting North Carolina's furniture manufacturing base with Chinese imports, they were replicating a pattern that had played out during the 20th century, when the North Carolina industry successfully competed with the furniture manufacturing industries of New England and Michigan.

History doesn’t repeat, but it does rhyme.

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Top Comment

Bryden Teich: The podcast Demetri did with Prof Calomiris was excellent. The argument about how a fiscal dominance situation would play out was very well articulated, however there was not enough elaboration about how the sequence of events would most likely be massively deflationary first. Prof Calomiris said something to the like that if banks were forced to hold higher reserves while receiving no interest, the amount of inflation he calculates would be needed drops from 40% to 10% (or so). What he doesn't explain is that the act of raising reserve requirements to that severe level would collapse bank ROE's and would likely trigger the insolvency of much, if not all, of the equity capital of the banking system. A 1930s-esq deflationary bank credit cycle would ensue.

My biggest beef with the "It's the 1940's!" crowd is that they completely miss the part that the 1940s were able to play out because of the deflationary 1930s and the depth at which the credit cycle played out created the conditions from which the '40s could spawn. What Prof Calomiris is describing would likely create the same conditions, I believe.

The deflationary '30s created the conditions for which the fiscal dominance of the 1940s could exist. The "It's the 1940's!" crowd does not get enough push back on their argument on the fin-podcast circuit. The 1940s argument today seems to be made by people trying to paint a bullish picture for equities and commodities, imho, while making it seem like the path forward is "easy" if we just do enough fiscal and add YCC.

MWG: I couldn’t have said it better myself. While we’ve experienced an inflationary episode much like the 1940s, when war both imperiled supply chains AND created an enormous fiscal impulse, we lack BOTH the precursor deflationary Great Depression cycle which radically lowered private sector debts, AND the population explosion that facilitated the consumer recovery post-WW2 (between 1930 and 1950, US population grew by 25% versus less than 10% post-GFC). But I’ll take a shot at some additional insights below.

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The Main Event

Last week, I suggested I might take a deeper dive into Charles Calomiris’ paper on fiscal dominance. This was met with enthusiasm. The paper presents a grim scenario of unchecked U.S. federal debt leading to a potential economic crisis, marked by rising inflation and financial instability. It argues that the high debt-to-GDP ratio, along with projected deficits, could trigger a "fiscal dominance problem" that results in monetary policy taking a back seat to fiscal imperatives. This is a long-hand way of saying, “The Fed loses its independence and must focus on its objectives as the fiscal agent of the US government at the expense of its role as steward for the US monetary system.”

While the paper raises crucial questions about America's fiscal future, it also suffers from key limitations, including assumptions about fiscal behavior, potential underemphasis on the role of the dollar in the global economy, a narrow focus on certain policy tools while ignoring others, and an (understandable) dismissal on the role of human ingenuity. This review aims to examine these limitations and suggest more nuanced perspectives on the fiscal issues facing the United States. While I agree with many of Charles’ conclusions (in particular that the banking sector is likely to be further impaired), the focus of the paper makes the strong assumption that other avenues are not politically available to the United States and we will inevitably drift into the inflationary tax approach. I am skeptical as it is rarely appreciated how few levers the US government has actually pulled to address the “intractable” challenges of the current fiscal deficit. This is not to argue for a higher tax burden, although that is effectively what Calomiris is noting is inevitable; it’s identifying the underlying issues that have given rise to conditions that would lead many to conclude that the US fiscal condition is “unsustainable.”

One of the primary reasons the paper is making waves is the timeliness of its subject matter as government bond investors endure the largest bear market in recent memory. Investors in the US bond aggregate (high-grade corporate and sovereign) have seen 5 years of returns wiped out. For global investors, already suffering from negative yields in many jurisdictions, the losses wipe out all returns back to 2010:

In real terms, the losses are even more staggering. In the US, investors have taken losses that destroy all returns since the GFC; global investors, again fair worse with losses taking out all gains since 2003. Jim Grant’s long-ignored warning that bonds represented “return-free risk” seems to have been borne out:

The sobering message for bank investors, that investors are likely to see the profitability of the banking sector further impaired as regulators broaden the tax base by effectively instituting a 100% tax on income from reserves (cutting IOER back to zero), likewise falls on alert ears. The banking sector has been an epic disaster for investors over the last 17 years. One of the many challenges for the active manager segment has been the collapse in the relative performance of the banking sector from near best-in-class as of 2004 to a worst-in-class performance post-GFC. With the relative performance of the banking sector now threatening to cut below the lows of the S&L crisis, any suggestion that the pain will continue is likely to be met with open arms. Note that I may be guilty of this myself and I would love reader feedback on ways that I may be overly bearish on the banking sector.

As long-time technical analyst Helene Meisler keeps pinned to her Twitter profile: