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LGT Investorama: Fiscal dreams versus debt nightmares

26 de abril de 2017

Many long-suffering patients live daily with the following roller coaster: They were first diagnosed with their serious condition years ago. After a swiftly implemented course of treatment that initially seemed to work wonders but then became less and less effective, it was complemented and quickly replaced by another treatment method. When this alternative cure then came up against its limits too, a new set of physicians started arguing once again for the original treatment that had long been written off…

Little wonder that patients and their relatives are constantly torn between despair and last hope!

This is precisely the situation in which the world economy and the financial system find themselves today. It will soon be a decade since the outbreak of the worst financial and economic crisis in the post-war period. Thanks to swiftly administered fiscal and monetary policy stimulus, a recovery from a worrying recessionary condition soon seemed within reach. However, when the undesirable side-effects of this heavily used medicine became ever more manifest in the shape of rapidly mounting piles of debt, austerity was ordered, and, instead of the conventional policy mix, a new and untested variety of monetary policy was prescribed. Meanwhile, this alternative monetary treatment has now reached the limits of what it can do – its effect has clearly amounted to no more than temporarily painless financial markets. For that reason, a comeback for fiscal policy has been postulated of late: the primacy of monetary policy is expected to give way to the approach, until recently written off, of injecting stimulus by means of public infrastructure investment along with substantial tax cuts… Will this mark the opening of a new and perhaps final chapter in the long-running debt crisis tragedy? Understandably, economists and investors fluctuate between skepticism and goodwill, not least because the new chief physician in charge in the White House is having a polarizing effect for entirely different reasons…

It is important for the moment to consider a few macroeconomic principles, without prejudice and free of superficial hysteria about the new US administration. Yes, increasing public credit and debt can indeed – not only theoretically but also in practice – bring about an economic upturn on a lasting basis, provided it is used to finance productivity-enhancing investment rather than government consumption, since the former ultimately adds to the base from which the debt will subsequently be serviced. In fact, public investment can even have a positive effect on the sustainability of government debt if it also improves the productivity of private sector activity – which, we must remember, depends on what infrastructure there is and how good it is. Anyone even half familiar with the state of the US road, rail, and electricity networks will see some potential here… However, given that Trump has held office for a little less than a hundred days, it is only possible to come up with a preliminary idea of how effective the recipe referred to in short as “Trumponomics” will ultimately be in enhancing growth and earnings and improving the key relationship between real interest rates and the rate of economic growth. Whether and to what extent the desired multiplier effect will result also depends on the interplay with monetary policy, the exchange rate regime and the fiscal starting position. Although a debt level on a par with the gross national product (GNP) represents a difficult burden to inherit, support from the Federal Reserve (Fed) is pretty much a given.

Will this lead in the end to a “Japanization” of the global economy? The parallels with the way the Japanese economy has developed cannot be overlooked: from Japan’s early experience of excessive fiscal policy decades before the financial crisis in the West to its introduction of ultra-expansionary monetary policy with zero and negative interest rates and quantitative easing, and then the latest comeback for fiscal stimulus, which has now produced debt amounting to 250% of the country’s GNP. However, Japan has not had the debt nightmare: thanks to the central bank influencing the yield curve over the entire maturity spectrum, the burden of public debt has been kept at a moderate level. That means the end-game many fear is far from beginning: as long as the Japanese people and investors do not become nervous and a general loss of confidence does not trigger a collapse in the currency, the system will remain under control.

The influence of psychology in all this should not be underestimated: a business cycle upswing starts in the head! Investor sentiment and consumer confidence cannot be captured by mathematical formulas. The relevant moods which subsequently give rise to economic reality are based on soft factors like confidence – or its opposite. As with recuperation from illnesses, so in the performance of the economy, medicine works best if patients and economic players, respectively, are optimistic and believe in a positive effect – regardless of whether or not they like the physician treating them. From this perspective, the chances of the latest fiscal hopes being at least partially fulfilled and leading to more robust growth in the medium term are actually better in a perhaps somewhat naively optimistic United States than notorious doom-mongers and know-it-alls in Europe might care to admit. This accords with a reminder from the US economists George Akerlof and Robert Shiller – probably not by chance – of the “animal spirits” defined by the venerable Mr. Keynes… With his trite witticism that in the long run we are all dead, Keynes accorded greater importance back in the last century to stimulating the economy and growth than to fiscal virtue.

Psychology has an equally decisive influence on the health of the financial markets. Here, too, a constructive mood added to trend-enhancing herd behavior can move mountains. Unlike the “homo oeconomicus” of the textbooks, who always factors in all the consequences of his actions (including side-effects) with full prudence, we humans are sometimes masters of glossing over guilt and debt issues – which means their importance can be downplayed subjectively for a long time. Things only become dangerous on the stock exchanges if the potential debt nightmare is completely ignored, the fiscal dream takes off, and any remaining doubts give way to euphoria. Then even in strong bull runs the phenomenon of the last gasp before death is to be feared. It is only at that point that it is time to say thank you and goodbye.

Dr Alex Durrer
Chief Economist

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