Budget leaves us no leg to stand on when bubbles burst

Budget leaves us no leg to stand on when bubbles burst
© Greg Nash

Much commentary has been written about last week’s congressional budget agreement that lifted the public spending ceiling by $300 billion over the next two years and how it will compromise the country’s public finances.

It has been noted correctly that soon this will contribute to increase the budget deficit to over $1 trillion, or around 5 percent of GDP, and to put the public debt on a path to increase to over 100 percent of GDP.

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Less commentary has been devoted to the more immediate and equally important issue of how damaging this budget deal could be to U.S. financial market stability, which might heighten the risk of an economic recession. 

 

Any faltering in the economic recovery would further compromise the country’s public finances by reducing the country’s tax revenue collections. 

These risks to the economy are primarily due to the fact that the latest public spending stimulus comes at precisely the wrong time in the country’s economic cycle. It also comes at a time that the U.S. equity market is in bubble territory and that the economy is already receiving substantial fiscal and monetary policy stimulus.

Prudent budgetary policy dictates that in the good economic times, one should run budget surpluses in order to provide room to stimulate the economy in the bad times through increasing the budget deficit. This makes last week’s bipartisan decision to increase the public spending limit all the more lamentable.

With unemployment already down to 4 percent and with the economy growing at around 2.5 percent, well above its potential rate of growth, these can hardly be called bad economic times. Does it really make any economic sense to use up further room for fiscal policy maneuvers in the good times?

A further reason to regret public spending increases at this particular juncture is that, even before these increases, there was already substantial economic policy stimulus in the pipeline that risked causing the economy to overheat. 

Not only was the Trump administration’s unfunded tax cut increasing household after-tax income and incentivizing corporate investment, but through its relative inaction last year, the Federal Reserve allowed U.S. financial conditions to become the easiest they have been in 40 years.

The Fed did so by not adequately raising interest rates to offset the big boost that the economy was receiving from a 25-percent increase in equity prices and from a 10-percent depreciation in the dollar since the Trump administration began. 

Even in normal times, overheating the economy is not a good idea since that would risk bringing on inflation. However, these are far from normal times in the sense that years of very easy monetary policy have led to a situation where we have equity and credit market bubbles around the globe.

As an indication of the size of these bubbles, it might be recalled that today, global equity valuations have reached lofty levels that have been experienced only three times in the last 100 years.

There is a real risk that should the economy overheat, bond holders will lose heart and will force long-term interest rates higher. That in turn would risk bursting the various asset market bubbles around the globe, that have present valuations that can only be rationalized in a world of unusually low interest rates. 

As was the case when bubbles last burst in 2008-2009, rising interest rates now could again burst bubbles and lead to a situation where the economy will very much need budget policy stimulus. It is all too likely that when that event occurs, we will find that the room for such policies had already been used up in the good times.

However, it very unlikely that Congress will take any blame for having got us into such a situation. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.