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Navigating Post-Pandemic Economic Challenges & Hidden Risks
Forgiveness, Part 2
Part 1: Recap
In The Heart of the Matter I advocate for forgiveness of financial and political debt. This includes loan forgiveness programs for poor countries, eliminating the US debt ceiling, and political pardons for the two warring factions of the American political establishment. Resolving these issues and others are prerequisites for greater economic stability and political harmony in the aftermath of the pandemic.
Most of my readers heartily agreed, even though no one under the age of 40 got my Don Henley reference. Some had trouble with the idea of political pardons, but most agreed that they are fatigued by the incessant media coverage of US political scandals. There is a strong desire for more practical economic and political solutions to our current problems, but no clear channel for them to be discussed dispassionately, and no incentives for leaders to resolve them.
Unfortunately, there are additional risks to the post-pandemic recovery such as new global taxation legislation, policy uncertainty and lack of consumer confidence in China, and in the US, student debt payments, an increase in credit card debt and auto loan defaults. All point to a need for wise policy choices that could include some degree of forgiveness or compromise. We need to take immediate action to alleviate visible risks, because there are undoubtedly other hidden risks.
Part 2: Post Pandemic Economic Challenges and Hidden Risks
Political security, the foundation of economic growth, is waning in many places including the streets of my own city, Chicago. Covid has upended the old balances by increasing debt, and costs to service that debt to flood levels, adding to economic uncertainty worldwide.
Global trade and finance are tightly interconnected, so the domestic policies of individual countries, especially the US and China, affect others. Still, many nations continue to act as if alone, or even at cross purposes. International organizations such as the United Nations, the WTO, and the World Bank/IMF are caught in the crossfire. New alliances are forming to meet the need for security and economic cooperation.
Trade wars and sanctions rarely achieve their goals and often misfire, but despite their proven inefficacy these blunt weapons are being used with greater frequency. Instead of negotiating geopolitical conflicts, we threaten our foes with prosecution prior to peace treaties, as we arm ourselves and others to the teeth. We expect rewards for ourselves, and punishments for others. We apply a pre-Covid mindset to post-Covid problems.
Meanwhile, danger lurks beneath the surface of financial and trade networks. In ways that are not clearly understood, shadow banking has become entwined with high levels of government and private debt, creating new channels for liquidity failure. We are not sure where the weakest links are, because private debt is not transparent and central banks don’t always tell the truth. Financial innovation including fintech is another known unknown.
Some headwinds to consider:
Taxes: the OECD is now negotiating with the US Treasury to implement a new corporate taxation regime. A battle is ensuing with Congress which has voiced opposition to what they see as incursions by the Executive Branch on the taxing authority constitutionally reserved to Congress. Should Pillar 1 and Pillar 2 of the BEPS plan become operationalized, it could have a further negative impact not just on US growth, but on global growth. Is the Federal Reserve aware of the potential impact? According to Congressional testimony by Adam N. Michel, Director of Tax Policies at the Cato Institute:
It is widely acknowledged, including by the OECD, that higher taxes under the Two Pillar proposal will reduce investment and shrink global GDP.25 Because a significant share of the businesses targeted are U.S. firms, domestic investment and American workers will face non‐trivial economic costs… higher tax rates are estimated to reduce U.S. jobs by about 370,000 (a 1.5 percentage point reduction) and cut annual investment by roughly $22 billion (a 2.4 percentage point reduction)…representing a significant risk to the American economy.26
Fintech: Tether, the stablecoin company, is now the 22nd largest holder of US Treasuries, greater than for example Mexico, Spain, or Australia. The integration of the new and old financial systems is simultaneously an opportunity for growth and a potential source of localized and systemic risk.
Regional Banks: This past year’s rapid shift in monetary policy has had consequences for US regional banks such as Silicon Valley Bank. Measures to shore up bank capital could have more adverse economic consequences than allowing occasional failures. Hopefully robust stress-testing of the effects of additional debt will be done before any implementation. According to Bloomberg:
If this week’s proposals from the Federal Deposit Insurance Corp. and the Federal Reserve are any indication, larger regional banks will have to issue more long-term debt to protect against losses during periods of turmoil. They will probably need to sell some $40.5 billion of holding-company debt to fulfill the new rules, according to CreditSights, and the first deals are likely to come in the near future, even if lenders may have years to meet the new rules.
Underfunded US Retirement Plans: Pension funds in many cities and states are under water due to faulty actuarial assumptions and poor risk management. Unfunded liabilities in the US are now about $1.4T. Illinois ranks #50 in this pending disaster, but local political considerations make it impossible to restructure payouts. Given the risks, there should be a federal initiative to protect retirees. This could require workers to forgo some benefits in favor of greater certainty in their future payouts. Forgiveness by unions in a tight labor market makes this unlikely to occur on a voluntary basis.
Local Government Debt in China: A weakening, more insulated Chinese economy poses a significant threat to global growth. As is now well known because of the real estate collapse, China’s financial Achilles heel is local government debt. The national government can probably make sufficient adjustments to avoid a financial crisis. The problem however is structural. Until local governments have a stable source of income i.e. taxes, they will continue to misallocate capital in an attempt to meet shortfalls. The demise of private industry in favor of state-owned enterprises is also a factor.
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Consumption and Personal Debt in the US and China
There were at least two possible individual reactions to the shock of the pandemic. To save, as Chinese consumers have done historically. The other is to spend and borrow as US consumers who post-stimulus payments are now are maxing out their credit cards. This incidentally also happened in the anxious aftermath of 9/11:
However, US consumption could fall in coming months. Total household debt is increasing, including credit card debt of $1T and student debt of about $1.5T. Student debt payments will resume in the US in October, as gas prices continue to climb. Interest rates are higher, but real estate costs are not falling due to supply constraints, so housing remains expensive. Increasingly, home insurance required by lenders is harder and more expensive to obtain, especially in states such as California which have been highly impacted by natural disasters.
Credit card and auto loans defaults are seeing an uptick. This will make new credit harder to get, further depressing consumption. Now that US consumers have used up their pandemic savings, we should be thinking of how to deal with these issues before they become a crisis. I have some recommendations below.
Chinese consumers did not increase spending as expected post-lockdown, although forecasts are that during the upcoming Golden Week holidays beginning September 27th we will see a boost in domestic travel, possibly due to pent-up demand that is still playing out.
Balancing this data out, services that are not optional such as healthcare have become more expensive, incentivizing savings. State statistics are harder to find today, but anecdotally, Chinese malls are uncrowded and durable good purchases are down. The transition to a dual circulation economy, driven by both exports and domestic consumption has failed so far. As Martin Wolf writes:
The most intractable economic problem is over-reliance on credit-fuelled investment, not consumption, as a source of demand and the parallel over-reliance on capital accumulation, not innovation, as a source of rising supply.
What is underestimated is the extent of institutional reform required to achieve a transformation to a consumption-led Chinese economy. Without it, I agree with Michael Pettis that China is unlikely to achieve long term growth that is higher than 2-3%, making it ever harder to find the fiscal room for institutional-level adjustment.
In addition to structural constraints, the negative wealth effect in China, which has seen both stock and real estate prices take the down escalator, should be a warning to US policymakers:
China has decided not to offer individuals stimulus relief in order to boost consumption. Now that the US has done so, there is a non-trivial risk that the government might need to do it again, in certain instances.
Recommendations to Increase Global Stability and Prosperity
What this data says to me is that Covid is not “over” and that both pervasive and subtle global economic effects will persist, especially as interest rates rise or plateau. Inflation, and the pendulum shift in the relationship between labor and management in the US, are but two examples of this long-tailed persistence. What could speed up normalization and growth?
Maintain US tax sovereignty over US companies, to maintain their competitiveness as global engines of technological and business innovation. Resist the urge to follow China’s lead to increase government influence over private enterprise.
Strengthen regional banks, but do not overburden them with new debt in a market overflowing with debt.
In China, create a modern tax regime to improve local government funding, including instituting property taxes. Structural changes far beyond fiscal stimulus will be necessary to create a consumption-driven economy.
Restructure US student debt, but in all cases require repayment of principal. This is something that many people would agree is fair, and directly deals with the issue of moral hazard.
Create a national commission to evaluate pension fund viability and regulation across the US. Stress test all of them.
Allow those who do not need social security to opt out in return for tax credits.
Curb usurious credit card interest rates of 30%. Review auto loans to see what can be done to lengthen terms to prevent defaults.
Create regulatory certainty in all aspects of fintech in the US by centralizing oversight, replacing the current system of competing and overlapping regulatory institutions. Optimize for global competitiveness.
Analyze the risks posed by shadow banking worldwide.
The Heart of the Matter
This all might sound a bit dismal, but my concern is that because of the human need to return to normality, we are underestimating longer-term impacts of the Covid-19 pandemic. Further substantial adjustments could still be necessary.
On the positive side, the resilience of the world economy in the face of this unprecedented exogenous shock was actually quite remarkable. I have faith that innovation and technology will solve our biggest problems longer term, if we don’t throw down unintentional policy roadblocks along the way.
Global commerce is interlinked, but politics remains local. National leaders should be more aware of the extraterritorial consequences of their domestic policies, and be willing to mark to market their post-pandemic losses to boost consumption. Weapons of finance and war should only be used as a last resort. However political courage —the ability to compromise and forgive and begin again— is in very short supply. And that truly is the heart of the matter.