Opinion
Why this billionaire Wall Street legend is so worried about the future
Stephen Bartholomeusz
Senior business columnistOne of the curious aspects of the post-pandemic period is how relatively resilient the US and other major economies have been in the face of the highest interest rates in more than two decades.
In the US, there have been 11 rate rises since March last year; in Australia, 12 since last May. The US federal funds rate is the highest in 22 years; the Reserve Bank’s cash rate the highest since 2012.
Hedge fund king Ray Dalio says the apparent health of the US economy is a little misleading.Credit: Bloomberg
Yet US GDP growth was running at 2.4 per cent in the June quarter and the RBA is forecasting growth of around 1.5 per cent in the Australian economy this year. In both economies, unemployment is at historically low levels.
In the US, the growth is underpinned by the expansive fiscal policies of the Biden administration – “Bidenomics” – and the long-term, fixed-rate nature of US housing loans that leaves most households unaffected by the rate rises.
In Australia, with the budget in surplus, variable interest rate housing loans passing through the higher interest costs and the cushioning effects of the pandemic-era largesse wearing off, the settings are nowhere as stimulatory. The economy has, however – at least to this point – been surprisingly robust.
Bridgewater’s billionaire founder Ray Dalio has an explanation for what seems like the immunity of the US economy to the rapid tightening of monetary policies, one that echoes within the Australian context.
In a LinkedIn post last week, he attributed the surprising response of the economy to a “big government-engineered shift in wealth” from the public sector – the US government and the Fed – and holders of government bonds to private sector households and businesses, which he said made the private sector relatively insensitive to the Fed’s rapid tightening.
“As a result of this co-ordinated government manoeuvre, the household sector’s balance sheets and income statements are in good shape, while the (US) government’s are in bad shape,” he wrote.
During the pandemic, there was unprecedented fiscal stimulus as fearful governments splashed cash on households, businesses, massive purchases of government bonds and other assets as central banks reduced interest rates to zero or below, while pumping near-costless liquidity into their financial systems.
The combination of those ultra-loose fiscal and monetary policies, and the severe supply chain disruptions caused by the pandemic, made inflation rates take off and reach levels not experienced for decades.
Central banks around the world continue to battle inflation.Credit: AP
Over the past year or so, central banks steadily raised rates and reversed their quantitative easing, while governments adopted less stimulative fiscal policies.
The settings, however, aren’t as harsh as the still-elevated inflation rates might have dictated in the past.
That’s particularly the case with fiscal policy in the US, where the government deficit is expected to be around 6.6 per cent of GDP next year, before rising further in 2025.
The US debt to GDP ratio of 112.9 per cent this year is significantly lower than its peak of 122.3 per cent in 2020, during the pandemic, but well above the 100 per cent level in 2019. It is projected to continue to rise, topping 118 per cent in 2025.
It was that deteriorating fiscal position, and a Congressional Budget Office forecast that the government’s interest costs would double to 3.6 per cent of GDP over the next decade – they are already approaching $US1 trillion ($1.5 trillion) a year – and the improbability of a bitterly divided and dysfunctional US Congress from doing anything about it, that led to Fitch Ratings’ downgrading of the credit rating of the US government’s debt last week.
Dalio asked himself a rhetorical question. Does it matter that governments and central banks have such bad balance sheets and income statements if the real economy is in pretty good shape? His answer was, “of course it does”.
“As with people and economies, governments that borrow have debt-service payments and eventually have to pay back principal, which is painful. The only difference in their finances are that governments can confiscate wealth through taxes and print money via their central banks, so that’s what we should expect to happen.”
The Federal Bank of St Louis referred to the potential for a possible “dollar inflation nightmare” in a recent research report.
This or future generations of Americans are going to have to confront and pay for the pandemic’s fiscal legacies. The rest of the world will also have to pay a price.Credit: Oscar Colmam
“Continuing deficits, if unchecked, eventually will lead to a fiscal dominance problem,” it said.
By fiscal dominance, it means that the compounding effects of deficits and debt could force central banks to relegate their primary policy objective of controlling inflation, to one of supporting their government’s fiscal position, regardless of the impact on inflation.
Indeed, in those circumstances, the central banks and the government are using inflation to erode the value of the government’s debt and interest costs and, if necessary, the central banks will print money and monetise, or acquire, that debt itself to help sustain otherwise unsustainable finances.
If the US (or any other major economy) were to be trapped in that “nightmare” of spiralling debt and interest costs – a realistic possibility given that large portions of its spending on Medicare – social welfare and defence are politically untouchable, the only options to reduce inflation would be very significant increases in taxation (also, for political reasons, unlikely) or the central bank’s monetisation of the debt.
Dalio asked himself a rhetorical question. Does it matter that governments and central banks have such bad balance sheets and income statements if the real economy is in pretty good shape? His answer was, “of course it does”.
The St Louis Fed also suggested that the Fed could eliminate interest on the reserves banks hold with it and introduce new reserve requirements that force banks to lodge more interest-free reserves with it. This would help fund the government and reduce the inflationary impacts of fiscal dominance.
In any outcome, there would be unpleasant consequences for banks, pension funds and other financial institutions and investors (particularly bondholders, who would face massive losses), and have global implications, given the global primacy of the US Treasuries market and the US dollar.
It is the circular interaction between deficits, debt and interest costs and the unwillingness or inability of a very peculiar US Congress to respond to an escalating challenge that led to Fitch’s decision to strip the US of its prized AAA credit rating.
The transfer of wealth from the public to private sector that Dalio referred to may have cushioned this generation to the worst of the effects of the shift in post-pandemic monetary policies (to a greater extent in some jurisdictions than others).
At some point, however, this or future generations of Americans are going to have to confront and pay for the pandemic’s fiscal legacies by either significantly tightening fiscal policies or opting to try to inflate the problem away. Either course would be painful, and not just for Americans.
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