Government finances will increasingly shape the financial markets
The United Kingdom is a good example. Ageing is hitting hard there as well, and this cannot be compensated by more immigration. In fact, immigration is being pushed back. The end result is that there will be more and more non-workers who must be supported by the working population. If nothing else changes, the government will automatically go bankrupt. People are living longer, but as they age, healthcare costs rise sharply. This means workers must hand over a much larger share of their income. This only works if workers earn much more or keep working far longer. The latter succeeds only marginally, because retiring is seen as an acquired right. So incomes must rise sharply. That is only possible if productivity increases strongly.
The big problem in the UK is that, due to all the tax increases of the past decade, highly complicated regulation, and Brexit, businesses have invested very little. This has resulted in many years of very low productivity growth. Add to this a limited increase in the labour force, and economic growth ends up being low. That in turn means little growth in government tax revenues. Against this backdrop, the finance minister had to present her autumn budget last week. The budget deficit is far too large, and the outlook is that it will grow rather than shrink in the coming years. All the more because de-globalisation has ended the era of deflation fears and has now shifted into inflation fears. This means interest rates will remain much higher than in the 2010–2020 period. Combine this with a large public debt and it becomes clear that the line item “interest payments” will rise rapidly and is already becoming the largest spending category in the budget.
Measures must therefore be taken to reduce the deficit. By far the best way to achieve this is to ensure higher economic growth and rising tax revenues. But that can no longer be done in the way we have grown used to in recent decades - stimulating fiscally and/or monetarily. First, government finances deteriorate just as fast as tax revenues rise. Second, inflation increases and the economy must later be slowed again to keep price rises in check. Measures must therefore be taken that structurally increase economic growth, for example:
• Flexibilisation of the labour market,
• More spending on infrastructure and Research & Development, higher education levels in the labour force,
• Deregulation, and so on.
However, these measures are often not popular. They either cost a lot of money that isn’t available, or they infringe on all sorts of acquired rights.
Although Mario Draghi has written excellent reports on this, only about 10% of his recommendations have been implemented so far. This also applies to the UK.
So what can be done? What the UK - and most other countries - do not do is start by looking at government expenditures. These should then be cut. However:
• The government now occupies a large share of the economy. Cutting spending depresses economic growth significantly. This is not so bad if it can be compensated with lower interest rates. Often, however, the room for this is very small.
• More importantly, it is politically unacceptable. Spending cuts mostly hit middle and lower incomes.
It is therefore seen as much fairer to raise taxes on the rich and on companies. In the UK, a large portion of the proposed government cuts has indeed been struck down by the Labour Party. The problem is that raising taxes on companies and the rich has never yielded much. They can hire the best advisers to avoid it and/or leave the country and settle elsewhere.
The end result is that deficits are reduced far too little. Everyone can see that it is only a matter of time before government finances seize up, but politically it is impossible to do much about it. As for the markets, they look ahead. They do not wait to react until public finances have “seized up” - they react as soon as they see it coming. What, then, is the last resort? The only option left is for the central bank to finance more and more of the government deficit by creating extra money. This only pushes the problem forward because it leads to rapidly rising inflation. Yet historically this is the path almost always taken.
A new Fed chair
Jerome Powell’s term as Fed chair expires in May. It appears Kevin Hassett will be his successor. He is an ally of Trump and advocates much lower interest rates. One may therefore wonder whether Trump is already nudging policy toward the inflationary side. Inflation is currently too high, and placing someone in a key position who nevertheless wants to cut rates seems counter-intuitive.
Yet markets have not reacted that way so far. If they had, long-term rates would have risen sharply and stock prices would have fallen. The opposite has happened. Two explanations exist:
• The chair’s position is very important, but there are still 11 other Fed members who must co-decide on monetary policy. It is far from certain that a majority would choose higher inflation - at least not as long as there is no panic around government finances.
• It is also questionable whether Hassett would truly choose inflation. So far, he believes rates can be lowered to help the economy and public finances without generating too much inflation.
We think that Hassett as the new chair - his nomination still needs confirmation - is a sign of things to come. No structural reforms are being implemented to boost growth; the “easy way out” is being chosen. This indeed points toward higher inflation in the future, but also toward higher long-term interest rates and a higher gold price in the coming years.
