PARADOX OF FISCAL DOMINANCE
EDU DDA Oct. 18, 2024
Summary: Copper to gold hits another new low. Swap spreads set records. Crude oil crashes again. Why aren’t these markets buying at least the China stimulus? For one thing, the idea of “stimulus” has been so thoroughly tested there is no reason to. Anyone claiming “fiscal dominance” is inflationary aren’t seeing these deflation signals or why that is. The evidence is unusually clear and conclusive. What’s missing is only unambiguous proof “stimulus” in addition to be ineffective is actually harmful.
People still believe heavy government stimulus can be effective and, worse, that it will be inflationary. The evidence conclusively shows otherwise, yet the myth persists. China is about to provide still another test case even after having done so several times. It’s chances of success are illustrated already in the copper to gold ratio, for example, hitting another multi-year low and doing so in combination with US$ interest rate swap spreads not to mention crashing oil.
No inflation. No recovery.
The notion of inflationary “fiscal dominance” is about to run into the cold deflationary reality of the paradox of government debt. Why the former continues to not just hang around but to be repeated confidently all over the place is beyond me. Actually, we all know why it does: 1. Few have paid attention to history while fewer understand the economics (small “e”) in favor of preferred ideologies; 2. Keynes was right about risky markets if dead wrong about the effectiveness of government “stimulus”, which means there is a profitable vested interest in literally buying what so many do know is a lie.
Government spending is ineffective in anything more tangible than the vague, unprovable (and unfalsifiable) claim of “jobs saved.” By being such a crystal-clear failure, how can it be inflationary? Those who suggest that major “stimulus” plans are once more hold gross misconceptions about what inflation even is, and likely stimulus, for that matter.
We have proof all over the place. Should anyone need any more, China is about to provide us with it.
The rundown of China’s GDP, Big Three, and home price data from last night is available here in our Daily Briefing. It also has the details on copper to gold and crude’s latest crack.
Taking the second part first, those who are buying “stimulus” may not actually believe all that much in it. Keynes said that stocks, for example, aren’t driven by fundamental anything let alone some monetary phenomenon like “liquidity.” Share prices are the equivalent of a beauty contest, though a strange one where you don’t judge each contestant, you are judging other judges.
If people believe other people believe nearly everyone believes “stimulus” works, then they will buy risky assets like stocks on the news of some forthcoming government action even if they don’t actually believe it themselves. You don’t have to think government spending solves any problem to chase these returns, you merely have to assume (a good bet) other people will be doing it causing basically a self-fulfilling prophecy.
Chinese stocks are the closest you’ll ever see to conclusive proof of this. Speculators repeatedly had done this over the last decade, as I pointed out recently, beginning in 2014 with the mother-of-all-short-run bubbles. Shanghai soared for a little while, then collapsed quickly under the weight of Keynes’ “liquidity.” It repeated to a lesser extent in 2019, not to mention more recently during “reopening.”
The thing is, it isn’t just stock investors who do this. In our latest test case, sure Shanghai and Hong Kong equities skyrocketed, though they were joined by participants in markets all over the spectrum. You can find September 10 in a whole bunch of them including critical commodities:
Copper had been rising from its awful August low before then, but made a sharp move higher on the 11th of last month. So, too, aluminum and even crude oil. WTI has since come to bet more heavily against China, but it didn’t start out that way. We know that was Chinese stimulus rumors leaking out because of how much it got pushed into the Hang Seng. The coincident timing gives it away.
That meant some in commodities were betting the news in the same way any speculator in HK equities or the SSE did. The uptrend didn’t go nearly in commodities because those others are real markets that eventually can’t outrun real fundamentals. Crude quickly sank once it cleared the latest Middle East threat, copper, too, as those nearest to China’s housing market realize the game being played by authorities.
In short, whatever bid in those markets it was short run and wasn’t a dependable belief in “stimulus”, merely those trying to catch a quick profit from those who were trying to catch quick profit (you can’t blame them). Meanwhile, it is mainly Economists and their financial media that keep the myth of “stimulus” alive alongside the one about fiscal dominance being inflationary.
There is a deeply embedded desire to believe in a powerful central authority. The modern pseudo-central bank has been playing on it for decades, including, by the way, the Peoples’ Bank of China. Each one takes credit for the good times then gets its “transmission mechanism” called into question when inevitably the growth runs out (largely due to problems in the banking system, the real master of money therefore actual inflation).
We have been fed a fetish for governments for years. It has led to this paradox of debt I wrote at the top, though it only sounds like a paradox being drawn from a misunderstanding of basic economics (small “e”) by mainly Economists (capital “E”). Every time any economy encounters difficulties, “we” are told to immediately look to some central authority to come up with a fix.
That’s one trait which needs to die if we’re ever to finally escape this mess. It’s up to the private economy alone to solve these problems, governments can’t do it. Not won’t, they can’t because of how they operate, one main problem with Keynes’ argument for aggregate demand.
I highlighted Paul Krugman’s summation of that theory in this recent DDA. Basically, economic difficulties are supposed to be mediated if not entirely eliminated by the careful dose of central authority “stimulus”, either via interest rates (this is not monetary policy since, again, that would be banks) or direct spending.
The paradox is simply recognizing that the more the government does the less it works, and the less it works the more call on the government to do more. What makes it appear a paradox is the disinflation and sometimes deflation – not inflation – which inevitably accompanies this over the intermediate and longer run. Demand for safety and liquidity under those conditions means that central authorities can issue as much debt free from constraint.
Without any kind of market check (the bond vigilantes of lore), it’s a self-reinforcing spiral. The weak economy forces governments to act which only leads to a weaker economy meaning more government action is inevitable, and so on. And act they do, since the resulting deflation keeps up demand for financing the one key reason why those deflationary circumstances are even more likely to then stick around.
The paradox.
Contrary to the idea government spending is inflationary, all the evidence shows the opposite. Yes, there are short run effects which might in certain cases lead to temporary increases in consumer prices and therefore measures of them, such as CPIs or similar. But that is not inflation so it will only ever be, yes, transitory.
Proof is everywhere. The most damning comes out of Japan, experience in Keynesianism to an almost unimaginable degree (before everyone around the world started doing it) that never once became inflationary. The multitude of programs never created a recovery, either, or even the perquisite conditions for one. All Japan got it for the constant “stimulus” was the debt plus the endless demand for it (the paradox).
Our focus here is and should be China. What the Chinese are outlining in very board and rough terms is nothing new even to them. In short, we already have all the evidence necessary, which explains why outside of speculators and stocks there isn’t any deep commitment to buying what Beijing is trying to sell.
The centerpiece of what authorities are attempting is the issuance of special central government bonds, the necessary funding for what will then become either local government assistance or real estate programs. And, as Lan Fo’an threw in there at the end, plenty more room beside for direct government economic spending. In other words, there are going to be a lot of bonds.
In the end, it doesn’t matter what they do with the proceeds; it’s all waste no matter what.
Going back to the third quarter of 2018 (yep, the landmine), China has been issuing these things in ever-increasing amounts. The fact they keep doing it already gives away the failure, the lack of effect. If it worked as intended, like the theory behind QE they’d only have had to do it once then spend the rest of the time using the booming economy to clear up the authority’s balance sheet.
WHERE’S THE INFLATION? THE ONLY BIG JUMP IN PRICES WAS FROM THE GLOBAL SUPPLY SHOCK. IT’S BEEN DEFLATION EVERY OTHER TIME.
You could argue the pandemic was different and unique, but it really doesn’t matter. What is absolutely clear when you actually examine the evidence is that very much like QE or rate cuts, government debt issuance is a response to weakness not a solution to it. In China, look at how constant bond issues have been since 2018 all the while economic data gets weaker and weaker.
Where’s the stimulated economy from all that stimulus? What actually did get stimulated was, again, more future demand for safety and liquidity.
Since we’re talking about a variety of circumstances and degrees of response, yet the results are the same nonetheless, China offers yet more complete and compelling proof alongside what Japan already established.
We can go beyond special central government bonds, too, and China ends up with the same conclusions regardless. Debt soared in 2009, for example, and then again in 2016 during former Premier Li Keqiang’s “growing a tree in the air.” That expression was famously and publicly written by Uncle He, a close Xi Jinping confidant, who at the time was openly criticizing Li’s “stimulus” relying on so much debt – the equivalent of trying to grow a tree in the air above the soil.
Yet, here is Xi’s government almost a decade later attempting the same for yet another time. Why? Because it never works.
The same results are found in the US or Europe, too. The data all clearly shows central authority “stimulus” is nothing more substantial than a response to serious trouble, therefore no more helpful than a warning about that weakness.
In China, the bond rally is already setting up for the paradox. As bond participants prepare for more failure, the demand for safety and liquidity keeps on rising in the form of lower inflation and growth expectations. The government will conduct its “stimulus”, having no trouble selling the bonds, only to fail and raise the demand for safety and liquidity on even lower growth and inflation expectations in the future.
Like copper to gold, bond yields all know fiscal dominance is inherently disinflation not inflation. Been there, done that.
One other major drawback is that “stimulus” isn’t just a neutral proposition. Why not do it, what’s the harm for just having a government try to “save” an economy is a bad way already?
US FEDERAL GOVT DEBT IS LIKE FED RATE CUTS/QE NOTHING MORE THAN A RESPONSE TO WEAKNESS, NOT SOME CURE FOR IT.
These programs distort even harm the private economy, the latter becomes rigid and increasingly co-dependent. Rather than look to seed long run opportunity in the private system, business becomes conditioned to seek profit only in whatever the next quick short run spending from the Capital might be. It’s even worse than crowding out.
So, while Japan offered a full test case for all this, the Chinese are doing us a small favor by doubling the number. Throw those together with Western experience and it should be very clear fiscal dominance is no different from central banking. They both lead to disinflation at the same time doing absolutely nothing to alleviate economic deficiencies. Market performance here is therefore consistent.
The evidence is a not quite so easy to establish in the other, proving beyond every doubt that both monetary like fiscal policies are actually harmful and therefore it isn’t simply a neutral case of, why not at least try? The idea is kept alive and fed by Economists who are almost always ideologues in the service of politicians rather than dispassionately interested in facts let alone truth. Those calling for an inflationary wave are doing so either out of their own self interest or coming from a purely theoretical standpoint which doesn’t stand up to the smallest scrutiny.
Thanks to the Chinese, the Japanese, and George W. Bush, we have a lot more than small scrutiny. The bond paradox really isn’t one; it’s actually the answer. Low interest rates aren’t the go-ahead for governments to issue bonds, they’re the intuition that issuing even a ton of bonds is going to just lead to more of the same.
