In my first macroeconomics class, the lecturer wrote on the board the following equation:
Y = C + I + G + (X – M)
GDP (Y) is a function of consumption (C), business investment (I), government fiscal spending (G) and X and M represent a nation’s exports and imports respectively. Few equations in academia apply in the real world but, ironically, the first one was the most relevant.
Output remains low in many advanced economies because the effects of the crisis are still being felt today. Stock markets have roared back, but such valuations have yet to validate the real economy. Monetary policy aims to act on the output equation above by increasing asset prices which in turn creates a wealth effect boosting consumption, C. This has not happened. Furthermore, by lowering the cost of capital via interest rate cuts, was supposed to encourage firms to borrow and invest (I), increasing capital expenditure (CAPEX).
Rather this easy money has meant equity values have risen causing large-scale share buybacks. Net exports, the difference between X and M, can rise off the back of a weaker currency, but that cannot be an indefinite solution because other countries get moody when you steal trade competitiveness. Markets were shaken last summer because China devalued the renminbi creating concerns that China was attempting to steal exports from Japan and the wider ASEAN region.
That leaves government spending. The US has a national debt of circa $16trn and continues to raise the ceiling which seems to get through congress unbelievably fast compared to any other fiscal proposal. One wonders why. Fiscal policy is restrained both financially and socially but one policy which does seem to appeal to both polar opposite parties is the idea of infrastructure bonds.
The Fed Decisions
A stronger dollar has caused havoc over recent months but until recently with the Brexit debacle, the Fed has decided to wait a little longer on its hiking cycle, causing emerging markets to all of sudden be a popular asset class. Sit tight for the 2017 rate tantrum, but that is another story for another day. If the government issued infrastructure bonds, it would not spark inflation in the usual QE fashion. The reason is because the Fed would buy the bonds directly from the government so the selling wouldn’t have an effect on interest rates and thus an impact on the dollar index.
The money would never hit the open market to boost asset prices but would be bought at a very low-interest rate, with the Fed simply holding them until maturity – say 30-50 years, maybe longer. The government would then have money to spend on infrastructure projects around the country boosting employment, but more importantly economic activity and wage growth. Inflation would be the indirect goal, with the primary being GDP growth. With rates at recent lows, the authorities should take the opportunity to set up spending for the next few years.
The Corporate Sector
Corporations have borrowed significantly with total debts rising, while the more important aspect, debt service costs, have not risen. When rates rise, the private sector needs to be aware, but given the markets expectations for rate levels over the next few years, no one should be too concerned. Rising rates are irrelevant for the government because the holder of these bonds would be the Federal Reserve and will likely just let them expire, or the government will roll over the debt by issuing more.
Such a project is necessary and could be the key to unlocking US growth potential. Emerging markets, beware.
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