The Bear’s Lair: The yawning global fiscal pit

President Biden recently produced his Budget for the next fiscal year, with projections for the next ten years; even with swingeing tax rises on the “wealthy” and sharp cuts over the decade in real defense budgets it proposes a series of trillion-dollar deficits, beginning with $1.78 trillion in the year to September 2025. When you look around, nearly all rich countries are running similarly unprecedented deficits and running up their debts rapidly as a percentage of GDP. Without a dramatic worldwide reversal in policy, the entire planet will go bankrupt by around 2040.

Several tendencies have contributed to this. The rise of Keynesian economics in the 1940s and 1950s, together with the gigantic budget deficits of World War II loosened the mental constraint that policymakers had previously that budgets should be balanced every year in peacetime. That constraint had been very powerful; Lord Liverpool and his Chancellor of the Exchequer Nicholas Vansittart had cut public spending by 69% in 1814-17 so that the budget could be balanced from 1818 and every year for more than a decade thereafter, allowing for resumption of the Gold Standard in 1819.

More recently, persistent albeit modest budget deficits in the late 1920s had made it very difficult for Britain to maintain the Gold Standard after 1925 (abandoning the economically suicidal policy of unilateral free trade would have helped, both on the trade balance and budget sides). Consequently, after Britain went off the Gold Standard in 1931, Neville Chamberlain as Chancellor of the Exchequer balanced the Budget by 1934, allowing Britain a much pleasanter 1930s than that suffered by the United States. In the United States itself, the policies of the Harding and Coolidge administrations, halving public spending to balance the budget, showed that Budget-balancing fervor extended worldwide, although like many well-accepted truths it was largely abandoned by FDR..

From the 1950s, Keynesian sloppiness was demonstrated worldwide, especially after the departure from the Bretton Woods Agreement in 1971 had made inflation and currency depreciation a problem rather than a crisis. The United States did not balance its budget for 30 years after 1969, for example, despite an annual “peace dividend” of some 3% of GDP from the wind-down and end of the Cold War, with a resulting fall in defense spending. (That “peace dividend” may now have to be repaid, with President Andrzej Duda of Poland this week demanding that NATO members spend 3% of GDP on defense, up from 1.55% by Germany today, for example, and higher than Biden’s 2034 projection of 2.45%.)

Global budget sloppiness increased sharply after 2000 and again after the 2008 financial crash and yet again after the 2020 Covid-19 epidemic. The main reason for this was appallingly profligate monetary policy worldwide, with interest rates held near zero for a decade, encouraging feckless socialist governments to believe they could “invest” in all kinds of rubbish and pay no cost for it.

Japan was first into this pit, having been persuaded by Ben Bernanke in 1998 that permanent zero interest rates would in some magical way solve their economic problems, rather than merely perpetuating them. As a result, Japan now has public debt of 270% of GDP; while they are finally beginning to raise interest rates from zero, thereby restarting their stalled economy, they have the problem that any significant rise in borrowing costs will hugely exacerbate their already terrible budget and debt position. Japan’s debt is now higher in terms of GDP than was Britain’s at its twin peaks of 1815 and 1945; the chance of Japan adopting Liverpool’s sensible solution and cutting public spending by two thirds is infinitesimal. Most likely Japan will adopt Attlee’s squalid expedient and inflate the economy, sucking their savers dry while pretending all is well; this will destroy Japan’s productive base, as it did Britain’s in the 1950s and 1960s.

Except in Germany, deficits worldwide have been yawning since 2010, as politicians look to spend the free money. The resumption of pointless wars in Eastern Europe and the Middle East has made matters worse, although from a long-term viewpoint those factors never disappeared. The novel Covid-19 problem, leading many governments to impose lockdowns on their citizenry and compensate them with handouts, has further worsened matters, as has the retirement into rentier status of the “Baby-boomer” post-World War II generation, larger than its predecessors and successors in most countries. Finally, grossly excessive immigration is imposing huge costs on most state budgets, as well as on the living standards of their unfortunate citizens; this factor has not been included in most long-term budget projections and indeed, so uncontrolled is the influx, may well be mis-reported in current economic statistics (as I wrote in February 19th’s column).

In the United States, Federal spending has increased from an already profligate $4.4 billion in 2019 to an estimated (and probably underestimated) $7.3 trillion in 2025, a real increase of some 31%. With annual budget deficits of 6% of GDP, you can expect the debt to GDP ratio to increase by about 6% of GDP annually, with the unhappy progress getting faster as debt service balloons. However, the U.S. is not in the worst shape – Britain and Italy are distinctly worse off — but sharp remedial action is needed, cutting budgeted spending by around 25% or finding a way to increase taxes by an equivalent amount.

There are a number of possible ways to attack the U.S. budget problem:

  • Close the border. Low-skill immigrants are expensive both in the short-term and long-term, as well as reducing the living standards of domestic residents. Closing the border will raise wage levels, thereby increasing tax payments, and vastly reduce costs, although many of those benefits may arise at the state level. Grants to NGOs can be eliminated, too.
  • End pointless foreign wars. Baseline defense spending is not excessive, but the additional costs of foreign interventions have overloaded the budget since the Iraq and Afghanistan wars began two decades ago. An isolationist foreign policy is much cheaper, as traditional Republicans knew.
  • Impose a 10% tariff on imports. Tariffs yield income; without them the tax system is far too biased towards income tax.
  • Remove the tax deduction for charitable donations and most other tax benefits for charities. Not only are these an unjustified tax loophole for the very rich, they encourage the proliferation of non-profits, most of which do considerable economic damage, both directly and indirectly through encouraging leftist agitation
  • Make a bonfire of regulations, especially in the environmental area. These add hugely to cost and retard economic growth (replace climate change regulations with a carbon tax if you must). In addition, there is a large coven of bureaucrats who can usefully be fired.
  • Raise the social security and Medicare retirement age. This should be a last resort but can be done by a year or two over the next half-century, as life expectancies have increased. Any serious scientific progress on longevity will destabilize the social security system altogether even though it will produce extra tax revenue; you should have a plan ready for this.
  • Abolish as many Federal departments as possible (e.g. education, which should return to the states). Downsizing departments does no long-term good; you need to abolish them altogether so the political push for their re-growth is eliminated.

If the above were done with sufficient vigor, the budget problem should be reduced to a manageable level without more than modest tax increases, removing the high probability of debt default. Unfortunately, such a program currently appears highly unlikely.

In other countries, the severity of the problem varies. In Germany, a total reversal of the climate-change-inspired lunatic energy policies of the last 15 years is all that is required. Conversely in Japan, mass hara-kiri appears the only reasonable alternative. Most countries are somewhere in between. Again, there are likely to be few countries that achieve an effective remedy for the problem.

Given this reality, and the inexorable climb of debt to GDP ratios, one can calculate that collapse will occur around 2040, when debt to GDP ratios will have achieved such a level worldwide – around 200% of GDP – that the capital market panics and it becomes impossible to finance the debt. Doubtless attempts will be made to print money to alleviate the problem, but that will only cause hyperinflation and economic decline, with bond investors refusing to accept negative real interest rates as confidence drains away. Japan of course will reach a point of no return far sooner than 2040; its default will wreck the lives of the Japanese people, but may not have all that much effect internationally, since most Japanese debt is held by domestic investors. Nevertheless, even an unaccompanied Japan default will make the markets think a bit – and thinking markets are the modern investor’s nightmare.

Probably good to book your one-way ticket to a desert island around 2038!


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)