A Vulnerable US Economy

Unhealthy economic imbalances have come to characterize the US economy not as single spies but in battalions. The country’s public finances are on an unsustainable path; reckless private sector and commercial real estate loans have piled up; the stock market trades at historically frothy levels; and the economy has become overly dependent on Artificial Intelligence investment to drive economic growth. All of this makes the economy particularly vulnerable to an energy and food price shock. This would be especially the case should such a shock result in the combination of higher inflation, slower economic growth, and higher long-term interest rates. Such a combination could be the trigger that bursts the credit and stock market bubbles. Start with our unsustainable public finances. Even before the war started, the Congressional Budget Office estimated that the budget deficit would remain at over six percent of GDP as far as the eye can see. In turn, by 2030, that would increase the public debt to GDP ratio to 108 percent or to more than its end of the Second World War level. The current war in Iran could exacerbate an already bad budget situation. Not only might Trump’s request for an additional $200 billion increase in defense spending add to the deficit. So too could any slowing in the economy and rise in interest rates associated with the war. It would seem only a matter of time before our poor public finances lead to a bond market crisis. Not only does the government need to raise around $2 trillion each year to finance the budget deficit. It also needs to roll over around $9 trillion in maturing government debt. In this regard, Trump’s repeated attacks on the Federal Reserve’s independence could make it difficult for the government to meet its financing requirements. Should investors come to fear that the US government might be on a path to try to inflate its way out of its debt problem, they will baulk at lending to the government at current interest rates. As if to underline the risk of a bond market crisis ahead, it is of concern that over the past month, since the start of the war, the 10-year Treasury bond yield has risen by over 40 basis points to its current level of 4.45 percent. It has done so at a time when we might have expected those yields to decline as heightened geopolitical and financial market uncertainty induced investors to seek the safe haven of US government bonds. Higher long-term interest rates and slower economic growth are the last thing that the troubled $3 trillion private credit market and the $4.5 trillion commercial real estate market now need. Those loans were made on the premise that interest rates would stay low and that economic growth would remain favorable. Going into the war, the private credit market was already strained by the impact of the Artificial Intelligence revolution on the software companies’ revenue outlook. Meanwhile, the commercial real estate sector was being strained by low office occupancy rates in the aftermath of the Covid pandemic’s effect on work and shopping habits. Those strains will make it difficult now for maturing private credit and commercial real estate loans to be rolled over at significantly higher interest rates than those at which the loans were originally contracted. It is hardly a good sign that private equity companies that have fueled this market are now being forced to put limits on the amount of money investors can withdraw from their funds. The equity market would also seem particularly vulnerable to a hike in interest rates and a slowing in economic growth. By any standard measure, equity valuations are well above their historical average, and investment is concentrated in a handful of AI-related companies. According to Warren Buffett’s favored measure, the overall valuation of the stock market in relation to GDP is now over 200 percent or more than double its long-run average. It does not bode well for the stock market that, in addition to having to cope with higher long-term interest rates, the market might have to deal with reduced enthusiasm for AI-related companies as a result of higher energy costs and reduced Gulf State financing of that sector. In 2008, both the Fed and the US government were caught flatfooted by the Lehman bankruptcy that triggered the 2008–2009 Great Economic Recession. With all the clues now pointing to the risk of another serious economic downturn, there would be no excuse for another major economic policy failure. At a minimum, the Trump administration should be thinking of rolling back its import tariff increases to ease inflationary pressure and of desisting from its relentless attacks on the central bank’s independence.