When Credibility Becomes the Risk Premium ft. Maurice Obstfeld

[00:00:00] Maury

This is an area where I think there are a lot of risks that haven’t been carefully considered and where governments outside the US are quite alarmed about the possible incursions into their domestic payment systems and haven’t quite figured out how to react, but certainly thinking hard about the risks that might be posed. And again, I think this could be another source of fragmentation going forward.

[00:00:40] Intro

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Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:35] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective.

This is a series that I not only find incredibly interesting as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle. We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations.

Please enjoy today’s episode hosted by Alan Dunne.

[00:02:20] Alan

Thanks for that introduction, Niels. Today I’m delighted to be joined by Maurice Obstfeld. Maury is the Senior Fellow at the Peterson Institute for International Economics and also professor of Economics Emeritus at Berkeley. He has served as a member of the Council of Economic Advisors under President Obama and was previously Chief Economist at the IMF.

He’s also been an Honorary Advisor to the bank of Japan. He’s won countless awards in academia for his work in international economics, the international monetary system, exchange rate and financial crisis and he’s also been the co-author of some leading textbooks on economics with Paul Krugman and Kenneth Rogoff.

Maury, Great to have you with us today. How are you?

[00:03:03] Maury

I’m great Alan, how are you?

[00:03:04] Alan

I’m very well thanks.

So, I went through your very long and distinguished career, but we always like to start off getting a sense of how people started off in economics in the markets. What got you interested in economics in the first place?

[00:03:18] Maury

Oh, great question. That’s a story I actually love to tell. I was a mathematics major as an undergraduate, and in the early 1970s, I had the privilege of spending a couple of years at Cambridge University doing maths again. But it was obviously a very turbulent time in the UK economy and the world economy generally. And I was in King’s College, Cambridge, which was Kansas College, and I had a number of friends who were doing economics, and I just got gradually drawn to it.

My problem was that I had a fellowship to go back, return to the US and do a doctorate in mathematics at MIT, and I wasn’t quite sure how to switch that around if I wanted to do economics. But fortunately, when I got there, they were willing to just let me come over and enroll in the Economics program.

So that worked out quite well for me.

[00:04:21] Alan

And you’ve been an academic and a policy advisor. I mean, you’ve served at the IMF, you’ve done a bunch of different things. Any standouts, or do you prefer the research, the teaching?

Which aspect, I guess, are you most drawn to?

[00:04:37] Maury

Well, at the moment, you know, I’m showing my age, and the typical life cycle of many macroeconomists, and being drawn more to the policy sphere and the sphere of commenting on current events. I still try to keep my hand in research, but it seems to me that as one gets older, the accumulation of what you may have learned is usefully deployed and trying to make the world a better place. And that’s what I’ve been trying to do in recent years.

I retired from teaching at Berkeley a couple of years ago, so I still advise some graduate students, but I’m not giving lectures anymore.

[00:05:28] Alan

Very good. Well, I mentioned you were Chief Economist at the IMF a number of years ago, and curious to get your perspective on that experience, and maybe on the IMF, and as we see it today. I know Scott Bessent spoke there not so long ago, calling for a forum and maybe the need for a new approach. Not just at the IMF, obviously, at other institutions as well. I mean, we’re seeing less financial crisis generally in emerging markets.

Is the role for the IMF diminished or changing, do you think?

[00:06:07] Maury

Well, the IMF role has evolved over the years. You know, it was primarily an organization based on the more industrial economies, back in the 50s and 60s, you know, in the sort of post war recovery period. When the world moved to floating exchange rates in 1973, many wondered what the role of the fund would be because the original idea of the Bretton Woods system was that the world would be on fixed exchange rates. The fund would be there to lend resources if countries had balance of payments difficulties as a result of the need to intervene using foreign exchange reserves to hold those exchange rates fixed. Suddenly, if everyone’s floating, what do you need a fund for?

But as it turned out, the move to floating also coincided, more or less, with a move to more open capital markets and the possibility of fast-moving financial crises. And so, the fund found a new role. Now, primarily, it has been involved with emerging markets, though the euro crisis was a glaring exception to that generalization. But you know, it still has numerous programs in emerging markets and also in low-income countries. So, there’s definitely a role there.

I think even though emerging markets have done well in recent crises (and we can talk about why that might be), there’s always the risk out there that with the vast expansion of global capital markets there could be reversals. And in those situations, IMF funding can be critical.

[00:08:15] Alan

Yeah, I mean, that’s something maybe we’ll get onto as we progress. But you wrote a paper recently, maybe you’re mentioning how you’re commenting on current policy. You wrote a paper around tariffs as fiscal policy. And obviously tariffs have been the big topic in the markets this year. For a lot of market participants there was a lot of uncertainty as to what was the purpose of the tariffs in the first place. Was it more from a budgetary perspective? Was it trade, industrial policy? And in the paper you address this. I mean, what’s your assessment on what’s been the rationale for the tariffs and the likely impact?

[00:08:55] Maury

If you look at the 1.0 tariffs, 2018, 2019, the rationale was twofold. It was to try to reduce the US trade deficit and furthermore to bring back manufacturing to the US. I think both of those motivations were fueled by a grievance narrative that foreign countries had been unfair to the US through their trade policies, and the tariffs would level the playing field and offset some of those alleged harms. Now, what we’ve seen in this new round is the use of very broad tariffs on all imports.

The targeted tariffs are still there on certain sectors. But the sort of across-the-board tariff idea is novel, and it’s motivated by the same goals: the trade deficit, manufacturing renaissance hopes, and redressing grievances. But it also raises the possibility of large-scale revenues.

And you know, in this recent round starting in the election campaign, Donald Trump raised the possibility of using the tariff revenues to offset tax cuts in other areas. He even floated the idea of replacing the US income tax entirely with tariff revenues.

So, you know, in some sense that is an additional motivation, basically reforming the US tax system to make it much more heavily dependent on tariffs as opposed to, say, income tax or corporate tax or other taxes. And that raises a host of issues that Kim Klausing and I tried to assess in that recent paper on tariffs as fiscal policy.

[00:11:15] Alan

I mean, this was, as you say, muted as part of the campaign. But generally, the view was, well, you know, it had been done before, I think, like in the 19th century, but obviously the amount of spending was a lot less then and the tax requirement was a lot less. So, there was kind of general skepticism about this being a plausible kind of tax revenue tool. But that seems to have shifted a little bit.

I mean, if you look at the financial markets last month or so, now the view is, well, if the tariffs got repealed, that would be seen as negative or a problem for the deficit. And obviously the CBO has come out saying the tariffs will contribute around US$4 trillion over the next decade.

So, has that, has that viewpoint shifted in economic and financial market circles, do you think?

[00:12:06] Maury

Well, the premise of the Trump tariff idea was basically the premise of a sort of free lunch. That somehow these tariffs were going to be paid by foreigners. You know, it’s money for the taking and therefore we can, you know, have our cake and eat it. We can lower income tax, we can get revenue from foreigners for free and a win/win for the US. And, you know, we’re not too worried about the effect of foreigners or the possibility that they may retaliate.

Now, you know, the idea that foreigners pay for tariffs as an operational matter is wrong simply because it’s importers in the US who actually pay the fees that go to the Treasury. As a substantive matter, it’s not so clear because one of the fundamental issues in analyzing any tax is its incidence.

In other words, it may not matter who actually pays the tax in the operational sense. You know, do we tax buyers or sellers of our product? Because the market equilibrium that results from the tariff will result in effects on both buyers and sellers, which may disproportionately fall on buyers or sellers, regardless of who is physically handing the money over to the government.

So, in the tariff sphere, the idea would be that, you know, yes, importers pay the money to the Treasury, but, you know, foreigners who are exporting to the US, facing reduced demand, will be induced to lower their prices. And in the Trump narrative, they lower their prices by the full amount of the tariff.

Therefore, even though US Importers are the ones who fork over the money to the Treasury, they’re benefiting from proportionally lower global prices, and therefore, there’s no loss to them. The incidence of the tariff is all on the foreigners. So that’s basically what Trump… That’s the most charitable way of interpreting Trump’s insistence that foreigners pay for tariffs.

Now, if we look at the evidence of the 2018, 2019 tariffs, there is very little evidence that foreign sellers of goods into the US market lowered their prices. Now, with these across-the-board tariffs, that’s a different situation.

But the early returns would still indicate that they haven’t lowered their prices, that importers are not paying lower prices for imports. And therefore, American residents, firms, or consumers are paying for this tariff revenue that is flowing into the Treasury, which, by the way, is more likely to be closer to US$200 billion a year than the US$400 billion a year number that you cited.

So, as far as the markets are concerned, they’re looking at what’s happened to consumer inflation, to the consumer prices of imported goods and goods that compete with them. And you haven’t seen increases that are in line with the tariff increases.

So, you know, the conclusion seems to be, okay, fine, you know, we’ve moved to this new regime. We haven’t seen big inflation consequences. The other consequences of tariffs, namely, if you levy tariffs and lower income taxes on rich people, this is a very regressive policy. Markets don’t care a wit about that.

But, you know, in reality, if foreigners haven’t lowered the prices they charge the US, and if the Treasury is getting all this revenue, which is, you know, basically about US$20 to US$25 billion a month in new revenue, then who’s paying for that? Someone’s got to be paying for that.

And, you know, where it’s coming from is a combination of some increase in consumer prices, but also, you know, importing businesses, which are swallowing a reduction in their margins. Now, they can’t do that forever. So, likely more price increases are on the way or, if these firms feel unable to raise their prices (and this is probably more true of some of the smaller businesses) they’re going to go out of business.

And so, there are consequences which I believe are inevitably coming down the pike and I think which might disturb some of the complacency we’ve seen in the markets. Now, that being said, you know, the Supreme Court in early November is going to hear an important case on the constitutionality of Trump’s broad-based tariffs, the emergency tariffs.

And there is, as you said, concern in the markets that if suddenly the Supreme Court rules that these are illegal, the government would have to actually refund a large amount of tariff revenue. The revenue wouldn’t be available on an ongoing basis to fund the huge hole in the budget left by the one big beautiful budget act. And then you have a situation where you’re opening up the bond market to stresses that could be pretty severe down the road. So, that’s something certainly we’ll all be watching carefully.

[00:18:43] Alan

Yeah. I mean, as you say, the long-term ramifications, we’re still to see them, obviously. It’s going to take time. We’ve seen a very different approach to policymaking under Trump. That goes without saying.

You wrote a separate paper recently kind of looking at how that may impact the global international monetary system called The International Economic System: A Fork in The Road. And the paper is about how the shift in US policymaking may set up a scenario where we get more fragmentation in the international monetary system which could undermine the US dollar.

So, I mean, could you give us a sense on what you think are the key components of this argument, that this change in policy approach could ultimately undermine the dollar?

[00:19:44] Maury

Well, the dollar’s primacy in international markets rests on a number of pillars, not all of which are, you know, purely economic pillars. But, you know, I would say that what they share is the idea that the United States is a predictable and reliable player in global economics, finance, and security, that, to some degree, internalizes the effects of its actions on the rest of the world.

I don’t want to say that it depends on the US being a hegemonic power, which, you know, it was for basically some years after 1990. But, you know, it’s still at this point the undisputed leading power, you know – most powerful nation. And countries throughout the world have relied on it, in many respects, for security assurances, for aid, for financial support, for stabilizing interventions in financial markets.

So now, instead we’ve moved to a situation where the Trump administration is taking a hatchet to international institutions and agreements, to domestic institutions and agreements, and where all of that is now in question. If you look across the spectrum of policies being followed, both in the economic and the security realm, and their linked policies, it’s caused a great deal of concern, such that foreign players may lose faith both in the value of the dollar and in the wisdom of exposing themselves to US pressures that might be connected with their reliance on a system that is based so heavily on the dollar.

So, take an example, tariffs. It would be one thing for the US to simply say, well, we feel we need a 15% across the board tariff because we’d like to address our trade deficit as a revenue source, for whatever reason. (And we can discuss whether tariffs are an effective way of addressing the trade deficit. I don’t believe they are.)

But what the Trump administration has done is it’s been using tariffs as a coercive instrument to sometimes extract concessions from other countries that are not really trade concessions, or to make political demands on countries. So, in the former category, the US has been negotiating with Korea, Japan, Europe, for large investment funds that would be basically under the discretion of the President.

It’s very unclear what the details are on these and to what extent the foreign partners have actually agreed. But this is sort of unprecedented. It’s basically a form of extortion in which the US says, give us these funds or else.

Now, again, you know, when I say the tariff threats are being used here, yes, there are tariff threats, but all the policymakers involved, across Japan, Korea and the EU, understand that the implicit threat is a withdrawal of military support. You know, Japan and Korea are very worried about security in East Asia given not only China’s sometimes aggressive behavior, but North Korea, which has nuclear weapons and is totally unconstrained and has actually moved much closer to Russia and to more normal relations with China. China and Russia are no longer trying to constrain North Korea’s behavior.

In Europe there is still considerable US assistance, if not monetary, than in other areas. And Europeans are very worried about that. So, you know, this is a very different world from the pre-Trump world in which US security guarantees were predictable and reliable. And of course, there would occasionally be discussions about cost sharing, which is certainly a legitimate topic. But, you know, the idea that the US would even implicitly threaten to withdraw these supports in return for monetary or commercial payoffs was not really on the table.

Within the domestic sphere, key institutions are also being attacked. When the US government insists on taking stakes in US enterprises, or in deploying export controls to pressure companies for stakes in their foreign revenues, when the government attacks the independence of the Federal Reserve, when the Congress throws off any pretense of fiscal prudence and manipulates its budgetary rules to pretend that it’s not creating possibly unsustainable budget deficits cheered on by the administration. These are all things that make the rest of the world worry about the security of dollar assets and the wisdom of being so plugged into the dollar system.

And there’s subtle ways, too, in which this works. I mean, one of the factors that has promoted the prevalence of dollar borrowing throughout the world is that the Fed makes swap lines available to key countries which allows them to support their financial systems, which are very dollar dependent at this point. If the Fed’s independence is compromised, then maybe those swap lines can become additional tools of coercion. And this is a real concern among foreign governments.

[00:27:20] Alan

Yeah, I mean, it’s interesting. On the one hand, as you touch on, there is this ambivalence towards the value of the dollar. At the same time, the administration is talking about stablecoins as a mechanism to promote even greater demand for US treasuries. So, I mean, how do you reconcile those viewpoints? That’s one question.

And I take your point about, you know, foreign concern about US policymaking, but, against that, the view has always been, well, there’s no alternative. So, what else can people use?

[00:28:04] Maury

Well, there’s no alternative to the dollar as a sort of universal currency, which is kind of the status it has now. I mean, almost 90% of transactions in the foreign exchange market pass through the dollar as a vehicle currency. And I would say that the reach of the dollar, globally, at the moment, or at least coming into this Trump administration, is really unparalleled, even compared to the days when the Bretton Woods system required countries to peg basically to the dollar. So, it has quite an amazing reach at this point.

But you could move to a multipolar system where more countries elect to be more aligned with the euro, or more countries, particularly in Asia and possibly Africa, are more aligned with the Chinese yuan. And so instead of having this global dollar system, you have a system based on multiple currencies and even some smaller currencies. You know, the Japanese yen could play a regional role. You know, sterling could improve its share, although the UK has its own problems.

So that would be the world we move to. And you know, that’s less efficient, but it’s not a disastrous scenario in and of itself. What’s more worrisome are the forces that would be driving the world to a multipolar configuration. But I think that’s completely feasible.

[00:29:52] Alan

Yeah, I mean, it’s been talked about for a while, and we’ve had Barry Eichengreen on here before and spoke to him about it. And he’s made the point that there has been increased demand for international reserve managers for the smaller currencies the likes of the Australian dollar and sterling, Canadian dollar, etc. Your paper is all about fragmentation and a more fragmented international system. What do you think that would mean?

Presumably it would mean a dollar block, a euro block, a yuan block, Is that it? And as you say, it’s not necessarily disastrous, just a change of features. Or is there some kind of implication for moving to that kind of system for global markets?

[00:30:34] Maury

Well, I think there are a number of layers to this. The use of multiple currencies in itself is a form of fragmentation. The possibility that regulatory cooperation erodes in the financial sphere could be another source of fragmentation. I mean, the US participation in the Basel process in the Financial Stability Board. How that will evolve going forward is a question that the administration certainly seems to be rejecting – multilateral cooperation in a number of other areas (not so far in the IMF), and we can certainly talk about that more.

The discretionary use of tax policies in capital markets I think is not really off the table, either for outflows or inflows. One possible harbinger was the so-called revenge tax that was contained in the House version of the bill that became the OBBBA. The idea that if foreign countries try to impose taxes on US corporates, then the US can tax their revenues, prevent repatriation on a one for one basis. That threw a fright into markets momentarily, or at least into the business community.

You raised the issue of stable coins. I think the capacity of the stablecoin initiative to raise the demand for treasuries is probably exaggerated. The idea that this would be a net demand and would not subtract from demand elsewhere in the system is really untested and not thoroughly considered by those who promote stablecoins.

But the stablecoin issue, you know, raises a number of problems. You know, countries may not be happy about parts of their payment system, moving to a more lightly regulated venue based on the dollar, it might affect the transmission of monetary policies. It might raise the possibilities of financial instability or illicit transactions.

And so, this could lead to more barriers to international payments. And in that sphere, you know, if countries become highly dependent, say on US stablecoin providers, they become more vulnerable to actions that the US government might pressure these providers to take, like canceling wallets and the like.

So, you know, again, this is an area where I think there are a lot of risks that haven’t been carefully considered and where, you know, governments outside the US are quite alarmed about the possible incursions into their domestic payment systems and haven’t quite figured out how to react, but are certainly thinking hard about the risks that might be posed. And again, I think this could be another source of fragmentation going forward.

[00:34:22] Alan

The big risk, obviously, from a financial markets perspective, what people worry about, is a big sell-off, a big decline in the dollar for all the reasons you’re highlighting that foreigners decide to reduce their holdings of US assets. You’re talking about potential fragmentation. Do you see that associated with a potentially much weaker dollar or a secular downtrend in the dollar? And then linked to that would it also mean less demand for US treasuries and, obviously, higher yields as a result of that?

[00:34:52] Maury

Yeah, I think those would be possible consequences for sure.

[00:34:56] Alan

Yeah. And I mean, you talked about possible tax policy and the other one that has been mentioned, with Steve Miran’s paper before, is dollar swap. So, swapping kind of treasuries into longer term debt issuance or some kind of, I guess, coercion, I suppose, maybe as part of quid-pro-quo for access to the market or for defense, as you say. Do you think that’s likely? I mean, everybody’s talking about possible financial repression. I guess that would be part of that kind of approach. Do you see that as a possible risk as well?

[00:35:36] Maury

Yeah, I don’t think that the Miran idea is likely to attract a lot of support, you know, even from within the administration. I mean, it would be a direct hit on the treasury market. And you know, I think from the standpoint of the Treasury’s desire to smoothly finance these deficits, they’re much happier to pursue the idea that the stablecoin initiative will help solve the problem.

And now, again, this administration has proved pretty unpredictable. But I think what Dr. Miran proposed really doesn’t have a lot of support on the Treasury side.

[00:36:26] Alan

I mean, you also mentioned, obviously, the international impact of all of this is mistrust, I guess, or concern, lack of confidence in the US, and then you also talked about the more unusual approach to policymaking domestically, taking stakes in the likes of Intel, cutting deals with Nvidia, etc., which is all new and obviously, I guess, counter to kind of free market economics.

What do you think, from an economics perspective, this leads to? If you were tracing this out, simple economists don’t advocate these kinds of policies for a reason. So, what are the adverse effects of these policies over the longer term?

[00:37:11] Maury

Well, I think, ultimately, they harm investment, innovation. Those are classic arguments that free market conservatives have made that have more than a grain of truth. And if you’re contemplating an investment, and you think the government may come along and force you to give up a stake of that, I mean, this is taxation. But it’s not taxation that is debated in the Congress, and that has some firm political or public policy purpose or basis. It’s capricious actions at the whim of an executive that is not really constrained by the judiciary or the legislature.

And, you know, we know that those environments, which characterize authoritarian countries, are not particularly good for investment, and they’re also terrible for inequality. I mean, you end up with a sort of a system, you know, closer to the Russian system in which oligarchs are willing to invest on the premise that they’re protected by the state, but that they’ll also do the state’s bidding. And that’s… Clearly, we’re not close to that, in the US, at this point, but these sorts of moves certainly push in that direction.

And had they occurred under a Democratic administration in the US the other party would be screaming bloody murder. But they seem to be fine with this approach, which to me is very surprising and very puzzling.

[00:39:18] Alan

I mean, the big issue that’s a cause of concern is around the Fed and obviously the pressure, the overt pressure that the Fed is under for an easier policy. I mean, not just the fact that we will have a new Fed Chair, presumably next year, but there’s lots of calls for reform, a new approach at the Fed from Scott Bessent, from other people. Do you think we’re possibly at a fork in the road for the Fed as well? Could you see the Fed taking a different approach, looking ahead?

[00:39:55] Maury

Well, I think there are legitimate questions you could raise about the Fed’s performance. You know, as with any legislatively independent agency, you need transparency and accountability. And it’s not as if that has been missing. You know, the Chair does appear before Congress and has tried to be more transparent with press conferences and the like.

So, you know, there’s always, there’s always room for doing better and there’s always room for reassessment. I would say that the Fed’s performance has not been perfect, but it’s done pretty well in the face of, you know, a lot of disruptions – Covid, reopening, the Ukraine war. It’s not been a sort of easy period.

Now, that being said, while one can legitimately make those criticisms, I think that this is not really what the President’s agenda is. The agenda is to fund the Treasury at lower interest rates. It’s basically a fiscal dominance agenda. The President’s statements are very clear. The Treasury is paying too much for borrowing and the US should have low interest rates, like other countries, because that would make it much cheaper for the Treasury to finance its deficit. So, I mean, that’s sort of the key issue here.

It’s not even really so much supporting the economy because Trump denies that there are any negative pressures on the economy. So, there’s a pretty clear danger that instead of the Fed being devoted to the current dual mandate of price stability and maximum employment, it basically becomes an agency for financing the fiscal deficit.

[00:42:15] Alan

Yeah, I mean, I did see Scott Bessent in the Wall Street Journal. He had an article talking about the third mandate of stable interest rates. I’m not sure if that’s a formal one or if that’s one he just added in himself.

[00:42:29] Maury

No, no, that’s actually in the legislation.

[00:42:31] Alan

It is, is it? Okay.

[00:42:32] Maury

Well, you know, okay, these come out of the Humphrey Hawkins Act, which was passed in the late 1970s, when inflation was out of control, and long-term interest rates were sky high. And the previous Fed mandate, which came out of legislation passed in the late 1940s, was based entirely on full employment. And this new legislation said, okay, you know, price stability is also important.

And I think there’s been a general recognition that the main cause of very high, long-term interest rates is inflation. That’s been the case historically. And if you basically achieve the price stability mandate, you’ll automatically achieve the long-term interest rate mandate.

Now, that being said, if the federal budget is totally out of control (which it was not in 1977), and if the administration is pushing the Federal Reserve to become its fiscal agent by accommodating deficits with lower interest rates, then long-term interest rates are going to reflect that. And then to sort of, bring up that mandate at such a time is very rich. Because what you’re basically saying is, okay, we and the administration are undermining the Fed’s credibility and thereby possibly pushing up longer-term interest rates. And now we want the Fed to suddenly remember this third part of the mandate and to push those interest rates down.

But I think that does lead to a policy which would turbocharge inflation, which is yield curve control. But basically, the Fed… And this was practiced in Japan in the face of deflationary pressures until recently, the idea that the Fed would manage say the 10-year yield to keep it low by buying up that part of the bond market, effectively. That’s what the Japanese did, and that would turbocharge inflation. I view this invocation of the third and least known part of the mandate as incredibly disingenuous on the part of the Treasury Secretary.

[00:45:25] Alan

How would that play out? Because obviously the Fed still has an inflation target. So, on the one hand it would be buying bonds to keep interest rates down, and presumably ignoring the fact that inflation is running above target. Do you think, is that how it would play out in that scenario or presumably they wouldn’t formally abandon the inflation target?

[00:45:48] Maury

The inflation target is not in the Humphrey Hawkins bill. The idea that there’s an inflation target is much more recent, and came in under the Bernanke Chairship, in line with international practice.

So, there’s no legislation, there’s no mandate. The Fed could just not say anything. You know, they’re not really constrained in that sphere, and I think we would just see inflation creep up. You know, the Fed would still say, we’re committed to price stability.

And I think there would be the hope of somehow managing expectations through. What, in the past, have been called open mouth operations. And you know, it simply wouldn’t work. It might work briefly but, but it wouldn’t work in the long-term.

So, I wouldn’t say it’s terra incognita because we were certainly there in the 1970s, but you know, we would gradually, in the US, slip into a much higher inflation environment until such point as the political backlash became so strong that there was a reaction from the administration to induce the Fed to do something else.

[00:47:19] Alan

Yeah, obviously you’ve done a lot of work on crises in emerging markets and elsewhere in fiscal crises. I suppose traditionally, when you get debt crises, it’s also often in the private sector and the banking sector. But at the moment there are no issues in the banking sector and the private sector balance sheets are in good shape by and large, it seems. So, it’s very much a public debt issue.

So, I mean, looking at the situation, particularly in the US, but not just in the US, obviously the likes the UK, France, Japan, all with high debt levels. I mean, what’s the typical scenario that this goes from being a problem into a crisis, would you say?

[00:47:59] Maury

Well, we should never say that the banking system is immune to crises. I mean we recently, in the US, had the Silicon Valley Bank episode which could have become more systemic without the immediate backstopping from the Treasury.

So, we should never, ever, ever be complacent in the face of… You know, there’s always financial innovation and whenever we think we’ve figured out a way to reduce risks, financial activity moves to the riskier, less regulated sectors. And we’ve seen this in the move to non-bank financial intermediaries like hedge funds where a lot more activity takes place. The stablecoin sphere might be another area where there is trouble afoot eventually.

But putting that aside, the risks do seem to be much more, at the moment, in the public finance area. The risks would play out more in the form of concerns about long-term solvency leading to problems auctioning off debt or rolling over debt, much higher interest rates in countries which have their own central bank which can backstop the debt. The higher long-term rates might reflect fears of inflation more than fears of outright default in countries like France, which would be reliant on the European Central Bank for support. And then that becomes a political issue within Europe.

Some of the jitters might reflect the possibility of restructuring which, of course, would be unprecedented for France, in recent history. But you know, it’s a tail event that we can’t take off the table. I mean, generally speaking, you know, there’s a lot of public sector debt and there’s a lot of private sector debt and much of it was contracted in the COVID period at low interest rates, particularly in the private sector. And if we’re moving out of that era, then we’d be unwise to discount financial threat in either sector.

And in the public sector the aging of populations brings in the entire question of entitlement programs, pensions, healthcare. How are you going to support those programs with aging populations and which become more expensive with aging populations.

So, that sort of demographic time bomb, I think, is an important factor, particularly for industrial countries. But not just industrial countries but everywhere, with the exception of Africa, we see demographics slow down.

[00:51:33] Alan

The flip side of that, from an optimist’s perspective, is that AI will be a game changer and can boost the growth side of the equation even in the face of the labor market challenges. How optimistic, or not, are you on AI as an economic driver?

[00:51:55] Maury

It’s clearly going to have some positive effect in terms of productivity. It’s not clear how big that will be. It’s not clear if that will be an ongoing growth effect as opposed to more or less one time shift in productivity.

How that affects output is unclear. We can’t have both large-scale unemployment, which some people fear, and a big increase in output if the AI is merely replacing workers. So, just basing your hopes for fiscal salvation on the idea that AI will come to the rescue is pretty rash in my view.

And, in any case, any sort of prudent scenario planning would allow for the possibility that AI does not come to the rescue and that we actually end up having to pay these bills, or more accurately, future generations end up having to pay these bills.

[00:53:05] Alan

Yeah, just conscious of time. We’re coming up to the hour. Obviously, you spent a lot of time at the IMF and that’s kind of synonymous with the term of the Washington Consensus. And we’ve also had Gary Gerstle on here talking about the end of the neoliberal era.

I mean, what do you think comes next? Obviously, it looks like economic nationalism maybe in the US. Is that going to be the trend globally or is that a US phenomenon? Or how do you think the global markets from a kind of a policy ideology might look over the next number of years?

[00:53:43] Maury

Well, I think there’s going to be more of a realization that public investment is important and that key sectors vulnerable to security threats are important. To some extent, the neoliberal laissez faire Washington consensus view is based on the premise of a stable, peaceful world in which the biggest threats, the Cold War, had receded. You know, to some extent, I would argue, the social policy in that world was also distorted by the… if not distorted, at least shaped by the hope that peace and security would be durable.

So basically, if your country is not in a position where it might have to go to war, where you might have to draft young people to serve in the army, social solidarity might appear less important. In some sense social solidarity is a national security asset. And you get social solidarity by worrying more about inequality, worrying more about public education, worrying more about things that I think economists have always been worried about. The idea that economists never thought about these things is a distortion of economists’ actual thinking.

Adam Smith, in The Wealth of Nations, made a really strong case for public education of the laboring classes. And that’s still something that I think is important. So, I think, certainly, economists got a bad rap. I think the laissez faire aspects of neoliberalism probably are not suited to the world we live in, and we just have to recognize that fact.

Now on the other hand, the sort of interventions that the Trump administration is implementing are going to be negative for efficiency, negative for growth, in my view, run against the investments you would want to make. For example, in your research establishment, to actually enhance national security, I expect to see Europe trying to move in a counter direction.

And if they implement the type of recommendations that are in the Draghi report and the Letta report, you know, that calls for more purposeful investments in key areas. And I don’t think that’s necessarily a bad thing. But we shouldn’t lose sight of the fact that some of the lessons of neoliberalism are important.

Remember where neoliberalism came from, the sort of Hayekian view of how the economy should be managed. Hayek was a refugee from Nazism and he saw how the Soviet system and the Nazi system oppressed individual freedom. And so, part of his espousal of neoliberalism was based on this idea that individual freedom is important. And as we see the US move toward this sort of authoritarian, opportunistic self-dealing, interventionism, I think it might make us more nostalgic for Hayek and his general view that the free market can be a bulwark against arbitrary authoritarian actions by the government. There is more than a kernel of truth in that perspective.

[00:58:02] Alan

Very good. I’m conscious that we’ve just run over. We always like to ask our guests for maybe for advice for people who are coming into economics or the markets early in their career. Obviously, you’ve worked as an economist, a policymaker, policy advisor for people looking to pursue a career in macro or international economics. Anything you would think has been very beneficial or influential in your career are things that people should read or do?

[00:58:34] Maury

If you look across universities and look at what PhD students are working on, there’s less interest in macro in international. And it’s partially because if you go into applied micro areas, the formula for writing a dissertation is pretty clear.

You find a novel data set which allows you to identify the economic effects you’re looking for econometrically, and then you’ve got it made. And macro finance, international, they appear more mysterious to people in some sense. But I think that I would advise students not to give up.

When I went into macroeconomics and international, it was after my experience in the UK seeing the effects of high inflation, seeing the effects of a transition to a new international monetary system. I think these issues are fascinating, and important, and susceptible of good research.

And so, I would say what my advisor, Rudy Dornbush, said to me when I was on my way to my first job interview with the IMF in 1979, which is, learn something about the real world, not just what we teach you in graduate school. And I think that’s great advice.

[01:00:07] Alan

Absolutely. I think that definitely makes a lot of sense. Well, Maury, thanks very much for coming on. It’s been fascinating to get your perspective on policy and economics and everything that goes with that at the current juncture. So, for all of our listeners, make sure to follow Maury’s work at the Peterson Institute.

And we’ll be back soon on Top Traders Unplugged with more content. So, talk to you soon.

[01:00:35] Ending

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