China has unveiled a massive fiscal stimulus plan that, according to the WSJ, "includes spending in housing, infrastructure, agriculture, health care and social welfare, and…a tax deduction for capital spending by companies." The plan, at $586B, would equal 16% of China’s output in the prior year; for comparison, the previous U.S. package of $168B was about 1% of last year’s output (though it leaves out the much larger funds being made available through Treasury’s TARP and other programs).
This raises some important questions about long term interest rates, commodity prices, and inflation. First, it is likely to mean lower demand for U.S. Treasury debt, and (perhaps) selling of existing Treasury debt, both of which would raise interest rates, all else equal. As Tony Crescenzi of Miller Tabak put it:
China’s need for money will collide with the ramp up of U.S. borrowing, expected to be between $1.5 trillion and $2.0 trillion because of the massive U.S.. This brings back the larger question which I would call the question of our age: Can the U.S. borrow its way out of a debt problem…?
Another concern is the impact that these moves could have on commodity prices, given the Federal Reserve’s extremely easy stance at the moment. As the WSJ points out, Beijing feels it needs at least 8% growth in GDP to maintain social and political stability; with the U.S. economy likely contracting, what appears to be a sensible monetary policy at home could end up financing inflationary pressures abroad, causing commodity prices to resume their upward climb, and creating renewed inflationary pressures here at home in 2009. News of rapid commodity ‘supply destruction’ in the wake of this summer’s demand destruction and the global credit contraction seems to support this possibility. Such an outcome would line up well with our thesis that the current decade is very similar to the 1970s. While we we admit that there are shades of the early 1980s and even the early 1930s, we believe this is a result of the massive financial leverage that was carried into this slowdown. More importantly, we still believe that the risk of long term inflation is more significant than is widely believed. Consider that several of the world’s most important countries (China, Japan, and Germany according to the WSJ), with historically high savings rates, are now embarking on programs that entail significant dissaving. The U.S. is doing the same thing, but lacks the domestic savings base (and rate) of those countries. And if the interplay between monetary and fiscal policies diminishes incentives to save at the margin, as we expect, then at some point central banks will simply end up monetizing a significant portion of public and/or private debt, a measure that is inevitably inflationary and has negative impacts on standards of living.
There is a scenario that could prove us wrong, however, and it would arise if ‘fiscal stimulus’ becomes analogous to trade barriers in the 1930s. In that respect, it’s somewhat disconcerting that both China and the U.S. are considering stimulus measures that are largely inward looking.
Another anti-inflationary scenario would be that key central banks, including the Fed, enact policy measures that prevent ‘inflating away’ the value of public or private debt, much as Paul Volcker did in the early 1980s. We think the probability of this is virtually nil, as people and politicians simply don’t seem to have the stomach for it. However, if countries enacted fiscal, trade, and regulatory policies designed to incentivize productive and lasting investment, employment, and output, then anti-inflationary measures would be a much more palatable prescription. As we wrote in September, it’s all about the policy mix.