Roubini: Supply-Side Vodoo Black Magic, Geopolitical Implications of Imperial Financial Overstretch

Nouriel Roubini is masterful in talking us through his recent CNBC debate with Arthur Laffer on supply side economics and the Bush tax cuts: Deja Vu Voodoo Economics...or Supply Side Voodoo Black Magic, June 20, 2005. I don’t want to spoil his magic. Go read it! But permit me a to repeat his conclusion:

So today Laffer argued that the latest fiscal figures of increased revenues had vindicated his Voodoo Magic while the reality is that, of course, return to trend GDP growth was bound to eventually lead to some temporary recovery of revenues relative to their totally dismal lows of recent years. So, he must have been smoking some suspicious substance having spent too much time in Voodoo Cabal ceremonies to argue that the data vindicate his supply side Laffer Curve that should be better renamed as the Laughable Curve. We have now a country that has a structural gap between government spending and government revenues that averaged 3% of GDP now and is expected to increase to over 4% of GDP in the next four years. This reckless fiscal policy driven by reckless and unsustainable tax cuts is a major threat to the medium-term prospects of the economy. While these massive fiscal deficits have not led to increases in long term interest rates as most of the financing of these deficits comes from abroad, especially foreign central banks, this is a Ponzi scheme cannot last forever. At some point, foreign will tire of cheaply financing the U.S. and they will pull the plug. And no government can afford to permanently collect revenues at a rate that is 4% of GDP lower than what it spends.

And, as recently lucidly pointed out by Gale and Orszag in a recent LA Times op-ed piece, our long term fiscal problems are much more severe today than they were in the 1980s and early 1990s for several reasons: private savings rates were much higher then than now and thus the crowding out effects of budget deficits on investment and/or net exports are much more serious today; we were then a net foreign creditor while we are now a net debtor country, the biggest debtor in the world; we were then a quarter of a century away from the retirement of the baby boom generation while today those baby boomers are starting to retire in mass; Reagan had the sanity of reversing part of his tax cuts once he realized the impact of voodoo economics while the ideology of this administration is "tax cuts, tax cuts" to death regardless of reality; in the 1990s we got lucky with the end of the Cold War that led to a fall in defense spending of 3% of GDP while today defense and homeland security is way up and expected to go up even more; the Republicans allowed the PAYGO constraints to deficit spending to expire in 2002 and they are now vehemently against reintroducing them as they would clash with their senseless goal of making all tax cuts permanent.

So, while this voodoo magic religion seems to have also infested the halls of the the U.S. Congress, the next time you hear Mr. Laffer and his voodoo magicians tell you that their strange religion and odd beliefs have been vindicated, remember that this black magic has been tried twice before and has miserably failed. It is time for the U.S. to get rid of such barbarian delusional beliefs and get back to a reality-based mainstream economics of budget constraints. Otherwise, as predicted in a recent S&P study, the U.S. would be on its way to experience over the next decades an unsustainable death path would eventually lead to a junk bond credit rating status. That would be the ultimate verdict on supply side Voodoo Economics!

The very next day Roubini follows with a wonderful tour or the world’s geopolitical landscape, subtitled The Risks of Imperial Financial Overstretch, June 21, 2005. Roubini concludes:

[T]he recent strength of the U.S. dollar will turn out to be a curse rather than a blessing as it will further worsen the U.S. current account deficit at a time when this deficit should start to shrink rathen than increase. Moreover, the low long term interest rates are also a mixed blessing as they postpone the necessary adjustment towards fiscal discipline and they provide fuel to an asset bubble in real estate that has already led to dangerously low levels of U.S. private savings. So, let the Panglossians cheer the strength of the dollar and the low long term interest rates. Both of these asset price developments are feeeding the domestic and international imbalances that risk to lead to an eventual hard landing for the U.S. and the global economy.

And beware dollar and bond bulls: last year the dollar rallied for a good part of 2004 until the evidence that the U.S. current account was worsening and we needed to borrow $2 b plus a day to finance it sank in during the summer and fall. You can expect the same this year: once the realization that the U.S. current account deficit is headed above $800 b (well above the 2004 level of $ 650 b) expect the dollar to start weakening and the bond market rally to reverse itself. And with the Fed headed to raise the Fed Funds rate to at least 4% by year end (see the latest Berry Fed commentary on this), we will see whether 10 year Treasuries can still defy gravity and levitate around 4%. As such a sharp flattening of the yield curve would make only sense if the U.S. economy were to be headed towards a severe economic slowdown and an inflation easing that does not seem to be over the horizon, expect instead long rates to move towards 5% by year end. Then, it will take little to prick the housing bubble where the froth is reaching levels that make even Greenspan and his governors nervous by now.

In conclusion, the rise and decline of the British Empire show the risks of imperial financial overstretch. The U.S. is on a similar slippery path where the growing vulnerabilites are disguised by unsustainable private and public borrowing and bubbly asset prices in bonds, stocks and real estate. Landing back to reality from this increasing froth may end up quite hard and painful. The Emperor has no clothes even if it is still parading around blissfully blind to its own near-nakedness.