Brad W. Setser, CFR’s Whitney Shepardson senior fellow, leads a conversation on the likelihood of an economic recession, the current debt ceiling debate, and recent instability in the U.S. banking sector.
TRANSCRIPT
FASKIANOS: Thank you. Welcome to the Council on Foreign Relations State and Local Officials Webinar. I’m Irina Faskianos, vice president for the National Program and Outreach here at CFR. We’re delighted to have participants from forty-eight states and the U.S. territories with us for today’s conversation, which is on the record.
CFR is an independent and nonpartisan membership organization, think tank, publisher, and educational institution focusing on U.S. foreign and domestic policy. CFR is also the publisher of Foreign Affairs magazine. And, as always, CFR takes no institutional positions on matters of policy. Through our State and Local Officials Initiative, CFR serves as a resource on international issues affecting the priorities and agendas of state and local governments by providing analysis on a wide range of policy topics.
We’re pleased to have Brad Setser with us today for our conversation on “U.S. Economic Uncertainty.” Brad Setser is the Whitney Shepardson senior fellow at CFR, where he focuses on global trade and capital flows, financial vulnerability analysis, and sovereignty debt restructuring. Prior to this role, he served as a senior advisor to the United States Trade Representative and as a deputy assistant secretary for international economic analysis in the U.S. Treasury. Dr. Setser is also the author of the book, Sovereign Wealth and Sovereign Power and the co-author of Bailouts and Bail-ins: Responding to Financial Crises in Emerging Economies. Brad, thanks very much for being with us today.
I thought I would throw you a softball question and ask you to talk about the state of the U.S. economy and what we’re looking at, especially in light of the debt ceiling discussions in D.C.
SETSER: Well, I think the economy is in an OK, but not great, position right now. Clearly, the economy has slowed substantially compared to the initial phases of the recovery from the pandemic. But that slowdown was largely the expected response of the withdrawal of some of the fiscal stimulus and the Fed’s tightening. What I think, though, stands out right now is that there's enormous uncertainty, as the title of this panel suggests, about the future economic outlook, large possibilities of significant deviations from a sort of stable, orderly path of growth.
So I thought I would highlight what I think are the three biggest risks, just to get the discussion going. The first risk is, in some sense, we are driving through terrain that we don't fully understand. Largely because the effects of the pandemic are so with us and a once-in-a-century, or once-in-a-millennium pandemic is not something that was easy to model or has been easy to model as we emerged from it. We should remember that we never really saw the kind of shutdown of the U.S. economy that we experienced in the second quarter of 2020, in the very early days of the pandemic. I mean, both Irina and I were in New York at the time, and the city literally shut down for a period of time after the enormous initial outbreak and while we were waiting for the vaccines, and basically learning how to manage this particular pandemic.
That shutdown had reverberations and consequences that have stayed with us over time. It’s left the path of economic growth—it’s created a much more unstable path of economic activity than is typical in the U.S. economy. Obviously, it's hard to disentangle the effects of the pandemic, per se, from the effects of the policy response to the pandemic, the initial rounds of stimulus under both the Biden and the Trump administrations, and then the snarls in global supply chains that complicated the path of recovery. Those snarls reflected both a shift in demand towards goods and away from services, which was really quite substantial when you look at the data, and then the fact that we encountered infrastructure constraints as well as production constraints around the global economy.
In 2021, our ports literally couldn't accommodate all of the containers coming in with all the goods our economy was demanding. And then because there was such repressed demand, we had, like, an enormous trade deficit in the first quarter of 2022 and then a big fall-off in trade late last year, which actually had nothing to do with any change in trade policy. It was simply the fact that it, you know, there was such high demand for goods in 2021 that wasn't really met until early 2022, but then there was a fall-off in demand once our economy had kind of adjusted to this new equilibrium.
One sign that these pandemic-related disruptions aren't completely past is pretty straightforward, when you think about it. Auto prices are still up quite a lot, quite significantly. Normally, when prices go up supply responds, production goes up. But only very recently has U.S. automobile production—it's also true for North American automobile production—recovered to the levels that we had before the pandemic. Our economy didn't forget how to produce cars, but the availability of the semiconductors needed for a modern car was really constrained. And that limited the ability of the economy to respond as one would expect to a clear signal from the market.
So there was just—whenever you look closely at the U.S. economy, you find relationships that have held for long periods of time that aren't quite holding as one would expect, even three years after the pandemic. We still haven't managed to return to a fully normal economy. We're still dealing with some of the aftershocks. So that creates one source of uncertainty.
The second source of uncertainty is that the Fed really did tighten rates quite substantially last year and early this year. It’s the largest tightening cycle in recent economic history, largest and fastest, going from zero to five in a very—in a relatively short period of time. And that tightening cycle, you know, clearly was a response to the fact that inflation was above the Fed’s target, through the tightening of supply because of the higher demand from some of the policy responses to the pandemic. No one doubts that inflation was above target. No one doubted the Fed needed to react. And I don't think anyone really doubts the Fed needed to react quite strongly.
But the magnitude of the increase in interest rates and the pace of the increase in interest rates is large. And there's always a risk when you tighten monetary policy that you do too much, that you push the economy, or you tighten—you pull back the economy too, too heavily. And rather than bringing the economy back into equilibrium, you push on the brakes too hard, the economy stops. And effectively, there's a recession. There's also a risk of doing too little. You don't tighten enough. The economy slows, but not enough to bring down inflation. And the concern then is that expectations about future inflation become entrenched and inflation never comes back down to pre-pandemic levels.
So the Fed has had to try to navigate between those two risks. And it has had to do so while driving over uncertain terrain because of the pandemic and dealing with the normal uncertainty that accompanies all Fed policy. The Fed’s monetary policy famously works with what are called long and variable lags, which means that the effect of tightening last year is still being felt in the economy this year and will still be felt next year. An easy way of seeing that is when you think about how trade responds to a Fed tightening cycle. The dollar goes up, but it takes eight quarters before all of the trade impacts of a stronger dollar typically feed through to the U.S. economy.
When interest rates go up, that impacts housing. Impacts the affordability of homes. All that, though, feeds through to the broader economy over time. It doesn't happen instantly. And it doesn't always feed through at the expected pace. There's arguments why the pace of tightening last year, that the normal lags will be shorter. Financial markets looked ahead. long-term interest rates went up very quickly even before the Fed completed its tightening cycle. That arguably pulls forward some of the contractionary impact.
But there are other variables which suggests that the lags may be particularly long. We didn't actually see the labor market tighten very significantly when the Fed started raising interest rates. Employment has remained very strong. Inflation has come down, but maybe not quite as much as the Fed might have hoped. Although I think there's some evidence that is feeding through. But famously, I think, one of the ways in which lags are long and variable is that the main way monetary policy tightening tends to impact the U.S. economy is through the banking system.
And for a long time, it wasn't obvious that the Fed’s tightening was slowing the banks, that it was pinching on the banks, that it was restraining bank lending. It took actually a really long time before higher Fed interest rates led to higher deposit interest rates and problems for those banks that had, in effect, bet that deposit interest rates wouldn't go up that much and therefore they were going to be safe, even though they put a lot of their portfolio into bonds, long term what are called agency-backed securities, repackaged mortgages, that gave you a bit of a yield pickup back when interest rates were zero, but you locked in 2 or 3 percent interest rates over a really long period of time—seven years, five years.
Long enough that when now that deposit rates have started to come up, the banks are losing money on this part of their portfolio. We know this because this was the bet that Silicon Valley Bank and a few others made, and when colossally wrong. The banks effectively depleted their capital because of a bad bet on interest rates. Simple error, not a complex error. Silicon Valley Bank didn't go get into trouble because it lent to Silicon Valley Bank. Silicon Valley Bank got in trouble because it bought really safe securities, but locked in low-interest rates for too long and wasn't prepared when the Fed raised rates.
But the net effect is that after a long period of time, when Fed tightening, higher short-term interest rates didn't seem like it was impacting the banking system, all of a sudden we've seen a lot of evidence that it really has started to impact the banking system and that the banks are going to cut back on lending. And so one source of uncertainty—it's very much on the minds of Fed officials—is that the Fed has to calibrate how much this new contraction in bank lending is going to slow the economy and, therefore, how much more they need to do by raising policy rates. Or, whether they should pause or even pull back lower rates, which they aren't going to do.
But, you know, conceptually, if you thought that this was going to impact the economy so heavily that the economy would naturally slow and pull inflation below target, you would be cutting not raising. The difficulty for the Fed is that it is very hard to calibrate exactly how the combined effect of last year's increase in interest rates and this year's banking crisis will impact the economy over the next several quarters. Which adds to the risk that the economy may slow more than expected.
A third source of uncertainty is the obvious one, the debt ceiling. I personally would prefer if we didn't have a debt ceiling and if we weren't threatening the U.S. government with default every few years when government is divided. The debt ceiling though generates one of two outcomes. One outcome is essentially a disaster. If the U.S. defaults on its debt or if the U.S. prioritizes paying the deb but doesn't have the capacity to borrow new money and has to cut back heavily on all other activities of government, the U.S. economy goes into a big contraction—if that is sustained for any period of time whatsoever.
There's absolutely no ambiguity about it. The only ambiguity is whether the U.S. prioritizes treasuries, which Treasury says will be very difficult to do, or whether it defaults. If the Treasury prioritizes treasuries, it's probably good for long-term bonds. If the Treasury defaults, it's probably a disaster for bonds. So there's uncertainty about, in that situation, which way the Treasury would—which option the Treasury would go for and how it would impact long-term bond prices. Which is a problem for bond traders.
But there's no question it hits the economy hard, it hits equity markets hard. It would fundamentally be a self-created disaster. But because everyone knows if you actually went into default or could not honor other promises of the government—and pay wages, pay bills, pay social security—that it would be a disaster, the assumption is that there will be a deal. And if there is a deal, the economic impact is probably pretty modest. There's a bit of extra uncertainty that maybe slows the economy just a bit, but it isn't devastating. So we're faced with what is sort of fundamentally a low probability of a really high-impact event, which is something that is very hard for markets to discount and price.
So we're in an economy with multiple sources of uncertainty. That's almost always the case. But I think many of those sources of uncertainty are actually unusually large right now. And we're at a delicate time. We're always—it's always a delicate time when you're trying to bring inflation down without putting the economy into a stall. So it's a challenging few months.
FASKIANOS: Fantastic. Let's now go to all of you for your questions or comments. You can either click on your screen to raise your hand or else you can put your question in the Q&A box. If you do that, please identify—tell us who you are. And I'll read the questions and/or call on people who have raised their hands. And we really love to hear from you live, so do consider that.
So the first question that we have is from Mike Zoril, who is a District 14 supervisor in Rock County, Wisconsin: How does the debt ceiling impact the banking sector? And what are the potential consequences if the ceiling is not raised in time? I think you—I think he may have typed in that question before you got to the third part of your scenario, but is there anything you want to expand upon that you didn't cover in your in your points, Brad?
SETSER: Well, I think there's one obvious way in which the debt ceiling impacts the banking sector, and one perhaps less obvious way. The obvious way is that an awful lot of banking transactions are collateralized with treasuries. So they're secured by treasuries. So the one way in which you reduce risk associated with short-term lending is that you lend someone cash, but you they give you their treasuries in return. And you do that, you think you have an absolutely safe extension of credit. It is the safest thing you can do.
If your counterparty doesn't pay you, you have treasuries which are money good. And if treasuries aren't money good, then all of a sudden a set of transactions that underpin our banking system would become problematic. And I mean, in some sense, the consequences of that are so dire that the operating assumption is that the U.S. government wouldn't stand still, that it would quickly cure the default. But if there were an extended period of default, a set of transactions between banks that are considered super safe suddenly stopped being safe.
I think the second impact is more subtle, and I'm not actually 100 percent sure it's true. But when people put money in a bank they're counting a bit on the quality of the bank, the safety of that particular institution, the wisdom of that bank’s manager, the quality of the loans. But most of us don't monitor our banks that closely. We trust the federal government to supervise and we rely on Federal Deposit Insurance to make sure that our money is good, even if the bank fails. And if the Treasury is in protracted default, what worries me a little bit is that some people might wonder whether the credibility of the U.S. government's backstop for bank deposits remains intact.
I can come up with arguments for why it would. The FDIC has some independent authority. But ultimately, if the U.S. government can't borrow, the U.S. government cannot do an awful lot of things. And many of those things are pretty essential to financial institutions.
FASKIANOS: Thank you. I'm going to take the next question from Ronald Campbell, who's the co-chairperson and treasurer in the Office of Georgia Representative Lisa Campbell, District 35: Is there an economic positioning system similar to GPS for navigating in the economy? If not, what are the key economic coordinates to monitor?
SETSER: Like, unfortunately, you can't turn on Google Maps and get precise instructions for how to go from point A to point B. There's a range of tools and data points that the Fed, the White House, the Treasury do use. Financial market variables are very important. Financial markets are important in and of themselves. They tell you how much it costs to borrow. But they also can give you some insight into how professional traders are interpreting the economic data. And that can help provide some guidance. There is data from surveys that tell us how consumers view the economy. There's data from surveys that tell us how businesses view the economy.
The federal government collects data on wages. It collects data on the number of people who are employed. And those labor market variables tend to be some of the best high-frequency indicators of how the economy is doing. And then we collect various data points that measure how consumers are spending, what retail sales are, some are pretty well-defined in real-time. Others are less so. And between those variables and kind of old-fashioned physical measures like how much freight is moving on trucks and how many containers are coming through the ports, you can get some guide to how the economy is doing. And that can help you use your policy tools to try to get to the destination.
I think the hard part is that there's lags between when things change in the economy and when you see them in some of these data points. And it is hard to forecast with the same precision that Uber can forecast whether you're going to get to your destination in eight minutes, ten minutes, fourteen minutes, or twenty minutes, how policy changes, like the Fed’s tightening, will impact the economy in one quarter, two quarters, or three quarters. So there's those difficulties that make it hard to have the same kind of precision that we get from GPS, and the new Google Maps and Uber software tools.
FASKIANOS: Thank you. I'm going to take the next question from Robert Cantelmo. If you could unmute—accept the unmute prompt and tell us who you are.
Q: Hi, thank you so much. Brad, thanks for sharing these remarks this afternoon. My name is Robert Cantelmo. I'm a City Council member in Ithaca, New York, and the Democratic candidate for mayor.
We've heard a lot about the potential for remote work throughout the pandemic. And I know several small and midsize cities had hoped that we might be able to leverage this modality shift into some economic opportunity over the intermediate term. However, as you're noting, we're in a period of uncertainty and relative instability. And I was wondering if you could care to comment on how modestly sized cities might better prepare to weather that uncertainty, especially with the lens on, you know, how you think it might impact our long-term ability to attract capital investment and keep up service delivery over a period of inflationary pressures?
SETSER: That's a hard question. I mean, to be honest, I don't think municipal government should be forced into the position of having to think about how to manage a default by the federal government. I think it's much better for our economy and our society when the only question municipal governments face is whether the federal government might provide help to manage their budgets during periods of global or national economic stress, like during the pandemic, when municipal governments have to think about how to manage risk that really can't be managed. I think that's asking a bit too much.
I mean, just stating the obvious thing, you know, if you're putting your cash in a treasury money market fund, you would normally think that would be the safest thing in the world. But there are scenarios where short-term treasury bills are in default and what normally would be the safest thing in the world, safer than a big bank deposit, isn't safe. So I do think it's probably important to think about sources of cash if there is protracted default, not that you want to but probably be a good idea.
And then, if there is either a default or if there isn't a clean resolution of the debt ceiling, so that there's going to be a series of high-profile games of chicken that push up borrowing costs. I don't think municipalities can insulate themselves from that because municipal bonds price off the treasury market. I think you just have to plan for the possibility of higher interest rates that impact your borrowing. I think it's probably good practice to have stress tests on your access to the municipal bond market. Make sure that municipalities have access to enough cash that you can survive if there's a period of interruption.
But at the end of the day, if you can't afford to borrow you can't afford to make a lot of long-term investments. And that will constrain any municipality’s ability to position itself for the future. I worked a lot in my stint in government on Puerto Rico. And Puerto Rico lost access to the municipal bond market, and it was devastating. Absolutely devastating. They relied heavily on short-term borrowing because of some weirdness in how they had pledged sales tax revenue. So they pledged sales tax revenue to first go to the bonds and then go to the budget. So they had no sales tax revenue for the first six months of the year, and all their sales tax revenue came in from month seven to month twelve. And they typically borrowed short term during the first six months of the year against their expected sales tax revenue in the second half of the year.
But when you couldn't pay your long-term bonds, the banks wouldn't lend to you short term, so you were faced with the risk of a really tight cash flow constraint. And that just illustrated to me some of the complexities of municipal budgeting. And the fact that you have to have probably more buffers than the federal government typically has. Because the federal government, you know, historically has able to operate with a limited cash buffer because of the consistency of its ability to access short-term bill markets and always raise cash.
FASKIANOS: Thank you. I’m going to go next to Robert Myers, who is a senator in Alaska: What's the current outlook on energy markets, especially oil and gas?
SETSER: Oh, I think some people—I know there are many people, maybe some on this call, who probably are better positioned to answer that. You know, there is no doubt that one of the biggest sources of uncertainty in the global economy over the past twenty-four months has been energy markets.
Russia's invasion of Ukraine and the associated sanctions, and the reduction or elimination of a lot of pipeline flows of natural gas to Europe, have all disrupted global oil markets profoundly. A world where Europe no longer buys oil from Russia, at least not tanker oil, and most of Europe, not pipeline oil, and instead has to import oil from everywhere else, and where Russian oil goes to Turkey and now to India—a lot goes to India, as well as China and parts of Asia—that has lengthen the amount of time Russian oil has to spend at sea. And it has, like, disrupted the standard global flow of oil in so many ways.
So obviously, last summer, that meant really high oil prices. And really high oil prices then in turn induce—you know, markets work. People started drilling more. It took a little while, longer than I would have liked, but markets have responded. There are more sources of oil supply. And then high prices tend to reduce demand. And China has been weaker than expected. So right now, the oil market seems relatively well supplied. But the oil market is not a completely free market.
And on the supply side, OPEC and OPEC+ work to manage the market. And the Saudis have signaled that they don't want oil to go much below seventy. I tend to believe them. And I think the U.S. now is doing something that is quite smart, although maybe we're not doing it as nimbly as we should, and I would like to have more capacity to do this quickly and do this with more force. But we're starting to refill the Strategic Petroleum Reserve. We signaled that we'll kind of start buying some oil, which should also put a floor under markets.
The natural gas market has really stabilized. European gas prices have come way down, thank God. And thank a relatively mild winter in Europe that left gas storage full. But we are in a different world now than we were twelve months ago, because the European natural gas storage tanks are full. So—and Russia has exercised its option, it's exercised its threat; it’s not supplying Europe with gas. And Europe was able to get through the winter. It overpaid for LNG for a while. It no longer has to. So that's putting downward pressure on gas prices.
So my sense is that oil prices won't go much lower, largely because the producers are now in a position where they're going to respond to weakness. We're hitting the limits of their willingness to tolerate lower oil prices. And we're also hitting levels where the U.S. should refill the Strategic Petroleum Reserve. And if oil prices stay at this level, there'll be some reduction in drilling. So that's my sense of where we are, but I don't follow the oil market on a day-to-day basis.
FASKIANOS: We will—that's a good note for us to cover that in a future webinar. So we'll put that on our list of things to delve deeper into. So thank you for that question, and for your response, Brad.
I’m going to go next to Commissioner Aaron Mays in Shawnee County in Kansas: It seems like the rate of inflation has slowed some in recent months. Is there a possibility of some deflation or should we permanently adjust our budgets to accommodate higher wages and prices?
SETSER: Well, Irina left out one critical part of my biography, which I was actually born and raised in the state of Kansas. So, hi. It’s—Shawnee Mission was always, you know, aspirational for me. We used to go to debate tournaments there. And the Shawnee Mission High Schools in that era were the best-funded in the state of Kansas. So I hope the high quality of the Shawnee Mission School Districts has been sustained over time.
I mean, deflation is an unlikely, I would say, possibility. And we're currently on a trajectory which economists called disinflation, which means that we're going from high inflation to medium inflation, and hopefully back to lower inflation. So the pace of inflation is slowing. But deflation would be an absolute fall in prices. And given the tightness in the labor market and the momentum in prices, that seems an unlikely outcome. I do think the most likely outcome is that the pace of increase in inflation continues to fall. And that means that the Fed will be closer to its target than it is now.
So in a forward-looking basis, the Fed wants price increases to get down to about 2 percent a year. We went up to eight, which is too high. We're now at four-ish, I think. And some of the forward-looking indicators would suggest that we're going to be on a trajectory where we should get down to three. Certainly, the pace of increase in housing prices have slowed. And in some places, housing prices are coming down. But the way the inflation series is constructed, it's kind of complicated, but it's basically the average of price increases over the past twelve months. So it just takes a long time before that feeds into the measured variable. And that is expected to bring the pace of rent increase, as measured, down.
Wage increases are still pretty strong. And that's expected to keep service prices up. Although, there’s a hope that they will be generally coming down in response to the Fed’s tightening and the contraction of banking credit. But they will come down without too much of a drag on the economy. But in terms of budgeting and forward-looking forecasts, I think it is safe to forecast, to expect price increases of—that are a little above the Fed’s target for the next couple of years. And then there's a debate about whether they will be back precisely at the 2 percent target or maybe a little higher, but I think it’s really unlikely that we would have an extended period of inflation where there was no increase in prices or a fall in prices. That would be an indication that the Fed had overdone it, and that’s something that typically only happens in a pretty serious recession.
FASKIANOS: Thanks. We’re going to take the next question from Commissioner Bob Heneage—my apologies if I mispronounced it—of Teton County in Idaho: What is the likelihood of—the federal government will attempt to claw back unspent American Rescue Plan Act funds from local governor—governments? Excuse me.
SETSER: Very low, because that would be political suicide for any member of the House of Representatives. I think there will be some efforts to claw back or not use some of the unspent federal resources, but anything that has already been provided to the states and municipalities I think is safe. I haven’t thought in detail—I don’t know in detail if there’s a pool of money that has been pledged to state and local governments but hasn’t yet been disbursed, and I would watch that. But anything that has already been transferred is yours. And if it’s not, I mean, wow, that is a—that’s crazy politics.
FASKIANOS: Next question we’ll take from Beverly Burger, who has raised her hand. So if you can unmute yourself.
Q: Sure. Can you hear me?
FASKIANOS: We can. And identify yourself, please.
Q: Yes, Alderman—I'm sorry. Excuse me. Alderman Burger from the city of Franklin, Tennessee, just south of Nashville.
Sorry, I came on a little bit late, so I didn't hear the very, very first part, but did get most of it. But can you shine some light on how what is going on right now in our economy affects our local city investments in funding new water treatment plants, new city hall? We're thinking of partnering with an entity to build a larger conference center, not to own it but to partner with them, in a way. A few water projects as well. I might just say that our city plans conservatively on our budget. We’re a AAA-rated city, and we have a policy of having 33 percent of our general budget in reserves, which right now we have 54 (percent). We have a low property tax, heavily rely on sales tax at 9.75 percent. We also impose road and facility and parkland dedication fees on new development. Our sewer plant’s already been built. We already have long-term funding for that. But my question is, how wise is it right now to invest in these other projects mentioned in the coming two years? And, by the way, our city is about 88,000 in population and we are AAA-bond rated.
SETSER: Well, the best advice would be that you should have borrowed a ton of money back when interest rates were really low during the pandemic and locked in that funding. But that's unrealistic. And obviously at that time, there was a concern that the economy might not bounce back, and that demand wouldn't be there, that you didn't need to plan for projected growth. I would not let—personally, I would not let too many long-term plans be impacted by timing around the bond market. Long-term borrowing is up a bit. It's more expensive, clearly, than it was two years ago.
But, you know, the U.S. Treasury is borrowing at 3 and 3 ½ (percent). I don't know where a AAA muni can borrow. So there's going to be a subset of projects that maybe made sense when you could borrow at 2 percent that don't make sense when you can borrow at 4 percent. I wouldn't recommend borrowing a lot at 6 (percent). But if you can access markets at four nominal, to me if you can confidently forecast growth in revenues over time that will generate 4 percent growth if the economy performs normally, and you've got a decent reserve, you should go ahead and make necessary investments in your infrastructure. But clearly, the cost has gone up a bit. I just don't know how much it has gone up for AAA munis over the past few years off the top of my head.
FASKIANOS: Thank you. Let's go next to Jeremy Gordon, who is Polk County, Oregon commissioner: What other inflation responses outside of the Fed are possible but not talked about?
SETSER: Well, fiscal cuts tend to reduce inflation. To some degree, those are being a little bit talked about now because of one possible outcome of the debt ceiling. Tax increases clearly slow the economy and slow inflation. Now there's, you know, a little bit of a debate about exactly how. And, you know, I think a lot of people if the sales tax goes up, they think inflation has gone up because the price they actually pay is gone up when, for an economist, they would say, well, if you increase sales tax than other prices are going to not go up as much, and so the price—the underlying price level growth will slow. But I understand that's not quite how most consumers think.
But those would be the kind of classic tools that are outside of the Fed. Some have argued, and it's a very debated proposition, that reducing the monopoly or power of some big businesses would lower prices. That you could get more competition in the economy, lower markups, and that that would help bring prices down. And some have argued, and this has obviously been a partisan fight, that the U.S. government could help lower drug prices by negotiating the price it pays the big pharmaceutical companies for lifesaving medicines.
I tend to agree with that. I think there's no good reason why U.S. medical prices are many multiples of the prices paid in Europe and other jurisdictions that have access to the same meds, same quality that we do. But that's been a huge source of political debate, as we all know, over the past ten years. But I do think that that is something that was talked about but is no longer talked about because it has no chance of going through our Congress.
FASKIANOS: We go next to a question from Rob Hotaling. And if you could accept the unmute prompt.
Q: Hi. Yes. Can you hear me?
FASKIANOS: We can.
Q: Perfect. Thank you so much. Yeah, hi, this is Rob Hotaling. So, the question really isn't around the impacts of economic uncertainty—oh, by the way. Deputy commissioner of Connecticut's Economic and Community Development.
So yeah, my question is around what are the impacts of economic uncertainty on investments? Earlier you mentioned IRA, no clawbacks, things like that be political suicide, to quote you. But I am wondering from an infrastructure, workforce training, technology, and innovation perspective, looking at our state, in Connecticut, what we can do and what we can advise our businesses and individuals to do in Connecticut. Of course, the rest of the nation probably has the same concern about economic uncertainty as regards to investments.
SETSER: Well, there's a certain amount of uncertainty that is a fact of life in a capitalist economy, in a market economy. And businesses and states have to manage that uncertainty. There's a set of standard recommendations. I think, the Alderwoman from Tennessee highlighted some of that, which is that, you know, holding buffers on hand to help manage the unexpected is always good advice, even though it is costly.
But the bigger, I think, issue is that there's a set of sources of uncertainty in our economy that it would just be helpful to eliminate. The debt ceiling as a source of enormous uncertainty that hopefully we will be able to get through without having a catastrophic outcome. I don't think, as I said earlier, that that is something where state and local officials really should be responsible for having to help people navigate it. There is no good way to navigate it. It is really the responsibility of the federal government to figure out a path forward.
And then there is no easy way to manage through a period when, for a broad set of reasons, our economy is slowing. We've gotten a relatively strong recovery by global standards from the pandemic. We’re much closer to the level of output that you would expect had there not been a pandemic than some other economies throughout the world are. We came out of the pandemic with, you know, a very strong economy powered by a very large stimulus. That stimulus has mostly been withdrawn but is still partially—there's still some lagged effects of that withdrawal of stimulus. And we came out so strong that the Fed felt the need to slow the economy.
And there is—there is nothing that localities can do, other than maintain standard buffers, to prepare for the possibility that the Fed will either overdo it or underdo it. But this is this is a time when you—I think, sensible forecast would not expect a very high probability of very strong growth. There's a pretty high probability of relatively weak growth, just because the Fed is trying to grow the economy. And then there's a small probability of a really sharp slowdown, most obviously induced by the debt ceiling but possibly induced by further banking stress. So I would weigh my decisions according to that distribution of outcomes.
Q: Can I ask one follow-up question? Is that feasible?
FASKIANOS: Sure. Sure, go ahead. Go ahead.
Q: Just Connecticut, like a few states, has a pretty healthy rainy-day fund. When roughly the majority of America thinks we're going to enter a recession, what is your advice for states like Connecticut who have a healthy rainy day fund and a surplus? Do you—we're not looking for state financial advice, per se. We're just saying, what is the overall guidance on considerations for what to do with that rainy-day fund ahead of a recession, considering the inflationary environment we're in?
SETSER: I think a rainy-day fund is a very good thing to have when there's a recession. So this would not be a time to run it down. We're in a period of heightened uncertainty. If the recession—if a recession materializes, if you see a fall in revenues, then that is the time to start drawing on the fund. I would wait until the economy has kind of normalized, we're back at normal growth and normal inflation and we're past the debt ceiling, before making any long-term decisions about levels of spending and revenue that would materially reduce that buffer over time.
Q: Perfect. Thank you so much.
FASKIANOS: So, Brad, there’s a question from Commissioner Robert Sezak in Somerset County, Maine: There's been talk of invoking the Fourteenth Amendment to eliminate the debt ceiling provisions. What would be the impact of that course of action? And I think I just—you say that you think it should be eliminated.
SETSER: Yeah. If I were given unlimited authority, I would personally get rid of the debt ceiling and just live in a world where the U.S. government was constrained by the budget, and any approved budget—which will have embedded in it a forecast of spending forecasts about revenue—any spending authorized by the budget itself authorizes the debt issued to fund that budget. So you—I don't think you need a debt ceiling, per se. Most countries around the world don't actually have debt ceilings.
There's a lot of debate about what would happen if the Fourteenth Amendment were invoked. I think it is fair to say that the effect of invoking the Fourteenth Amendment would be smaller than the effect of a default or the effect of forcing the U.S. government to run a cash budget and not borrow, and thereby really scale back spending. And then you have to factor in, if you scale back spending you're going to, like, lose a little momentum in the economy. Revenues are going to come down. It just becomes pretty devastating pretty quickly.
So if that's your alternative, invoking the Fourteenth Amendment is—will generate better outcomes. If your alternative is raising the debt ceiling so that you don't default and can keep borrowing, you can avoid some of the uncertainty associated with the Fourteenth Amendment. The uncertainty associated with the Fourteenth Amendment is, as I understand it, as follows: The Fourteenth—the use of the Fourteenth Amendment would be challenged in the courts. And any debt—there would be a question about whether any debt issued after the invocation of the Fourteenth Amendment is constitutional.
And so that that debt would likely trade in the market at a slightly different interest rate and a bigger discount than debt issued before the U.S. invoked the Fourteenth Amendment, at least until there was clarity from the courts. So during that period, there would be uncertainty about how the courts would ultimately rule. I personally think, and I may be influenced by my friend and colleague Anna Gelpern who’s been writing about this at Georgetown Law School, that the Fourteenth Amendment is—the intent of the Fourteenth Amendment is pretty clear. And that the president would actually be on strong constitutional and legal grounds to say that it is unconstitutional to default.
I think that actually is the meaning of the words that were written in the Fourteenth Amendment. Anna has uncovered some interesting historical evidence that the goal was to make sure that the Union didn't default on the debts incurred to fight the Civil War. That seems like pretty clear intent that the U.S. government's federal debt should be paid. That was the purpose of that language. But it is not uniformly accepted. It would be challenged. And therefore, we would have a new source of uncertainty if that were to be invoked. But, to be clear, the worst outcome is protracted default.
FASKIANOS: We have a raised hand from Liane Taylor.
Q: Good afternoon. Thank you. Liane Taylor. I'm from Montana Department of Commerce: And my question is a little bit of a different take. With all this information overload in the world right now, could you recommend one or two comprehensive sources of good information, such as you are imparting to us?
SETSER: You know, I think the major national newspapers actually do a pretty good job of reporting financial and economic news. So I rely pretty heavily on the reporting of the Wall Street Journal and the reporting of the New York Times. If you can afford it, the reporting from Bloomberg is also excellent. But I draw pretty heavily on the mainstream financial media. And I think, as a participant in some of these policy debates and some of these financial debates, I generally feel like both the news coverage of the Journal and the news coverage of the Times accurately reflects the state of the real debate that's going on. I don't think that there’s any lack of—I mean, I'm impressed, often, by how well-informed they are, particularly about discussions around the Fed’s policy in the state of the economy. So I would I would, boringly, draw on the conventional press.
FASKIANOS: Great. I wanted to just look at the questions we have in the chat. Where should we go next? Let's see. There are questions about if the federal government does not put a restriction on its spending, how long can they keep borrowing given its debt is already over $31 trillion? Is from Michael Yu.
SETSER: To be honest, there is no obvious limit. Japan has borrowed up to 200 percent of its GDP at low-interest rates. There's no sign that the federal government has difficulty funding itself. The absolute level of debt is high. It's about 100 percent of GDP when you do a certain amount of netting, which I think is normal. And the budget deficit’s about 5 percent of GDP, which is a bit higher than the level that is consistent with a stable debt-to-GDP ratio. I generally think it would be a good idea to move over time towards a budget deficit that is consistent with a stable debt-to-GDP ratio. But there isn't a clear limit on what an advanced economy like the U.S. can borrow.
If you borrow too much, you'll start putting upward pressure on Treasury interest rates and that will be a signal that you probably need to move more quickly towards a more restrained deficit. But the basic rule of thumb is you don't want a debt-to-GDP ratio that is increasing forever. But there isn't a clear limit on how much countries can borrow. U.S. debt is high, relative to our history. It is roughly equal to the debt of most European countries in aggregate. For the EU as a whole, debt is about 100 percent of GDP. Germany is lower. France is about where we are. Italy is a bit higher. Japan is way higher. And there’s a huge debate about China.
If you just look at the debt of China’s central government, it’s well below the debt of our federal government. But China has a lot of debt, much more debt than we do, at the state and provincial level. There’s a lot of hidden debt there, a lot of backdoor borrowing. So if you include all that, China’s debt is actually not that far below ours. So the absolute level certainly seems high, but it is not wildly out of line with global norms. And financial markets are currently quite comfortable lending to the U.S. for ten years at 3 ½ (percent), which is above where it wasabut it’s not a rate that suggests any near-term risks that the U.S. will cease to be able to borrow to fund some spending.
FASKIANOS: Great. So I’m going to go back to Mike Zoril, who has a question. He’s from, again District Fourteen supervisor of Rock County, Wisconsin: What specific plans and actions would be taken if there were a widespread collapse of banks? You know, taking into account the possibility that the FDIC may not have enough funds to cover all the losses? Would a bail-in strategy or the implementation of a new digital currency system be viable solutions? And how would this—you know, the introduction of FedNow affect this process? And the impact might it have on the monetary systems of the BRICS countries?
SETSER: So a digital currency is not a solution to a problem with the banks. A digital currency runs the risk of pulling funds out of the banks. A lot of economists think of a bank account as basically a digital dollar already, a digital dollar that pays, in some cases, a bit of interest. A digital dollar that is outside the banking system creates an alternative to keeping your money in the banks. It would weaken the banking system, or at least runs that risk.
The likely response to further banking distress—and, you know, that hinges on an assumption that the FDIC, the Fed, the Treasury, using their existing tools, won’t be able to contain the distress. And I think that’s unlikely. I think the FDIC, the Treasury, and the Fed have made it clear that they intend to protect deposits in the financial system by using the so-called systemic risk exception is a major bank fails. And that systemic risk exception lets you backstop the deposits using the money in the FDIC fund. And the FDIC fund can be replenished by a levy on bank deposits. So, it will—it can be renewed without any new budget appropriations. Which makes it, I think, unlikely that it would run out, particularly because the banks that get into trouble going forward will likely be—if they get into trouble, likely will have slightly better balance sheets that Silicon Valley Bank, some of the other banks that have already failed, and so the losses would be smaller.
But in the event that there was greater banking distress, I think the first response would be to use the provisions in Dodd-Frank that allow the FDIC to request a straight up or down vote in Congress on an increase in deposit insurance. So, I think the most likely response will be to request that Congress fully guarantee all bank deposits, so that people didn’t have to worry about whether their money in the bank was safe. There’s certainly some other technical things that the Fed would do to make maybe it a little less attractive for money to move out of the banks into money market funds. Greater bank distress would increase the probability that there’d be rate cuts.
So there’d be a lot of responses. But the first response would be to expand FDIC deposit insurance, which takes in most circumstances, I think, my read—the cleanest way to do that certainly would be for Congress to approve it. And then if there were really much deeper bank distress, then you would have to consider whether the U.S. government should request—or, the U.S. should have in place the capacity to put capital in the banks, which is what was done in 2008-2009. That’s an enormously political—you know, so that is, in a different way, runs the risk of being political suicide. But putting capital into the banks is way better than letting our financial system collapse.
But to be clear, I think the measures that have been introduced to date will contain the crisis. I think it is clear that the FDIC, the Treasury, and the Fed have the authority to protect deposits in any bank that fails, and they intend to do so.
FASKIANOS: And, I’m sorry, at this point we have to close. I am sorry we could not get to the rest of the questions, the raised hands.
SETSER: And I’m sorry I closed on such a down note. There is a—there is a path forward where these uncertainties are resolved and the U.S. economy continues to plow ahead. We’ve surprised people by not having a recession yet this year. That was sort of a pretty widespread forecast at the end of last year. And it’s certainly possible that many of these sources of uncertainty will resolve themselves and that we will be able to enjoy an economy that continues to move forward at a reasonable pace. Unfortunately, the level of uncertainty is high.
FASKIANOS: And there was a question in the—in the Q&A box about do you want to put a percentage on that, Brad, of what is that certain amount? Would you express it as a percentage? Plus, minus, standard deviation? Do you want to have—or do you want to just leave it as—
SETSER: I think any forecast would have to be, at this point, contingent on the resolution of the debt ceiling. And I don’t have a good forecast of that. I certainly hope that it’s resolved. If it is resolved, I think the chances of a recession are between one-third and a half.
FASKIANOS: Great. This has been a fantastic discussion. Thank you very much, Brad Setser, and to all of you for your great questions, written and raised. We will share a link to this webinar recording and transcript. You can follow Brad on Twitter at @brad_setser. And Brad also has a blog. It’s called Follow the Money. And you can subscribe to it on the CFR website. We will include a link to it when we send the follow-up note for this webinar. So you can follow what he has to say on a more regular basis. So, again, Brad Setser, thank you very much. I encourage you all to follow us. Go to CFR.org, ForeignAffairs.com, and ThinkGlobalHealth.org for more expertise and analysis. And do email us,
[email protected], to let us know how we can further support the important work you are doing. So, again, thank you all for being with us and thank you, Brad.
SETSER: Thank you.
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