The following article is based on our recent FS Insider podcast: Lyn Alden on Fiscal Dominance, Structural Deficits, and the Unfolding Economic Cycle. If you’re not already a subscriber to our FS Insider podcast, click here to subscribe.
In a recent interview with FS Insider, Lyn Alden, founder of Lyn Alden Investment Strategy and author of the highly acclaimed book Broken Money, delved into the pressing issue of fiscal dominance and its profound impact on monetary policy effectiveness. As the markets now assess the implications of a 50-basis point cut by the Federal Reserve—the first cut in over 2 years—Alden provides a thought-provoking analysis of why traditional monetary tools may no longer wield the influence they once did.
The Shift from Monetary to Fiscal Dominance
"The argument that I've been making is that fiscal policy is more impactful in the current era than monetary policy," Alden stated. She highlighted a significant shift in the economic landscape: fiscal deficits are now larger than the annual net new bank loan creation.
Investors have grown accustomed to decades of "monetary dominance," where central banks could steer economies through adjustments in interest rates. However, Alden points out that we haven't seen a situation like the current one since the 1940s. "We're running structurally 6% to 7% of GDP deficits during an economic expansion," she noted, emphasizing that such large deficits during growth periods are unprecedented in modern times.
The Ineffectiveness of Traditional Monetary Policy
Alden observed that the Federal Reserve's aggressive rate hikes have not had the expected impact on the economy. "A lot of investors have been shocked by the Fed's ability to raise rates to over 5% in this cycle and not cause a recession yet," she said. One key reason is the nature of private sector debt. "So much private sector debt is fixed-rate and locked in," Alden explained, meaning that rate hikes don't significantly affect existing loans.
Moreover, raising interest rates in a high-debt environment can have counterintuitive effects. "When you have very high debt-to-GDP levels... if you raise interest rates, you increase the deficit due to the interest expense channel," Alden pointed out. This can make deficits "inflationary, all else being equal," because higher interest expenses add to government spending without corresponding increases in productivity.
Comparing the U.S. to Japan
Looking abroad, Alden cautioned against making direct comparisons to countries like Japan, which have managed high debt levels differently. "Japan has very high public debt-to-GDP and very problematic demographics... but they ran decades of structural trade surpluses," she noted. This positions Japan uniquely compared to the U.S., which does not enjoy the same trade benefits and faces different demographic challenges.
"Both Japan's future is more inflationary than we've grown accustomed to... and the rest of the world is going to run into problems before they get to Japan's level because they don't have that strong of a hand," Alden warned.
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Anticipating an Economic Malaise
When discussing the likelihood of a recession or a soft landing, Alden suggested that we might experience something different altogether. "I think the United States is likely going to go through some sort of economic malaise. I think we already are for the bottom half of the population," she said.
Instead of a dramatic recession characterized by high unemployment, Alden predicts a period of stagflation—slow growth coupled with persistent inflation. "Recessions look different under periods of fiscal dominance... they tend to be more stagflationary type of recessions," she explained. In such scenarios, people may not lose their jobs en masse, but they'll find their wages don't stretch as far due to rising costs.
Investment Implications in a Stagflationary Environment
Given this outlook, Alden outlined several investment strategies that could outperform in the coming years.
Emerging Markets Poised to Benefit
Alden sees potential in emerging markets, particularly in Latin America and Southeast Asia. "Interest rate cuts of that magnitude are relatively immaterial when it comes to forecasting recession risk... but 50 or 100 basis points would do quite a lot to alleviate some of the pressures on emerging markets," she stated. These regions often carry dollar-denominated debt, and a weaker dollar could provide significant relief.
"Relatively minor cuts to interest rates probably are not going to cause a lot of mortgage activity... but they could really boom emerging markets," Alden added, drawing parallels to the post-2001 recession period.
Gold and Bitcoin as Safe Havens
Alden is also bullish on gold and Bitcoin as hedges against inflation and currency debasement. "Generally speaking, when you have decades that are more inflationary, those are decades where neither stocks nor bonds historically do particularly well," she noted.
She pointed out that gold has held up well despite high real interest rates. "It's been interesting how well gold held up... I think that as we go forward, we're going to have less of a headwind of so high positive real rates," Alden said.
As for Bitcoin, she views it as a "modern version of gold," highlighting its lower supply inflation rate and global portability. "I think that's still in a structural growth phase until it reaches whatever its total addressable market might end up being," Alden remarked.
Caution with Overvalued Stocks
Alden warned investors about overvalued sectors in the current market, particularly big tech stocks and companies perceived as "safe." "Investors are ironically paying up for safety," she said, citing examples like Costco trading at over 50 times earnings.
"You can turn a safe investment into an unsafe investment if you overpay for it," Alden cautioned. She suggests that investors willing to accept near-term volatility might find better opportunities in carefully selected emerging markets or undervalued small and mid-cap stocks.
The Intractable Nature of Fiscal Dominance
One of the critical takeaways from Alden's analysis is the structural entrenchment of fiscal dominance in the U.S. economy. "I think it's locked in," she said about continued government spending. Demographic trends, such as the aging baby boomer population drawing on Social Security and Medicare, make significant spending cuts politically unfeasible.
"Any attempt to meaningfully cut Social Security or Medicare is kind of a non-starter," Alden stated. She also pointed out that military spending is unlikely to decrease given the current global geopolitical tensions. "I don't think there's a big appetite for a substantially reduced military budget either. If anything, the opposite."
Conclusion: Navigating a New Economic Paradigm
Lyn Alden's insights present a sobering view of the economic challenges ahead. With traditional monetary policy tools losing their efficacy due to fiscal dominance, investors and policymakers must adapt to a new paradigm.
"These fiscal issues have impacts domestically, but when we look out globally, they have other impacts, sometimes in the other direction," Alden observed. As the U.S. grapples with high debt levels, structural deficits, and an aging population, the path forward will require careful navigation.
For investors, this means rethinking traditional portfolios and considering assets that can weather a stagflationary environment. Emerging markets, commodities, gold, and Bitcoin are among the areas Alden believes might offer better returns in the years to come.
To listen to this full audio interview, see Lyn Alden on Fiscal Dominance, Structural Deficits, and the Unfolding Economic Cycle. If you’re not already a subscriber to our FS Insider podcast, click here to subscribe.
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