Paul Diggle
Hello and welcome to Macro Bytes, the economics and politics podcast from Aberdeen. My name is Paul Diggle.
Luke Bartholomew
And I'm Luke Bartholomew.
Paul Diggle
Fiscal policy is increasingly supplanting tariffs as issue number one for markets, with the US Congress debating the so-called ‘One Big Beautiful Bill’ tax cutting legislation; markets worrying about some of the specific provisions within that bill; question marks over quite how much revenue tariffs will bring in; Elon Musk leaving his role at the cost-cutting Department of Government Efficiency; and bond yields not just in the US, but globally, increasing. So today on the pod, we are going to be discussing all things fiscal policy and bond yields. And I think the place to start, Luke, is with just a little bit of fiscal scene setting up because the US Congress is currently actively debating the ‘One Big Beautiful Bill Act’, the O-B-B-B-A, which is Trump's fiscal legislation – tax cutting and some spending cuts. It narrowly passed in the House. It's now being debated by the Senate. The bill involves extending many of Trump's first-term tax cuts, those previously contained within the Tax Cuts and Jobs Act, making them permanent rather than temporary as they were previously; going further and cutting some of the taxes Trump spoke about on the campaign trail. In particular, things like tax on overtime and on tips, making state and local tax deductions more generous. And it involves net spending cuts as well – things like introducing Medicaid work requirements, which will reduce the amount of Medicaid payments; reducing food stamps; scrapping some of the Biden-era clean energy subsidies. But there are also spending increases in their targeted administration priorities, such as border enforcement and deportations.
Luke Bartholomew
Yeah. So, as you say, Paul, the bill is currently being debated in the Senate, where it's worth saying the Republicans have a slightly larger majority than they do in the House -- so 53 to 47 seats. And they also have the tie-breaking vote with the vice president's vote as well. But so, it is plausible that some of the things that you were discussing there, some of those provisions, Paul, could get changed, as it’s debated in the Senate. But it's not obvious which way those changes will swing in terms of making the bill bigger or smaller in terms of its fiscal consequences. There are some senators who are certainly quite concerned about the deficit implications of the package, [xx] would like more, quote unquote, fiscal conservatism. And perhaps one place that the Senate could reduce the deficit implications is going after the state and local tax deductions, which I think are more important to House members, typically, than in the Senate. But it's also worth saying that there are a number of senators, in fact, potentially even more senators, who have concerns about the Medicaid work requirements that are included in the House provision, which tend to harm Republican voters. And so, they may try to dial back on those, which would increase how much the bill pushes up on the deficit. But look, I mean, what is crucial to remember is that any changes that are made in the Senate then would have to be ratified again in the House. And the Republican majority in the House is extremely slim, and the marginal voters, the ones that would determine whether it passes or not, are ultimately, those who are quite fiscally conservative. So, I think the broad quantum of the package will end up having to stay roughly where it is. Some of the provisions may change, but the overall deficit implications are unlikely to move that much. That's just what's required to get this through both houses of Congress.
Paul Diggle
And let's talk some specific numbers. All told, the act according to nonpartisan bodies who've added up the numbers, estimated these things add something like $2 to $3 trillion to US public sector debt over ten years. So, that might mean increasing the deficit from its current 6%, 6.5%, make it larger still, adding perhaps 5% to 10% on US public sector debt over ten years. And depending on quite how you measure it, US debt is currently about 120% of GDP. So, we're talking big numbers. But as we'll get into, the exact size of this impact is going to depend on many things: the final size of the bill, given that to- and fro-ing between the House and the Senate, Luke, that you were talking about; offsetting tax revenue; prevailing interest rates; growth; and much more besides.
Luke Bartholomew
Yeah, and as you say, a crucial component is the offsetting tax revenue from tariffs. And of course, that's been extremely uncertain for the last couple of months now in terms of where tariffs will end up as they've been announced and taken off again, negotiations have occurred, deals have maybe been done, or not. And then to add to that, uncertainty has been brought into legal proceedings. And most recently, a court has ruled that the International Emergency Economic Powers Act, so-called IEEPR, which the Trump administration had used to put in place many of the tariffs, including the ‘reciprocal’ tariffs, the fentanyl tariffs, could not be used as the Trump administration was using them. Now that ruling has been delayed in terms of its implementation, whilst it gets litigated through the courts and it's likely to get all the way to the Supreme Court. It's not clear how the Supreme Court rule, we've been given to understand that the legal arguments overturning Trump's ability to use IEEPR are strong, but the Roberts court has so far been pretty deferential to claims of presidential authority. And for what it's worth, there is a 6-3 majority of Republican-appointed judges on that court. So it is far from clear how the Supreme Court will end up ruling on that.
Paul Diggle
Yeah, and in any case, Trump has other tariff-setting powers: Sections 232, 301, 122. Some of those are legislation that he's used previously to impose tariffs during the first term, which he's used, some [xx] the second term tariffs. The administration will not be giving up on tariff policy, even if the Supreme Court ruling on Trump's ability to set tariffs under IEEPR goes against him. We still expect, I still expect, US weighted average tariff rates to be settling around their current 12%, perhaps moving slightly higher from where they are now.
Luke Bartholomew
Yeah, and so that represents about a 10 percentage-point increase in the average effective tariff rate, from when Trump entered office. And that clearly will raise some revenue. And then the question becomes how much of that revenue increase is then used to compensate losers from the tariffs, or indeed, losers from a broader trade war that comes about because tariffs are imposed by other trading partners. And that's exactly what happened during the first term with various agricultural subsidies to help the agricultural industry during the trade war back then. And, you know, that's kind of what you might expect through standard political economy considerations. And then how much is actually banked to offset the, the One Big Beautiful Act. And all told, it's probably reasonable to think that something like a third of the revenue raised by tariffs will have to be used as subsidies to support various industries. So, two-thirds, as it were, going into the treasury. And I think, as you say, Paul, that probably leaves the fiscal deficit somewhere between six-and-a-half to 7%. And the thing to say about that number, to really stress, is that that is extremely large for this point in the economic cycle, when we are effectively at full employment. You know, this would normally be the time where you'd expect very low deficit, an attempt to reduce deficit and debt. Not to be running, you know, what is on some measures, pretty unsustainable fiscal policy. And look, plenty of people have noticed that, everyone from Elon Musk to the bond market itself.
Paul Diggle
Yeah. Well, let's talk about Elon Musk and his leaving the administration in his role at the head of DOGE, the Department of Government Efficiency. We did a whole previous podcast, I think we called it: DOGE - More Bark Than Bite, question mark. And I think we now know the answer to that question is, yes. We are always somewhat dubious about the extent of spending cuts, and federal reorganisation more broadly, that was going to stem from DOGE, although it is important, I think, to acknowledge that some very big things have happened – the cutting of USAID; we're now seeing a definite drag from federal employment in the payrolls data, and that will get bigger before it gets smaller, because too many federal government employees affected by those cuts are on paid severance, which will eventually turn into job losses over coming months. So that federal government drag from DOGE is going to get bigger.
Luke Bartholomew
Now, in some senses, the fallout between Musk and Trump is the most predictable, and predicted, thing that has ever happened. It is on some senses, deeply over explained, I mean, there are, outside of the various personality issues between the two, and the difference is, of interest. You know, quite different views on, so, we’ve discussed matters of fiscal policy, where I think Musk was quite in earnest in wanting tighter fiscal policy and having genuine concerns about the inflationary implications of budget deficits and the impact of debt on growth; but also on immigration policy; energy policy; China policy; trade policy. These are all things where Trump, you know, we've sort of talk [xx] him in the past as being on the side of the angels on some of those questions in the Trump administration. And now he is outside of the administration, you have to believe that despite his wealth; his threats of backing alternative candidates; the threats of funding and founding a third party that has political influence on those kinds of questions, is likely to diminish. Even as it remains extremely large, given X, Starlink, Space X, which, as we've discussed before, do have geopolitical aspects to them, as well.
Paul Diggle
Yeah, I wouldn't rule out that Musk's particular concoction of tech futurism and libertarianism, doesn't have a political constituency in the US. Obviously, Musk himself was born outside the US – it prevents him from running for the highest office in the future. But you know, he is a popular figure, both politically as well as in business. What we can say for more certain, I think, is that at the margin, we should expect less in the way of federal spending cuts now that he is outside the administration. And I think that should confirm that any thought that this is an administration concerned about deficits and going to reduce them is for the birds, frankly. Deficit reduction is not, I think, a priority of Trump's, in a way that trade deficit reduction is. It's, in general, not a congressional Republican priority, or at least not in practice. And that, of course, is despite Treasury Secretary Scott Bessent laying out a policy platform that included aiming for a 3% US fiscal deficit. I think at this point, getting to that kind of fiscal deficit, which, you know Luke, given your point about the economy being at full unemployment, is a, would be a much better, healthier position to be in, now requires perhaps some sort of big rebellion from the bond markets. We've spoken, again on a previous podcast, about the ‘bond vigilantes’, this idea that markets can constrain government policymaking, especially [xx] fiscal policy. And it may be that, at this point, that is the only way in which we get a reduction in the size of fiscal deficits – not through normal legislative means.
Luke Bartholomew
And, yeah, once the bond vigilantes, so-called, have not staged that ‘rebellion’, as you put it, Paul, I mean, they do I think, look like they are noticing what is going on on fiscal policy. Bond yields are rising not just in the US but in the UK and Japan. And that's been especially so in longer-maturity bonds, say, 30 years or so. And that's exactly where you might expect concerns about fiscal policy to show up. I mean, for example, the 30-year US Treasury yields have risen from just below 4% pre the election to now, pushing 5% or so. And it's important to stress that that isn't really about changing views about Federal Reserve or other central bank interest-rate expectations, which of course can push interest rates around. But very much about the so-called term premia component of bond yields. And term premia, as we’ve discussed on the podcast before, is the extra compensation that investors demand to hold government bonds above and beyond just their expectations around where policy interest rates will go. And for a variety of reasons, these were extremely low for much of the post-financial crisis period. Indeed, they were negative in the US. So there's a sense almost, in which, investors were paying Treasury, the US Treasury, for the privilege of holding US government debt, given the various properties that it had in terms of an insurance product. But that term premia is getting higher. It's moved up to about 1% or so, which is still low by historical standards, which is maybe an average of 3% or so on the US 10-year. And indeed, there are good reasons for thinking it could increase further, perhaps not all the way to that 3%, but certainly reasons to move higher from here -- inflation volatility is likely to be higher; higher policy uncertainty; the shifting bond-equity correlation, all of which are reasons for pushing up on term premia. And of course, as we've been discussing, higher bond issuance given these fiscal developments. So that doesn't itself have to be concerns about fiscal sustainability. It's just the fact that when very large deficits are being run, a lot of bonds have to be issued. Investors have to hold those bonds. And you can think of it in normal supply-demand dynamics – higher supply requires a lower price to clear. And that lower price shows up as a higher term premium. But then the point is, and this is where, sort of, some self-reinforcing dynamics can kick in, that higher term premia that starts off as just being about issuance suddenly increases the financing costs for governments. It costs more to issue all of that debt, which then, in turn, puts upward pressure on fiscal policy. And so, you can find yourself in a situation where higher interest rates begets more borrowing, which in turn, begets higher interest rates.
Paul Diggle
And I think another development is adding to that upward pressure on term premia on long-end bond yields is that there are fewer natural, or captive, buyers of long-term government debt. So, pension funds, life insurance companies, institutions who are managing a complex set of assets and liabilities, were during the period of ultra-low interest rates, almost forced buyers of long-term government paper, long-term debt, because they needed to match their growing liabilities – the future pension payments, for example, are increasing, the present value of those were increasing as interest rates fell – with fixed-yielding assets, aka government bonds. So, they were natural buyers of the long end of bond yield curves, especially so as interest rates fell a sort of self-reinforcing way. Now with much higher interest rates, many of those same institutions are in surplus, not in deficit. They don't have the same pressure to match their assets and liabilities, and therefore, they're therefore, buying less in the way of long-term government bonds. And this is the development, not just in the US, but notably in the UK, in Japan. It is, I think, another way in which upward pressure on long-term yield curves is playing out, and it's even affected what many treasuries and finance ministries plan to do in terms of their bond-issuance schedule. So previously, the conventional wisdom had been it's attractive to issue a lot, if you’re the government raising capital, at the long end of bond yield curves, term out future repayment obligations. But increasingly now, the thinking and announcements from the likes of the Japanese Ministry of Finance is that that will mean there'll be more short-end bond issuance to avoid these pressures at the long end [xx] bond yield curves.
Luke Bartholomew
And the other bit of conventional wisdom that's been challenged recently, Paul, is the idea that fiscal policy typically be supportive of growth and risk assets; that tax cuts, spending increases, should push up on growth, that should be supportive for asset markets. But in this environment of rising term premia that we've been discussing, that's much less obvious. And again, we've talked about how the deficit is extremely large at this point in the cycle, that we are a full employment economy, effectively in the US. And in a sense, you really shouldn't expect fiscal policy to be that growth boosting in that kind of environment, there aren't really the spare capacity, the resources, to put to work through easier fiscal policy. It's one thing when unemployment is high, we've just been through a recession, the spare capacity, tax cuts and spending increases can mobilise that capacity. But when it's already being mobilised in a full-employment economy, that's less clearly the case – there has to be crowding out. That effectively what happens through fiscal easing is there is a redistribution of resources across the economy rather than a bigger economy. And the very mechanism through which that crowding out occurs is through higher interest rates, both policy interest rates and the term premia. And that is what is playing out now, what is going on in bond markets, you can think of as being just that crowding out mechanism that you should expect to play out in the full-employment economy, limiting the growth upside from this policy and also, therefore, the impact it should have on risk sentiment as well. Because, ultimately, long-run growth isn't determined by fiscal policy stimulus. It's through the supply side of the economy, the productivity and the amount of resources we have. And if you are being really generous, you could argue that some parts of this Big Beautiful Bill Act could boost the supply side. Perhaps through deregulation, lower taxes on some work could encourage an increase in labour supply, the corporate expensing provisions could encourage investment. All of this could be supply expanding. But I think that that would be a relatively generous reading. It's far from obvious that those effects would dominate, at least in the short term.
Paul Diggle
Well, the other part of the bill, another part of the bill, which could harm US long-term growth potential and which is increasingly now an object of market interest is this section called Section 899. So, it's buried deep within the 1000 pages of the One Big Beautiful Bill Act, but this is an obscure sounding but extremely important part of the bill because it would give the US Treasury the ability to impose withholding tax – tax on profits of US-derived income of foreign residents, foreign corporates, maybe even other sovereigns, especially where those foreign countries impose certain taxes that the US itself does not like, things like digital services taxes. But as we’ve said earlier on, there’s still a lot of water to flow under the bridge during the congressional back and forth on the bill. It's quite possible that this section, Section 899 is changed a lot or perhaps even struck down by the Senate parliamentarian for various arcane procedural reasons. But I think it is super important, if it makes it through, because it may raise the corporate tax rate effectively, the corporate tax rate on corporates around the world, many of which derive a significant share of their income from the US. And while the sense in which it could be used to tax Treasury holdings of foreign sovereigns seem to to be being cleared up, it's not going to be used in that sense, it's nonetheless a potentially very important change in the nature of the global corporate tax system. In extremis, it's just another factor playing into the sense of fading US exceptionalism and the US as a systematically less attractive place to deploy capital and do business. So, by watching the progress of fiscal policy, don't just look at the macro impacts on bond yields term premia, the size of the fiscal expansion, but also track this particular Section 899 – very important part of the legislation.
Luke Bartholomew
All right. Well, I think that is a great place to end there, Paul. So as ever, listeners, please forgive me if I ask you to like, subscribe, if you have not already done so, wherever it is you get your podcasts. And then all that remains is for me to thank you all for listening. So, thanks very much and speak again soon.
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