The real impact of growing budget deficits - Ruchir Sharma

The bond market, not political will or ideology, will be the ultimate enforcer of fiscal discipline because investors will eventually refuse to fund unsustainable deficits at any price, forcing austerity through rate spikes.

“do you think the countries in Europe will start to pull back on government spending well I'm not sure that they're going to start to pull back but you know like on government spending because very few do it until they face a crisis what do you think will cause the crisis the bond market that you know when the bond market revolts we saw that in UK we and we're seeing some signs of that in France this year”

If the US budget deficit reaches 7% of GDP and an economic slowdown occurs, the deficit could spiral to 8-9% of GDP because tax revenues fall during slowdowns while government spending automatically rises, creating an unsustainable arithmetic.

“next year the you know when the budget deficit in America begins to hit 7% imagine what happens in America if there's an economic slowdown then the budget deficit gets to 8 to 9% of GDP because if you have a Slowdown then the revenue slow down spending automatically goes up”

Large budget deficits become problematic when auction sizes for government borrowing become so large that the market's ability to absorb them comes into question, creating a limit even for reserve currency holders due to the finite capacity of bond markets.

“yeah it's a problem just because of the fact that now we're getting to levels where we are borrowing so much that the auction sizes are also going to become much larger now and the Market's ability to absorb all this I think at some point is going to come into question”

Scandinavian countries like Sweden that became overextended in the 1990s with government spending at 70% of GDP faced a crisis, which forced them to pull back spending and become more fiscally disciplined, making them better examples of fiscal responsibility than current America.

“even in places like Scandinavia and staff that places like Sweden and all that that when they became very overextended in the 1990s and they faced a crisis even they were forced to pull back their government spending as a share of GDP had reached 70% and stuff in the early 1990s and they reached a crisis and then the good thing is that these countries uh are much more fiscally disciplined today compared to let's say America”

Having many zombie companies in the system leads to reduced efficiency because deadwood is kept alive by bailouts and easy money, preventing the exit of inefficient firms and the entry of new competitors.

“that's where you end up having so many inefficient companies that stay alive because of that asymmetry and then it prevents new companies from entering prevents new entrance uh from um entering the system”

The reserve currency status allows a country to run larger budget deficits than other countries, but this status is not permanent—the average duration is about 100 years, and it changes when the currency issuer becomes too indebted and the world's trust in that currency declines.

“if you are the reserve currency can you have as much budget deficit as you want uh for a while yes but eventually remember that the reserve currency is not a permanent status it's a long-term status but not a permanent status the average time that a country has been able to have the world's Reserve currency has been about 100 years or so every 100 years the world's Reserve currency tends to change”

The problem with evaluating debt is not the total level but the pace of acceleration—when debt extends too quickly over a short time horizon (5 years), you end up making bad loans and create instability.

“typically it's not the level of debt which matters but it's the pace of acceleration because if you uh extend too much debt over a short uh span of time uh often end up making bad loans and so the typical sequence which happens is that the private sector makes uh those mistakes which is that you see a big lending boom which takes place”

For the first 250 years of America's 300-year history, the nation did not run a budget deficit except during recessions or wars, with the norm being balanced books or surpluses, but from the 1970s this pattern began to change after the end of the gold standard removed fiscal discipline.

“if you look at the pattern Let's Take America as an example uh it's uh in it's 300 years or so of existence in the first 250 years America did not run a budget deficit except when there was an outright recession or there was like a war going on the norm was to balance the books or to run even surpluses then from the 197s that began to change why uh and I think that like in terms of that the Habit then some people B it to the fact that you had the end of the gold standards so the discipline went away”

Historical examples of reserve currency decline include the UK and Sterling in the 1950s-1970s and the French currency, where gradual investor retreat occurred as bond markets signaled that fiscal deficits had become unsustainable.

“well often it's not a Tipping Point it is the fact that it gradually happens over time but it generally is the you know when the investors the bond market they begin to say enough is enough we saw that with UK and Sterling uh in the 1950s 60s and finally they had a big crisis in the 1970s and before that we saw that with the French currency”

Until the 1970s, America rejected bailouts of private sector companies, with any proposal to bail out companies meeting fierce resistance in Washington, Congress, and state levels, marking a fundamental philosophical shift in capitalism.

“if you look at even America right up until the 1970s America believed that private sector companies are not meant to be bailed out and then when the first attempts at bailout happened in the 1970s there was a lot of resistance uh uh in uh Washington uh in Congress uh in the city state levels any talk of bailing out private sector companies was met with Fierce amount of resistance”

The Continental Illinois Bank bailout in 1984 was a landmark moment as the first major bailout of a financial institution in post-World War II America, after which every time there has been a problem in the financial system the government has bailed out institutions.

“that in 1984 was a landmark moment because that was the first major bailout of a financial institution in America that was the the Continental Illinois Bank and once that happened then every time there's been any problem in the financial system the government's been there to bail out”

Examples from UK sterling in the 1950s-70s and French currency history show that tipping points for reserve currency loss typically occur when bond markets gradually lose confidence and demand higher rates, rather than as a sudden discrete event.

“we saw that with UK and Sterling uh in the 1950s 60s and finally they had a big crisis in the 1970s and before that we saw that with the French currency so so we're not seeing it in the States now”

Productivity growth in America has been declining for the last 30-40 years despite incredible technology booms, with only a brief resurgence in the late 1990s and early 2000s during the tech boom.

“if you look at productivity growth and this is the great Paradox right which is that productivity growth in the last 30 to 40 years has been declining even though we've had some incredible technology booms through it uh and so I think that the only way that you can explain it is that because you've had this increased role of government in the last 30 to 40 years because productivity growth should be going up on the back of the tech boom and except for a brief period in the late 1990s and and early 2000s when you had the tech boom and you saw big increase in productivity yeah um otherwise productivity has been declining”

Bailout culture is a relatively recent phenomenon—up until the 1970s America believed private companies should not be bailed out, and proposals to do so met fierce resistance in Washington and Congress.

“this is relatively new Nikolai because if you look at even America right up until the 1970s America believed that private sector companies are not meant to be bailed out and then when the first attempts at bailout happened in the 1970s there was a lot of resistance uh uh in in uh Washington uh in Congress at the city state levels any talk of bailing out private sector companies was met with Fierce amount of resistance”

The Greenspan Put (originating in 1987 when the Fed explicitly cut rates after the stock market crash) created an asymmetric policy signal: on upside, policymakers claim they cannot predict bubbles so do nothing; on downside, they immediately intervene to support markets.

“the greenpan put was also very significant and this is the irony of it we associate the 1980s with this Golden Era of free markets and capitalism being Unleashed by Reagan and Thatcher and stuff that's the popular image and yet a couple of landmark moments which totally distorted capitalism happened in the 1980s...in 1987 for the first time when the stock market crashed the Central Bank explicitly cut interest rates and intervened to prop up the stock market and that created this feeling of a green span put which is that once again on like on the upside the policy makers say we don't know how to predict bubbles or when markets become too expensive so we'll do nothing about it on the downside if something happens we are here to clean up the mess”

For the first 250 years of America's existence, the country did not run a budget deficit except during recessions or wars; the norm was to balance the books or run surpluses, but from the 1970s onward this changed.

“in it's 300 years or so of existence in the first 250 years America did not run a budget deficit except when there was an outright recession or there was like a war going on the norm was to balance the books or to run even surpluses then from the 197s that began to change”

Unlike historical patterns, the current debt crisis is unusual because the private sector has not increased debt much in America (neither households nor corporations have borrowed heavily), but instead government debt has gone up exponentially, leaving no lender of last resort available if the government gets into trouble.

“this time what's happening currently is that the private sector has not increased debt that much in places like America if you look at the households even the corporate sector the increase in debt has not been that much but this time the unusual thing has been that the government which is supposed to be the lender of Last Resort that is where the debt has gone up exponentially and so now the problem is that if you get in trouble where the government uh debt becomes an issue you have no lender of Last Resort left because the government was supposed to be the lender of of Last Resort”

Capitalism without bankruptcy is like Christianity without hell—if you have capitalism you must accept risk, but current systems have socialized risk where government protects downside while allowing upside profits.

“capitalism without bankruptcy is like Christianity without hell which is the fact that if you have capitalism then you have to accept risk as well you cannot have a system like you have today where risk has been socialized where the you know where the governments are telling you on the upside you can make as much money as you want fine we will tax it you know when we have to but you can make all the money on the downside we are here to protect you so this is what you call the bailout culture”

The Greenspan Put, created when the central bank explicitly cut interest rates and intervened to prop up the stock market after the 1987 crash, established the expectation that policy makers would do nothing about rising asset prices but would always intervene to support falling prices.

“and then in 1987 for the first time when the stock market crashed the Central Bank explicitly cut interest rates and intervened to prop up the stock market and that created this feeling of a green span put which is that once again on like on the upside the policy makers say we don't know how to predict bubbles or when markets become too expensive so we'll do nothing about it on the downside if something happens we are here to clean up the mess”

Switzerland is among the world's richest countries and one of the 20 largest economies, and it successfully balances government spending and capitalist principles better than other developed nations, serving as a positive counterexample to France and Germany.

“one of the countries I speak about are countries like Switzerland where I say that here you know like it's the richest country in the world it is among the 20 largest economies and they seem to get the balance much correct in terms of their spending as a share of GDP there is no utopian Nation but uh they get the balance correct”

Housing prices have become unaffordable in America, with more than 50% of 20-year-olds living with their parents and high percentages of Americans believing they cannot achieve the American dream of home ownership, which Sharma identifies as the leading symbol of capitalism's failure.

“if I were to say what's the leading symbol of what went wrong with capitalism it is housing prices that in places like America it is unaffordable to buy a new home uh the number of 20 year olds who are living in with their parents today is more than 50% the number of Americans who say today that you know that they'll not be able to realize their so-called American dream of having their own home is staggeringly high”

Home prices have risen dramatically due to excessive regulation that makes it very difficult to build new homes, creating a supply shortage, combined with easy interest rates that drive high demand, resulting in a massive supply-demand mismatch.

“and one of the big reasons home prices have gone up a lot is because uh you have so much amount of Regulation that it's very difficult to build new homes now and so Supply is very short on the other hand if you have very easy interest rates then the demand is very high for for for home so you got this massive mismatch”

An asymmetric risk-reward system where governments protect downside but allow unlimited upside leads to too many inefficient companies staying alive, which prevents new companies from entering the market and prevents new entrants from competing.

“that's where you end up having so many inefficient companies that stay alive because of that asymmetry and then it prevents new companies from entering prevents new entrance uh from um entering the system”

Sweden and Scandinavian countries faced a crisis in the 1990s when government spending reached 70% of GDP, were forced to pull back, and are now much more fiscally disciplined than America as a result.

“places like Sweden and all that that when they became very overextended in the 1990s and they faced a crisis even they were forced to pull back their government spending as a share of GDP had reached 70% and stuff in the early 1990s and they reached a crisis and then the good thing is that these countries uh are much more fiscally disciplined today compared to let's say America”

The end of the gold standard in the 1970s removed fiscal discipline, allowing a culture to develop where governments believed they could run budget deficits with no consequences.

“I think that like in terms of that the Habit then some people B it to the fact that you had the end of the gold standards so the discipline went away and then this culture sort of crept in which is that you can run budget deficits and there are no consequences to it”

Budget deficits become a problem when they reach levels where borrowing is so large that auction sizes become much larger and the market's ability to absorb this debt comes into question.

“it's a problem just because of the fact that now we're getting to levels where we are borrowing so much that the auction sizes are also going to become much larger now and the Market's ability to absorb all this I think at some point is going to come into question”

The current US economic growth is artificially inflated by deficit-funded spending, and investors are being misled because the growth appears healthy while the underlying deficit situation is unsustainable, contradicting the historical pattern where full employment has coincided with only 1-2% deficits.

“I think that investors are being misled because a lot of this deficit today is artificially funding the growth so the economic growth in America looks pretty good and you think that what's the problem but I think that because it's being funded by the deficit because usually in the past when America has been at this stage of the economic cycle where the unemployment rate has been this low the budget deficit has historically been only 1 or 2% of GDP today you have full employment virtually in America and a deficit of 6 to 7% of GDP so this is I think uh an unsustainable situation”

Zombie companies—defined as firms that cannot make enough profit to cover their interest expenses for three consecutive years—were roughly 2% of listed companies in America in the 1990s but now comprise approximately 20% of all listed companies according to BIS estimates.

“you know uh this term zombie companies first became popular in Japan and the 1990s uh when um and if you read the Western press then or of even the American Press and staff they would almost be scornful that you know these zombie companies which are defined as companies that don't even make enough profit to cover their interest expenses for three years in a row that these companies exist in places like Japan it's not in in in like America they don't exist now in the 1990s zombie companies were roughly 2% of the total amount of listed companies in places like America today by some estimates such as the bis the number of zombie companies is close to 20% of the total number of listed companies in places like America”

During the pandemic, governments shut down economic activity and provided massive stimulus, causing asset price inflation that minted a huge number of new billionaires despite people staying home, demonstrating that the stimulus enriched asset holders rather than supporting real economic activity.

“during the pandemic when I saw what governments did which is that to shut everything down and then to say that we will just give massive amounts of stimulus and you can sit home and and in terms of it it does not matter and then that stimulus is what led to this huge amount of asset price inflation where in 2020 the number of new billionaires which were minted by people sitting at at home was incredible because because stock markets went up asset prices went up”

No bailouts is actually a populist measure that is good economics, because bailouts are deeply unpopular with average people, and the 2008 bailouts, while possibly necessary for the banking system, were very unpopular and contributed to anti-establishment sentiment and anger.

“here is one populist measure which I think is good economic ICS if you say no bailouts because bailouts remember are very unpopular with the average person the 2008 bailouts you can argue that they were required of the banking system they were very unpopular with the average American they were because they saw their small Community Banks fail and yet they saw these large Banks getting bailouts and that I think SED the seeds for so much of the anti-establishment feeling the anger that we have today”

The US is not currently showing explicit signs of reserve currency stress, but the turning point could come rapidly when interest expenses become very high and investors demand much higher interest rates to lend to the government, forcing a fiscal contraction.

“we're not seeing it in the States now yeah there is no sign of it now at least explicitly uh there other issues I address in the book as to what are the consequences of the government action which are leading to lower productivity growth and which are undermining economic growth well one of the things that that could cause a moment where investors just decide listen we want to have a much higher price to lend money to a country right so I think that generally when the interest expenses become very high that a lot of the budget now goes to just paying off your interest expenses and the price of money is also changed”

Productivity growth in the US has been declining for 30-40 years despite incredible technology booms, with the exception of a brief period in the late 1990s and early 2000s during the tech boom, indicating that technological progress is not translating into economic efficiency gains.

“well no um not everywhere else but core Europe at least because if you look at France Germany productivity growth is much lower than than even America in America too productivity growth has been declining for the last 30 to 40 years but in Europe it's a lot more why is this the case because as somebody said that Europe is really the Silicon value of Regulation uh like in America as we know that they're trying to now uh go after too much regulation we know that regulation has been a big burden on small to midsize businesses in Europe the regulatory burden is far higher similarly like in Europe government spending as a share of GDP is far higher”

Debt as a total quantity is less important than the pace of debt acceleration, because rapid debt growth over short timeframes (5 years) leads to bad lending decisions, the typical sequence being a private sector lending boom followed by crisis and government bailouts.

“what when is debt a problem and here's you know what I I found and something I've written about in my previous books that typically it's not the level of debt which matters but it's the pace of acceleration because if you uh extend too much debt over a short uh span of time uh often end up making bad loans and so the typical sequence which happens is that the private sector makes uh those mistakes which is that you see a big lending boom which takes place which is what we saw in America and in Europe in the 2000s uh it was mainly into the housing markets and then be if the pace of growth is very sharp over a 5-year time Horizon you end up making lots of bad loans”

The 1980s are popularly remembered as a golden era of free markets and capitalism under Reagan and Thatcher, but in reality several landmark distortions to capitalism occurred, including the Continental Illinois bailout (1984) and the Greenspan Put (1987).

“we associate the 1980s with this Golden Era of free markets and capitalism being Unleashed by Reagan and Thatcher and stuff that's the popular image and yet a couple of landmark moments which totally distorted capitalism happened in the 1980s we spoke spoke about the bailout of Continental Illinois in 1984 which was a landmark as the first major bailout of a financial institution in post World War II history and then in 1987”

Greece, despite becoming the poster child of economic crisis in Europe, actually underwent genuine fiscal reform after its crisis and has become a success story compared to countries like Japan and Italy that didn't face a crisis and continued extending and pretending.

“the poster child of an economic turnaround story in Europe has been Greece that Greece at this time last decade we were all what it sick about Greece and the crisis in Greece they were forced to cut back but but they faced a crisis the problem is if you don't face a crisis then you can keep on extending and pretending that's what Japan has done that's what Italy has done so it's almost sometimes better to have a crisis to force change because then the society the people understand the reason for cutting back and for change if you don't have an outright crisis even if the problem is Insidious in nature there is no incentive to cut it back”

America is now at a point where it thinks it can run whatever budget deficit it wants and the rest of the world will keep funding and financing it, which is becoming ridiculous and echoes the patterns seen with UK and Sterling in the 1950s-1970s and French currency historically.

“I think that with America we are now getting to that point where this has become a bit ridiculous where America thinks that they can run whatever budget deficit they want and the rest of the world will keep funding it and financing it... we saw that with UK and Sterling uh in the 1950s 60s and finally they had a big crisis in the 1970s and before that we saw that with the French currency”

The government's current large budget deficits are artificially funding economic growth, so the economic growth in America looks good but masks an underlying problem—historically, at this stage of the economic cycle with unemployment this low, budget deficits would be 1-2% of GDP, not 6-7%.

“I think that because it's being funded by the deficit because usually in the past when America has been at this stage of the economic cycle where the unemployment rate has been this low the budget deficit has historically been only 1 or 2% of GDP today you have full employment virtually in America and a deficit of 6 to 7% of GDP so this is I think uh an unsustainable situation”

The 1984 Continental Illinois Bank bailout was a landmark moment—it was the first major bailout of a financial institution in America, and every time there has been a financial problem since, the government has been there to bail out.

“1984 was a landmark moment because that was the first major bailout of a financial institution in America that was the the Continental Illinois Bank and once that happened then every time there's been any problem in the financial system the government's been there to bail out”

Government policies leading to lower productivity growth and undermining economic growth are consequences being addressed in Sharma's book, suggesting fiscal policy and government intervention are suppressing productive capacity.

“there other issues I address in the book as to what are the consequences of the government action which are leading to lower productivity growth and which are undermining economic growth”

The reserve currency is not a permanent status but a long-term one, with the average tenure of a country as the world's reserve currency being approximately 100 years, and changes occur when the issuing country becomes too indebted and extended, causing the world's trust in that currency to decline.

“but eventually remember that the reserve currency is not a permanent status it's a long-term status but not a permanent status the average time that a country has been able to have the world's Reserve currency has been about 100 years or so every 100 years the world's Reserve currency tends to change what will make it change when that firey becomes too indebted it becomes too extended and the world's trust in using that currency as a reference declines”