PremiumSINGAPORE : That this has been a year of unexpected and extraordinary twists and turns will be an understatement. But the year is not over yet and, by the way, there is a presidential election in America on 3 November. It is now conventional wisdom to predict that the US might face chaos after the election due to an inconclusive outcome.
Donald Trump, the sitting President, feels that postal ballots are a problem and that it is subject to rampant fraud. Hillary Clinton, a former presidential candidate, has advised the Democratic party’s nominee, Joe Biden, not to concede on election night, because postal ballots would take time to count.
Victory by a comfortable or a landslide margin for Joe Biden is likely to lead to a smooth transition of power as that would render complaints by the incumbent on ballot-frauds moot. In the event of Trump’s re-election, riots could break out on a far bigger scale than those that followed the killing of George Floyd.
Equally, if the victory margin for Biden is narrow and if there are widespread allegations of voter fraud in postal and in absentee ballots, the election result might have to be adjudicated by the supreme court and until the verdict is out, President Trump might not concede the elections. If uncertainty and confusion prevail post 3 November, it raises many risks for the global financial markets. Instability in financial markets could also arise from the reactions of China to such emerging uncertainty in America.
An inconclusive US presidential election will be the third confirmation for China that its time has come, after the financial crisis and the massive toll that the pandemic has extracted out of America. An emboldened China could be aggressive – militarily and otherwise. Here, both India and Taiwan are particularly vulnerable.
Of course, the US dollar will bear the brunt of the fallout of a leaderless and rudderless America.
In March, in the immediate aftermath of the outbreak of the pandemic, the US dollar strengthened as risk appetite gave way for risk aversion in global financial markets. Then, once the US Federal Reserve began to respond aggressively to the sharp economic slowdown and the rapid rise in unemployment by cutting interest rates to zero quickly and committing to buy financial assets, the dollar began to lose ground.
As risk appetite picked up in the subsequent months, the dollar continued to remain weak. In August, at the virtual Jackson Hole summit, Jerome Powell, chairperson of the US Federal Reserve, announced a new monetary policy framework.
America would allow inflation to rise above 2% and persist at a higher level to make up for sub-2% inflation in prior years. Similarly, it would allow the unemployment rate to probe new lows while leaving the maximum employment level undefined. This marks the end of the Phillips Curve unemployment-inflation trade-off (the claim that those two entities have a stable and inverse relationship) that has guided monetary policy in the country for the last four decades, if not longer.
During the Bretton-Woods era, the US dollar had a formal role as the anchor of the global monetary regime. Once that was dismantled, the future of the dollar’s status came under a cloud and geopolitical developments in the 1970s along with two oil price shocks and double-digit inflation further stoked concerns.
Even though America did not have a formal inflation target until recently, the Federal Reserve, under Paul Volcker, risked two recessions in two years to lower the inflation rate in the 1980s. That restored confidence in the US dollar and cemented its role as the anchor of the global monetary system in the post-Bretton Woods era. The dollar’s stature as the global monetary anchor survived all the other shocks that came after that.
However, purchases of junk bonds, targeting of average inflation rate and undefined maximum employment may be one shock too many to the US dollar as the new monetary policy completes the dismantling of the earlier Volcker legacy.
To be sure, other countries are not lagging behind. Low interest rates and asset purchases by the central bank are more the norm than the exception in the developed world. Reportedly, the European Central Bank too is contemplating allowing the inflation rate to stay above 2%. But political unanimity in America behind dollar debasement and the Federal Reserve’s deflation-phobia (in contrast to Germany’s inflation phobia) makes the US dollar exceptionally vulnerable.
Clash of economic ideology
President Trump, in his first term, had thrown his weight behind easy monetary policy, a rising stock market and a weaker dollar. The Democrats, on their part, are advised by economists who swear by the Modern Monetary Theory (MMT). They see in it the answer to America’s social and economic divisions. In reality, the theory is neither modern nor monetary and, in fact, it is not a theory itself.
In a country with low inflation and low interest rates, especially with a global reserve currency, proponents of MMT believe that the natural interest rate must be zero and that government spending could be easily financed by the central bank. They advocate fiscal policy intervention to manage the inflationary consequences of the pursuit of MMT, should they arise. They favour regulatory policies to control credit growth in the economy.
This policy is untested so far. However, in an economically stagnant and socially-divided America, an open-ended financing of government spending by the Federal Reserve could result in a vote of no-confidence on the US dollar.
The Democratic Party is backed by millennials (those born between 1981 and 1996) who have been hurt the most by the pandemic. Jobs lost by youngsters in the workforce far exceed the job losses for other age groups.
Millennials shoulder a big student debt burden and hence they favour redistribution and socialist policies. In the 2016 elections, they favoured Bernie Sanders. Again, in 2020, he was their favoured candidate. Clearly, they prefer socialism to capitalism. They would like to see a return of labour pricing power. That is a potentially troublesome backdrop for the next president.
Previously, pandemics have resulted in a rise in wages (Longer-run Economic Consequences Of Pandemics, NBER Working Paper No. 26934, April 2020). Labour supply had dwindled as the working-age population was ravaged by viruses. This time, the virus has spared the working-age population. Second, the supply of women’s labour has gone up as many of them have lost their jobs (The shecession (she-recession) of 2020, September 2020, VoxEU). Therefore, the wage dynamic of covid-19 will be different from earlier pandemics.
So, wages are unlikely to rise and hence the pandemic impact is deflationary rather than inflationary. Consequently, a return of inflation is not an immediate threat to American financial markets but policies pursuing it will be.
Amid job uncertainty and subdued wages that firmly restrain inflation, the Federal Reserve will try harder with its asset purchase policy, zero interest rate, forward guidance on the continuation of zero interest rates, and so on. It may even venture into negative interest rates.
All of this would favour boomer generation and older asset-holders.
These policies have contributed to the worsening plight of millennials. Elites have succeeded in directing the wrath of the millennials towards Trump, preventing the emergence of a class war that would have targeted them.
Indeed, corporate elites in America favour Joe Biden although the Democratic Party threatens to raise corporate income tax, raise minimum wages, re-work the inheritance tax and break up technology monopolies.
Despite these, their support for Biden is a reflection of elitist aversion to a non-elite being their president and a reflection of their anger over Trump ending corporate America’s profitable alliance with China that has made many executives unimaginably richer. Their hope is to influence Biden’s policies and restore at least semi-normal relations with China.
However, the Democratic Party may have moved too far to the left to permit the re-emergence of corporate profiteering. Once Trump, the lightning rod is gone, the underlying socio-economic tensions between the poor and the privileged in America will surface.
Socialism defined by rage will be at war with capitalism defined by greed.
A generational clash between the millennials and boomers is a prospect that awaits the Democratic president who might occupy the White House from January 2021. The denouement of that clash might be the election of a more avowedly socialist president in America in 2024 and the return of inflation with adverse consequences for both bonds and stocks in the second half of the decade.
Therefore, an uncertain and inconclusive election verdict may be a proximate risk for American financial assets and the currency. But the real risks are more insidious and they are likely to play out even if the power transition is smooth. Political, economic and social conflicts in combination with a monetary policy that actively seeks to debase the currency will prove to be a formidable headwind for the dollar.
For the stock market, an accommodative monetary policy might be its sole source of strength. But that would prove to be wholly inadequate in the face of other threats to the republic.
Trump’s re-election or exit from the White House—whether smooth or contentious—may simply confirm that America had entered a turbulent decade in 2020.
The Implications
What are the implications for India? First, if there is a meaningful clash at the India-China border in the winter months, then it will be a big setback to the economy and to markets. So, one has to hope that such a clash with China does not materialise.
Apart from that, in general, sustained dollar weakness has been good news for developing economies. Capital flows to developing countries more easily when there is plenty of dollars sloshing around.
However, managing persistent currency strength will be a headache and intervention in the foreign exchange market will become increasingly costlier. For investors and for corporates, enduring dollar weakness is an invitation to fund themselves in low interest rates and seek higher returns in India.
They should be careful for even short bursts of dollar strength would leave big holes in their portfolios and balance sheets respectively. For stock markets too, periods of dollar weakness have been positive. But, this time around, the outlook depends on the source of dollar weakness.
If the weakness in the dollar arises out of policy choices that America makes after a smooth election, then it will be positive for Indian stocks. At the same time, since a return to the era of hyper-globalisation pre-2008 will be unlikely, India must continue to invest in enhancing domestic production capacity and productivity.
Two crucial areas that demand attention here are administrative accountability and the regulatory and compliance burden that businesses face at all levels— Union, states and local.
If dollar weakness arises out of political chaos in America, then it will not be good news. Further, if the generational economic conflict, that appears inevitable, turns ugly, that would compound the bad news for the rest of the world. The ensuing global economic leadership vacuum will be unsettling because no one is ready to step into America’s shoes. Worse, there may be arbitrary assertions of power and dominance by other nations.
Far from stoking global risk appetite as has been in the case in the past in previous episodes of dollar weakness, it would trigger risk aversion.
Global economic recovery prospects would dim and emerging economies will face capital flight, restrictive trade policies from other countries and so on. The stock market will decline even as the local currency remains firm.
So, whether or not dollar weakness proves to be a boon or bane for emerging economies like India depends more on the source of such weakness.
Therefore, a lot rides on a smooth election transition and America successfully healing its economic, political and social divisions in the years ahead. Otherwise, not just America, all of us have to brace for a turbulent decade ahead.
V. Anantha Nageswaran is a member of the Economic Advisory Council to the PM. These are his personal views.
