USYields,Dollarindexanddebtrepayment

We wrote yesterday about the Senate elections in the US and how the indications of a tight race are manifesting in interesting market reactions. The three markets i.e. equities, currency and bonds are reconfiguring themselves for a possibility of a Democrat win in a current Republican stranglehold. The Dollar index is trading at 89.45 which is close to its 33-month lows. The possibility of more spending, more stimulus, more deficit and more currency printing appear to be in play here. However, printing of Dollars is an anachronism as nowadays central banks are more likely to create currency digitally.

On the yield side, the 10-year US treasury yields are trading around 1% level. It has crossed the 1% mark first time since the panic started in March and Fed responded with aggressive rate cuts. As more stimulus predicated on a Democrat sweep becomes more likely the drop in bond prices (rise in yields) is justified.

We wrote yesterday that prospects of more stimulus should be positive for stocks as it boosts consumption and kick starts the virtuous cycle of more demand leading to producers gearing up their manufacturing units which in turn leads to more hiring and more demand. That is a spin-off of quintessential Keynesian insight which imagines government as the spender of last resort and urges fiscal deficits to be run in case public is not spending. But the current softness in stock is more because the markets are not sure about the Democrats response on how this extra borrowing will be repaid. Will they bring back the corporate taxes which the previous government had eased in 2017 which started the stock market rally.

Let’s follow up on this point by continuing our discussion on Thomas Piketty’s work in his book Capital in the 21^st Century which we introduced yesterday. Piketty writes that debt which the national governments accumulate over year can be repaid in three ways. First one is that they embark on an austerity path by running lean governments and return to budget surpluses. Secondly, they can tax the populace by way of some sort of progressive wealth tax regime and thirdly they can debase the debt’s real value by stoking inflation. As per the author the first response is not democratically feasible as the popular support of such a program is hard to gather. In the recent past we witnessed the austerity medicine being administered to Greece during the time of European debt crisis.

The second option of taxing the rich through a progressive tax structure impacts the market sentiments and generates bad press. Hence, he writes that it is the third option which generally gets employed. The problem though with stoking inflation is that it quickly gets out of hand. Economics being an inexact science can’t pinpoint the exact inflection point when it will move from normal to hyper domain. Piketty writes that the inflation route has very harsh and morally ambiguous wealth redistributive effects. In our future notes we will look at some of the historical examples of such policy.