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A Recipe For Disaster

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We simply don't yet know what economic policies President-elect Trump will put in place after he takes office in January. However, based on his campaign promises and much of what we have learned since the election, there's real cause for concern. A combination of tax cuts, increased government spending and policies that would curtail international trade would push interest rates up sharply and, therefore, be a recipe for disaster for the economy and for the price of stocks, bonds, property and commodities, including gold.

Interest rates have fallen steadily since the early 1980s. As they fell, credit became more affordable. That allowed individuals and businesses to take on more debt to finance increased consumption and investment. Credit growth not only facilitated economic growth, it became the driver of economic growth. The ratio of total credit to GDP increased from roughly 160% in 1980 to 370% in 2007.

As long as credit continued to expand, the US economy grew and US demand drove economic growth around the world. By 2007, however, many Americans could no longer afford to service the interest on so much debt. When they began to default, panic spread through the financial system and credit began to contract. Consequently, in 2008, the US economy, along with the global economy, came very close to collapsing into a new Great Depression.

That disaster was prevented by ultra loose Monetary Policy. Central banks slashed short-term interest rates to very close to 0% and then "printed" trillions of dollars worth of new money and used it to buy financial assets. That strategy allowed credit to expand again and caused asset prices to soar, thereby reflating the global economic bubble and staving off economic collapse. It was a very close call. What happens next will depend on interest rates.

Five things will determine which way US interest rates move over the next two years:

  • The US Government's Budget Deficit
  • The US Current Account Deficit
  • Quantitative Easing by central banks outside the US
  • The Inflation Rate
  • The Chinese RMB Exchange Rate vs. the US Dollar

President-elect Trump's proposals would impact four of these five factors in a way that would drive interest rates higher.

Tax cuts and increased government spending would cause the budget deficit to jump significantly. When the government borrows more, interest rates tend to rise.

The US Current Account deficit is exactly offset every year by capital inflows from abroad. When the Current Account deficit becomes larger, more foreign capital enters the United States. Those capital inflows have become an enormously important source of financing for the government's budget deficit. If President Trump puts in place policies that cause the Current Account deficit to shrink, then capital inflows into the United States would also shrink. That reduction in capital inflows would tend to push up interest rates.

Inflation has fallen since the early 1980s because increasing trade with low wage countries has pushed down US wages and the price of consumer goods. Now, however, if the US imports less from low wage countries, the price of manufactured goods will rise, US wages will rise, and inflation will rise. Forcing companies to bring their factories back to the United States or imposing trade tariffs on imported goods, as President-elect Trump has proposed to do, would cause inflation to increase. If inflation climbs, interest rates will too. No one will lend money at a rate of interest below the inflation rate.

Finally, the value of the Chinese RMB relative to the US Dollar could also impact US interest rates. The United States will import nearly Half A Trillion Dollars worth of goods from China this year. If President Trump pressures China to push up the value of the RMB, then everything the US imports from China will become more expensive and inflation will rise.

The global economy is an enormous credit bubble that was reflated after 2008 by historic low interest rates and Quantitative Easing. The economic policies President-elect Trump has proposed are likely to cause interest rates to spike. If they do, the global bubble will pop. If it pops, the world could be plunged into a new Great Depression.

No one should underestimate the consequences of the economic collapse that would follow. Massive wealth destruction would only be the beginning of our problems. Our political institutions would probably not survive the strain.

To learn more about how the change of government in the United States is likely to impact the global economy and the value of your investments, subscribe to Macro Watch:

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Original publish date: December 15, 2016

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