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With the war in Ukraine, matters are going quickly from bad to horrid. Food and fuel prices have spiked, as Russia and Ukraine are big exporters of many commodities including gas, oil, coal, fertilizers, wheat, corn, and seed oil. Several economies in Europe and Central Asia, the Middle East, and Africa are almost entirely dependent on Russia and Ukraine for wheat imports. For lower-income countries, disruption to supplies as well as higher prices could cause increased hunger and food insecurity. And disruption to supply chains could broadly intensify inflation pressures. For many households across the world, rising inflation poses a significant challenge. Higher prices can erode the value of real wages and savings, leaving households poorer. But these effects are not felt equally: Low- and middle-income households tend to be more vulnerable to high inflation than wealthier households. That reflects the composition of their income, assets, and consumption baskets. Inflation may affect the very poorest households living below the global poverty line less directly, however. That’s because the poorest households have minimal wage incomes or assets and tend to rely on nonmonetary income, such as subsistence farming or barter, which may be less vulnerable to inflation. In advanced economies, low- and middle-income households tend to rely more heavily on wage income and transfer payments than wealthier households (Figure 2). Price inflation often outstrips growth in wages and transfers, while self-employment income and investment income may be more likely to keep pace with inflation. As such, inflation can reduce the incomes of poorer households relative to those of the richest. Among emerging market and developing economies, the picture is similar. In Brazil, for example, self-employment and investment income account for a larger share of income in high-income households than in low- and middle-income households. However, the very poorest households also rely on nonmonetary income. Poorer households often lack access to financial products that can protect them against inflation, because these products can have upfront or ongoing costs and therefore be unaffordable. In the United States, for example, almost all households have a transaction or checking account at a financial institution. However, far fewer households have savings or investment products. The distribution, moreover, is highly skewed: The wealthiest quartile of U.S. households is five times as likely as the poorest to hold certificates of deposit, six times as likely to hold savings bonds, and 12 times more likely to hold investment funds. High inflation, in short, tends to worsen inequality or poverty because it hits income and savings harder for poorer or middle-income households than for wealthy households. Households that have recently escaped poverty could be pushed back into it by rising inflation.

Inflation is a national challenge impacting us all. It is eroding our savings, challenging our daily lives, and sapping our economic strength. We cannot allow it to weaken our national security as well. Businesses across the country are finding ways to cope with record-high inflation. Some are raising prices on their goods; others are offering fewer goods for the same price. But what happens to companies who can’t charge more, or offer less? For those that have an important role to play in keeping us all safe, the options are more limited. If increased costs cannot be accommodated, companies may abandon Department of Defense work for commercial enterprises. Many companies I talk to, including critical suppliers, are ‘on the bubble’ right now and may flee the defense industrial base, which would be an enormous strategic setback. DoD admitted in May that one company has already requested to cancel a long-term contract due to inflation. And last week, top Pentagon officials acknowledged concern about inflation driving small companies out of business. Small businesses are being particularly hard hit by rising costs. For example, one small aerospace and defense business owner shared with me that his company’s lead time for some materials has increased threefold, transportation delays and costs are so significant that they have had to buy their own vans to deliver products, and salaries for skilled workers have jumped by as much as 40 percent. Small businesses did not have an opportunity to budget for these kinds of costs, and right now, the only certainty they have is that their costs will continue to rise. The ever-increasing threats from abroad – from Russia’s brutal invasion of Ukraine to ongoing malign activities emanating from China, North Korea, Iran, and other actors – mean that the industrial base can’t slow down or offer less. The security of our country depends on the defense industrial base’s ability to get the job done.

For decades, inflation averaged around 2 percent per year. Since early 2021, however, it has grown to 8-9 percent. The 2021 and 2022 defense budgets were developed before the onset of this rapid inflation and DoD is experiencing a significant loss of buying power as these funds are expended. Similarly, the 2023 budget was submitted to Congress before it was known how high inflation would rise and therefore significantly underestimates the funding requirement for the programs the Department wants implemented. This paper reviews the impacts of inflation on the defense budget and defense industrial base (DIB), provides estimates of specific impacts of inflation, and provides strategies for how Congress can address inflation. This loss of defense buying power comes at a perilous time. The 2022 National Defense Strategy (NDS), reaffirming the 2018 NDS , highlighted the re-emergence of threats from near peer competitors after decades of focus on terrorism and regional threats. China and Russia were not idle while the U.S. focused on terrorism following the September 11, 2001 attacks. They invested in their own modernization and in their forces. And as they have grown more militarily capable, their aggressiveness has increased, including on vivid display now with Russia’s invasion of Ukraine and with China’s increased belligerence towards Taiwan as well as its neighbors in the South China Sea. The NDS pivot requires shifting focus from a largely asymmetric terrorist challenge to the threat from large, technologically advanced states. This requires the U.S. to rapidly modernize capabilities and investment in forces and posture. The Defense Industrial Base (DIB) has stepped up to this challenge, by supporting DoD with accelerated development and the production of new weapons and advanced technology. The bipartisan NDS Commission found that 3-5 percent real growth in defense funding was required to implement this NDS imperative.1 While this has been the strategy and consensus across two different administrations, the defense budget was not reflecting this recommended level of growth prior to the onset of inflation and is now paradoxically experiencing negative real growth. When combined with the effects from COVID-19, supply chain, and other workforce disruptions, DoD and the DIB are struggling to increase capacity and to achieve the pace of modernization required to maintain our technological advantage over these near peer competitors in order to deter further aggression. Congress has become increasingly concerned about these defense budget shortfalls and their impacts on modernization and the DIB.

Forget the sub-prime crisis: another global depression could see millions thrown out of work, thousands of bankruptcies and severe losses in trade and financial markets that could bring the world economy to its knees. Think it won’t happen? Here are five ways the world could enter another Great Depression: 1. Hard Brexit: The most shocking geopolitical event of 2016 prompted widespread fears and forecasts of imminent recession in Britain, with potentially global ramifications. The morning after the June 23 referendum, the British pound plunged to a 31-year low and $2 trillion was wiped off global sharemarkets. Helped by a weaker currency, the British economy has since recovered some lost ground, while financial markets have recovered from their shock. However, the false sense of security that has developed in the wake of Brexit has renewed calls for a hard and fast break from the European Union for the world’s fifth-largest economy. With no historical precedent, such a move could act as a tipping point in pushing a soft global economy over the edge. 2. US Protectionism: The United States could one-up its Atlantic neighbors in the geopolitical shock stakes in the November presidential elections, where the two major party candidates can agree on at least one topic—what many feel are protectionist trade policies. Democratic contender Hillary Clinton, who as Secretary of State in 2012 praised the pending Trans-Pacific Partnership as the “gold standard in trade agreements,” has promised to kill off the trade deal if elected. Trade between the United States and the other 11 signatories totaled $1.6 trillion in 2014, and includes high growth prospects Malaysia and Vietnam. Republican rival Donald Trump has gone a step further, threatening to pull the nation from the World Trade Organization if it interferes with attempts to punish US companies who move production offshore. The bipartisan rejection of a global free market by its leading instigator could push the global economy into a downwards spiral. If there is a silver lining, it is that neither candidate has a track record of adhering to their policy pledges. 3. China Slump: The Chinese economy may be slowing down, but the IMF projects the world’s second-largest economy will still account for 1.2 percentage points of the forecast 3.1 percent global GDP growth in 2016. By comparison, the United States, European Union and Japan are seen contributing below 0.5 percentage points between them. This illustrates the seismic consequences China’s dreaded debt-driven hard landing could have upon the global economy. Chinese debt is accelerating at an alarming rate and now totals 250 percent of GDP, prompting comparisons with the pre-GFC US economy, and Japan’s infamous bubble. Most new debt incurred in China now funds the payment of existing obligations, rather than creating new value. China was crucial to maintaining global growth when Japan’s bubble burst, but there is no emerging economy equipped to provide a comparable degree of support now, leaving the already frail global economy badly exposed. 4. European Implosion: Brexit was a hostile response to a growing list of British complaints with the beleaguered European Union. This sentiment is not limited to the British Isles however, with similar movements consolidating support in France and the Netherlands for exit referendums of their own. The Syrian refugee crisis has expedited the breakdown of popular support for the single market, which was already strained by repeated bailouts of Greece and other debt-ridden member states. That issue is likely to worsen before it improves, with Greece’s most recent bailout blocked due to non-compliance with fiscal reforms, and Italian banks on the verge of collapse. Whether the next exit is sparked by fears over terrorism or currency, the prospect for Brexit to be the first of many appears very plausible, and that scenario could lead to the dissolution of the single market. Were the borders to return to the world’s largest single trading bloc, the Eurozone states could suffer an economic downturn with global ramifications. 5. Emerging Market Debt: Emerging markets have become the flavor of the month again with international investors, as much of the developed world’s interest rates are currently extremely low or even negative. However, these yield-chasing inflows have ramped up emerging market corporate debt, which was estimated in mid-2015 to total more than $4.4 trillion. Should the US Federal Reserve resume its interest rate hikes, the capital inflows that have propped up emerging economies could rapidly reverse, with the emerging markets seeing their currencies plunge and the value of their US-dollar debts surge. The resulting chaos could tip many emerging economies into recession, removing a growth source for the global economy and sparking more global instability and potentially conflict.

Economists have debated the extent to which this bout of inflation is the result of expansionary fiscal and monetary policy—low interest rates and large amounts of government spending, particularly transfers to households—or of pandemic-specific factors, including disruptions to global supply chains and, consequently, rising prices for commodities and manufactured goods. It remains unclear whether the rate increases the Federal Reserve has planned out will be sufficient to tame rising prices or the extent to which they will curtail economic growth. But whatever the impact, rising interest rates will not just affect the United States. Higher U.S. rates raise the cost of borrowing in U.S. dollars on international markets. They also increase demand for U.S. dollar assets relative to assets in other currencies, and they can therefore cause those currencies to fall in value. For countries where external debt is denominated in U.S. dollars, debt repayment will become more expensive. These consequences are likely to be most severe in some low- and middle-income countries. Relative to wealthier states, these countries generally have worse credit, and it costs them more to borrow. They are also more likely to borrow in U.S. dollars. It will be especially bad for developing and emerging markets that are still grappling with the pandemic’s economic fallout, as well as those that are net importers of food and energy, the prices of which have risen dramatically as a consequence of the war in Ukraine. These countries will likely see more debt distress and large currency devaluations, hampering their economic growth and making it more difficult for them to reduce poverty. The U.S. financial market is by far the planet’s largest, and the dollar is the world’s principal reserve currency. It is the backbone of international loans and the main currency of use in international trade transactions and internationally traded bonds. As a result, Federal Reserve actions have an outsized effect on the economies of other countries. That is especially true in emerging markets and developing countries, which often rely on the U.S. dollar for international borrowing. When the Fed raises interest rates to help tame U.S. inflation, external borrowing in dollars becomes more expensive. The hikes can also stoke inflation in other economies: as U.S. assets yield higher returns they become more attractive to investors relative to the assets of other countries, driving up the value of the dollar. This raises the cost of imports, which are often priced in dollars. It also makes it more expensive for governments and firms in developing countries to pay off their existing debts in U.S. dollars. The result can be domestic austerity measures, resulting in lower economic growth. (These effects are more modest in advanced economies, since they borrow primarily in their domestic currency and their domestic prices are less likely to rise when their currencies depreciate.) The U.S. interest rate increases come in challenging times. To cushion the effects of the pandemic, many poorer countries had to take on more debt, and with the decline in economic activity caused by the pandemic, they are struggling to service or repay that debt. Tourism-dependent economies, for instance, saw their main source of external revenue dry up as international travel came to a standstill. Many emerging and developing economies are also already facing domestic inflation, triggered by pandemic-related production disruptions and rising global energy and food prices. Rising food costs, in particular, stoke inflation in emerging and developing economies, where residents spend a higher percentage of their income on groceries than do residents of richer states. They can also trigger social unrest. The Federal Reserve, of course, can only directly set short-term interest rates, and U.S. long-term rates—such as the yield on government bonds that mature in ten years—also have an important effect on both economic activity and long-term rates in other countries. This is, again, particularly true in emerging and developing economies. But when the Fed tightens its monetary policy, it can cause these rates to rise, as well. And they are already going up: between the end of 2021 and March 31, 2022, the interest rate on 10-year U.S. Treasury securities rose by one percentage point. So far, this is a relatively small increase. It suggests that markets currently expect the increase in short-term interest rates is going to reverse at some point—and hence that U.S. inflation will eventually abate. For emerging markets and developing countries, that would be very good news. If the long-term rate increase remains modest, the repercussions for the developing world will be more contained. But unfortunately, a quick, painless end to U.S. inflation is not a foregone conclusion. The world is encountering its first bout of meaningful inflation in decades, an experience that is compounded by uncertainty around the pandemic and the war in Ukraine. And U.S. inflation has already defied expectations, exceeding 2021 forecasts by a wide margin. If demand remains strong in the United States and if the country’s labor markets remain tight, inflation could prove even more stubborn than most forecasts suggest. The Fed would then have to enact rate hikes that will be more rapid and sharp than the markets currently expect them to be, leading to higher long-term interest rates. The U.S. economy may then slow more sharply, and international financial repercussions would be more severe. Indeed, the uncertainty itself could harm poor and middle-income countries. During periods of high economic and geopolitical uncertainty, investors tend to withdraw from riskier assets. That includes holdings in emerging markets, which have more volatile economic prospects and higher political and policy uncertainty. The unfortunate end result could again be an outflow of capital from developing countries—the places most in need of investment. It is hard for economists to predict the future, and analysts need to be modest in their forecasts. No one knows exactly what path U.S. inflation will take, how the Federal Reserve will respond, and what the ultimate consequences will be for other countries. But the past can provide a guide for what it looks like in the developing world when the United States tightens its monetary policies. In some cases, history offers reason for hope. When the Federal Reserve increased interest rates from one percent to 5.25 percent between 2004 and 2006, emerging market economies did not experience financial turbulence, in part because the U.S. and the world economy were growing rapidly. In mid-2013, investors expected that the Federal Reserve would raise rates (they ultimately didn’t), and as a result, long-term interest rates went up by one percentage point, as has happened so far today. Several emerging markets faced declining purchases or outright sales of their debt securities by foreign residents and saw their currencies lose value. But both effects waned in a few months. In other instances, rate hikes have had more notable consequences. Between February 1994 and February 1995, the Fed raised short-term interest rates by roughly three percentage points, and long-term interest rates went up by some two percentage points. The increases—together with domestic economic and political factors—led the Mexican peso to collapse, causing a recession in the country. Mexico eventually needed an international bailout to stave off default. Argentina was also severely affected. But even then, there was no wider wave of emerging market crises. Similarly, when the Fed raised its rates between March and December 2018, Argentina and Turkey faced large currency depreciations, but the fallout elsewhere was contained. Yet rate hikes, if big enough, can lead to broad problems. In the late 1970s and early 1980s, U.S. Federal Reserve chair Paul Volcker nearly doubled interest rates—up to 20 percent—to try and tame persistent inflation in the United States. He succeeded, but the shockwaves of tightening U.S. monetary policy triggered a widespread debt crisis and numerous defaults in emerging and developing economies. Between 1981 and 1983, GDP fell by 2.8 percent in Brazil, four percent in Mexico, 7.5 percent in Venezuela, and an astounding 16 percent in Chile. The effect of the current rate hikes today may yet be modest. Many middle-income countries—including most of the largest ones—have stronger economic institutions (including independent central banks) than they did in the 1970s and 1980s, or even the first decade of this century. They are less dependent on borrowing in dollars, and they hold larger foreign exchange reserves. They also allow the value of their currencies to float more than they did in the past, which means they can allow their currencies to depreciate during periods of stress without provoking such severe domestic economic repercussions. In addition, high commodity prices help emerging and developing economies that are commodity exporters, which can now sell their goods at higher prices. But many poorer countries are not as well insulated, and U.S. inflation is at its highest level in decades. Washington’s policy adjustment may be more abrupt than anything it has done since 1994. The Fed’s actions could be compounded by rising interest rates from other central banks, given that many advanced and emerging economies are also dealing with heightened inflation. And this tightening will come as the world economy is still dealing with the consequences of the pandemic, and as it reckons with the war in Ukraine. That means that, although there is unlikely to be a severe crisis across major emerging economies, there are many vulnerable countries—already facing increased poverty—where high levels of external debt may prove to be unsustainable. An increasing number of countries may approach the International Monetary Fund for a loan, as Sri Lanka did recently, and face debt renegotiations with external creditors. Since the pandemic began, the World Bank, the International Monetary Fund, and the world’s richest countries have all discussed the need to offer debt relief to the poorest states and to other countries facing the most severe economic consequences of the pandemic. As the Fed works to control U.S. inflation, the necessity of such relief will grow increasingly pressing. The bulk of the developing world may be able to ride out the storm. But should U.S. rates rise sharply, more countries will need international financial support and face debt restructuring to avoid calamitous economic contractions.

Slowing growth, scorching inflation and rising U.S. interest rates are intensifying a squeeze on emerging-market finances and stoking concern over a fully fledged debt crisis in low- and middle-income countries. The anxiety is evident in sky-high bond yields and month after month of capital outflows, as investors ditch the assets of vulnerable countries in favor of safer returns elsewhere. Strains that have been building since Russia invaded Ukraine are gradually getting worse, as the outlook for global growth sours and hopes for a quick reprieve from rising inflation evaporate. Further ratcheting up the pressure, the Federal Reserve this past week announced the biggest increase in U.S. interest rates since 1994, a move that risks adding to emerging markets' debt and inflation woes by weakening their currencies and accelerating capital outflows. Currencies from the Brazilian real to the Chilean peso fell more than 3% against the U.S. dollar in the week through Friday. The benchmark MSCI Emerging Markets Index, which tracks stocks in 24 emerging economies, lost 4.7%. The risk of contagion—when a crisis in one country spills into another by pushing investors to take flight—appears contained for now but may heat up without renewed efforts to ease the burden on heavily indebted governments and buttress weak banking systems, economists and investors say. Countries including Sri Lanka , Zambia and Lebanon are already in the grip of crises and are seeking international help to provide loans or restructure their debts. The strain on emerging markets adds to headwinds for the global economy this year and next. The world looks set this year for its weakest expansion since the low point of the pandemic in 2020, and forecasters expect slow going in 2023 too. Galloping inflation and rising interest rates are eating into U.S. growth. Meanwhile, Europe is reeling from the war in Ukraine, and China's economy is being held back by the government's strict zero-tolerance approach to Covid-19. Emerging markets are caught in these crosscurrents. The World Bank this month cut its forecast for growth in developing economies to 3.4% this year from 4.6% previously, citing the effects of spiraling prices for food and energy and rapidly rising borrowing costs following interest rate increases in the U.S. "Financial stress could spread across countries," the bank said in its latest report on global economic prospects, noting that rising interest rates in the U.S. and other advanced economies have been followed by crises in emerging markets before, such as the Latin American debt crisis of the early 1980s. Bond yields offer an insight into investors' darkening assessment of some countries' prospects. Yields on the long-term debt of 23 countries are currently 8 percentage points or more above long-term U.S. Treasury yields, a sign of financial distress, up from 16 at the beginning of the year. The category includes Russia, Ukraine and Belarus in Europe; Argentina, Ecuador and Venezuela in Latin America; Ethiopia, Ghana and Mozambique in Africa; and Pakistan and Sri Lanka in Asia. The yield on Lebanon's long-term debt is around 32 percentage points above its U.S. Treasury equivalent, according to Oxford Economics, a consultancy. Emerging-market bond issuance has collapsed, falling 43% so far this year compared with the same period in 2021, according to data from Dealogic. The amount raised by emerging market issuers so far this year is the lowest since 2016, at $263.5 billion. "It's not a favorable time to tap international markets," said Luiz Eduardo Peixoto, emerging-markets economist at BNP Paribas. Economists say many countries that are struggling were already heavily indebted before the pandemic thanks to aggressive government spending spurred by low interest rates and ample funds from private lenders and new official creditors, particularly China. Between 2011 and 2018, the public debt for the world's poorest nations—defined as the roughly 70 nations that qualified for a global debt-payment suspension program during the pandemic—increased by 18% of gross domestic product on average, according to Marcello Estevão, global director for macroeconomics, trade & investment at the World Bank. "The seeds of this debt situation were sown way before Covid," Mr. Estevão said. About 60% of the poorest nations were at high risk of debt distress or already in distress in 2020, up from 30% in 2015, according to the International Monetary Fund. Debt is considered distressed when a country is unable to fulfill its financial obligations and debt restructuring is required. Debt continued to pile up last year as the pandemic dragged on. Debt owed to foreign lenders by low- and middle-income countries rose 6.9% on average in 2021 to $9.3 trillion, according to World Bank estimates—a faster pace than the 5.3% increase recorded in 2020. The bulk of that sum is owed by the 10 largest borrowers, including China, India and Brazil. India's debt increased 9%, while Pakistan's rose 23%. Egypt's debt swelled by 13%, and Peru's rose 22%. Rising interest rates, weakening growth and soaring prices tend to sap government revenue and make it harder for poorer countries to service their loans. The surge in commodity prices is especially painful for debt-laden countries that are net importers of essentials including food and energy, such as Egypt or El Salvador. Some countries face extra difficulties from foreign-currency debt, which can be harder to repay when the value of domestic currencies falls, and variable-rate debt, since interest payments will rise as rates go up. Countries with more than 50% of their external debt on variable rates include Papua New Guinea, Fiji and Zambia, World Bank data shows. Though concerns over emerging markets are intensifying, particularly as incoming data suggests global growth will be weaker than anticipated earlier in the year and inflation may be more persistent than central banks had thought, severe financial distress has so far been limited to only a handful of countries. Mr. Estevão said he isn't yet worried about the kind of contagious crisis in which trouble in one country triggers broad selling by investors of others with similar characteristics. Idiosyncratic factors seem to explain why some countries are being hit harder than others right now, he said. Such factors include governance and the availability of support from friendly nations, as well as precrisis debt levels and the size of import bills. "We don't seem to be in a situation where people are panicked," said Sonja Gibbs, managing director for global policy initiatives at the Institute of International Finance, referring to investors in emerging markets. "Rather, it's more a low-grade anxiety." It isn't clear how long the relative calm will last. Officials at the World Bank and other international institutions say governments and international creditors should use the breathing room they have to try to reduce risks, implement growth-enhancing economic reforms and reduce the burden of debts where possible. "In the end you can't avoid a crisis unless you correct the policies," said Gabriel Sterne, head of global strategy and emerging-markets research at Oxford Economics and a former IMF official. Rebeca Grynspan, secretary-general of the United Nations Conference on Trade and Development, this month urged the Group of 20 major economies to reinstate an initiative to allow developing countries to suspend debt servicing, which expired at the end of 2021, while pushing debt maturities back by two to five years to ease the burden of payments. "The risk of a major debt crisis with a possible domino effect is greater today than during the Covid-19 pandemic," she said.

Emerging markets are facing their demons as traders mull whether U.S. Federal Reserve interest rates will rise as high as 6%, a level that could kick weaker countries when they're down, while diverging global growth paths and China's reopening might cushion some of the blow for the bigger ones. Expectations for where the Fed's terminal rate would peak have been rising at breakneck speed: Markets are pricing in a 5.5%-5.75% range for September, while the CME FedWatch toolshows a near 50% chance for the band to hit 6% that month. The scale and pace of the move makes for uncomfortable reading for investors in developing stocks, bonds and currencies that have often buckled under rising global rates. "The current repricing risk in the Fed's terminal fed funds rate to perhaps 6% in a short period of time is in the context of (the) response to inflation running stubbornly well-above target in a weakening global GDP growth environment," Satyam Panday, chief emerging markets economist at S&P Global Ratings told Reuters. "This mix is generally a net negative for emerging markets." Expectations for further Fed hikes had been for 25 basis point increments, but Fed Chair Jerome Powell on Tuesday brought a faster pace back to the table. Few expect a smooth ride for the remainder of the week, with the monthly U.S. jobs report for February providing markets with more evidence to chew over. "Fed tightening towards 6% would firmly test historical 'pain thresholds' for emerging market assets," said UBS strategist Manik Narain in a note, predicting India's rupee, China's yuan and the Philippine and Chilean pesos could weaken as much as 5% if the Fed ramped up rates to 6%. A recent Barclays analysis showed a 50 basis point Fed rate hike would increase interest rate volatility, which "would be more destabilizing initially, as it typically comes with EM FX underperformance, which could trigger a further leg up in EM rates." Analysts at JPMorgan expect the dollar to weaken once the terminal rate stabilizes, but a 50-basis point Fed hike "would be a regime-shift in favor of outsized USD-strength." "Frontier markets is where you'll likely see the brunt of the hit" of sharply rising rates, said Sahil Mahtani, multi-asset strategist at investment firm Ninety One. The number of smaller, riskier emerging markets where investors demand a premium of 10 percentage points or more over safe-haven U.S. Treasuries has remained broadly steady at around 30 countries, with a recent rally bringing no relief, analysts at Tellimer found. These countries, which include Kenya, Egypt and Pakistan, are essentially locked out of capital markets. But local fixed-income markets in bigger developing economies are also set to feel the pinch. A 6% Fed rate environment alongside still-hot inflation does make short-term rates in Chile and India as well as Poland, the Czech Republic and Hungary most vulnerable, UBS found. Flows to EMs soared in January but slowed to a crawl in February, signaling a warning to investors. Citi data showed on Monday that outflows resumed last week, with real money leaving Latin America and emerging Europe, the Middle East and Africa while hot money, or speculative capital, left Asia and Latam. Investors, especially on the equities side, could see China's reopening somewhat offsetting a looming downturn in the United States and some of Fed rates' historic weight on emerging markets. Emerging stocks (.MSCIEF) are up just 2% this year after a combined 26% drop in the previous two and broadly lag developed peers. Chinese equities could provide a safe haven in a 6% fed funds rate scenario, UBS said. The emerging market universe being more Asia-centric than in previous sharp increases of global rates means that investors can't "look at the textbook of history" according to Nuno Fernandes, a New York-based portfolio manager for GW&K’s Emerging Wealth Equity Strategy. China accounts for nearly a third in the EM equity benchmark (.MSCIEF) and near 5% in the fixed-income hard-currency index (.JPMEGD), which is supportive of the asset class. "Investors are conditioned to think that EM tail risk emerges in the context of aggressive U.S. rate hiking cycles," said Ninety One's Mahtani. "I think it's dangerous to say this time is different, but it feels like it's not that mechanical this time."

The Federal Reserve’s efforts to fight inflation threaten to send the U.S. economy into a recession. They could also spark a series of economic crises in developing countries around the world. Higher interest rates are making it more expensive for many emerging economies to pay off the crushing debt they took on to survive the pandemic. On top of that, the war in Ukraine has sent the cost of staples like food and fuel skyrocketing. That’s bad news for dozens of countries where public finances are in perilous shape, such as Ghana, Kenya, Pakistan and El Salvador. The situation remains tenuous even for some larger emerging markets like Turkey that have underlying economic problems. “There is certainly a fragility that could interact with tighter financial conditions in a way that could trigger a certain amount of stress, even in some fairly healthy emerging markets,” said Tobias Adrian, director of the International Monetary Fund’s monetary and capital markets department. As the caretaker of the world’s reserve currency, the Fed has massive influence on global financial markets at a time when they are growing more tightly integrated. Monetary policies to slow inflation, such as raising borrowing costs, are transmitted primarily through these markets. As higher rates push up the value of the dollar, debt held in U.S. dollars anywhere in the world becomes more expensive to pay off. The Fed’s rate hikes can also lead to severe outflows of capital from other countries as investors pull their money out of emerging markets to get a better return in the U.S. This can have destabilizing effects on their economies. New data released Wednesday shows that emerging markets suffered a record-breaking fifth consecutive month of investors pulling their money out. The numbers, compiled monthly by the Institute of International Finance, a trade group for the global financial services industry, show that the capital flight — totaling $39.3 billion since March — is reaching the level of the “taper tantrum” crisis in 2013, when another move by the Fed to pull back support for the U.S. economy caused financial panic in some emerging markets. The stewards of the global economy are warning of extreme uncertainty as the Fed and other major central banks ratchet up their moves to tighten financial conditions around the world to battle spiking inflation. The IMF’s latest update to its global economic outlook revised inflation upward to 6.6 percent in advanced economies and 9.5 percent in emerging markets — nearly a full percentage point higher than previously forecast. Roughly 60 percent of low-income countries are in debt distress or close to it, according to the IMF. The amount of debt they could potentially default on totals $455.6 billion. If these countries were to default, it could mean hardship as governments would be unable to provide support for a wide swath of the world’s population. But former officials and experts say the shape of a potential Fed-induced global debt crisis looks different than in the 1980s, when rate hikes sent many economies into collapse. “Global financial markets have grown substantially as have capital flows, and the U.S. role in the global economy has somewhat declined with the rise of China and other emerging markets,” said Mark Sobel, a former Treasury official and U.S. chairman at the Official Monetary and Financial Institutions Forum think tank. The impact of the Fed’s policies may be felt the most in countries that are already fighting high levels of inflation and tighter financial conditions due to domestic and global pressures. That includes Central and Eastern Europe and sub-Saharan Africa, which are being hit the hardest by the shock of high commodity prices on fuel and food as a result of Russia’s war in Ukraine.

The U.S. Federal Reserve is set to raise interest rates by 0.75 percent for the second consecutive month as it tries to fight inflation. But while the U.S. central bank is trying to right the ship in the United States, its actions send ripple effects around the world. Whether those ripples become tsunamis depends on the timing of the Fed’s hike. If it’s during a time of economic growth, then the overseas impacts tend to be positive. When it’s during uncertain economic times, the outlook is less rosy. It also depends on how strong an economy is; advanced economies, which can usually raise money no matter the economic headwinds, are largely insulated. But for poorer countries, the effects can be dire. That’s because a U.S. rate rise can have a number of indirect effects internationally. It not only increases the cost of borrowing dollars; it also encourages investors to park their money back in the United States, draining poorer countries of investment. That, in turn, tends to boost the value of the dollar relative to other currencies, making it harder for poorer countries to pay back their U.S.-dollar-denominated debt. In its updated World Economic Outlook, released on Tuesday, the International Monetary Fund (IMF) warned of the effects interest rate rises in advanced economies could have on those further down the income ladder. The IMF particularly singled out the danger to low-income countries, 60 percent of which are at “high risk of debt distress.” “Higher borrowing costs, diminished credit flows, a stronger dollar and weaker growth will push even more into distress,” the IMF cautioned. The phenomenon is already playing out across emerging markets. Sri Lanka’s economic problems have several causes, but one is the high cost of debt repayments, which has only increased over the past year. Ghana has also been affected by the interest rate surge, which in part caused it to seek an IMF bailout this month. Bangladesh has followed the same IMF route, as its depreciating currency and import dependence left it burning through foreign reserves. On Tuesday, local media reported that its government was seeking $4.5 billion from the lender. Other countries could soon be next, with Argentina, El Salvador, Egypt, Tunisia, and Turkey all showing warning signs, Liliana Rojas-Suarez, a senior fellow at the Center for Global Development, told Foreign Policy. Rojas-Suarez said the problems plaguing some emerging-market countries are not just caused by rising rates but are best understood as an evolution: First came the pandemic, which encouraged these countries to go further into debt—at low rates—to survive the worst of that downturn. Then came the spiral of inflation as markets opened back up, followed by the ultimate shock: the war in Ukraine and the resulting price increase in key commodities like food and fuel. She blames the Fed for not dealing with the inflation warning signs earlier: “It means that now to contain inflation, the Fed has to increase interest rates much higher than if it had reacted earlier on. And that is the big problem for emerging markets. Because now, the cost of financing is going up and up and up.” The problem has not gotten worse largely due to savvy policy on the part of other emerging economies, particularly in Latin America, which began increasing interest rates earlier than the United States. There’s also the fact that this shock comes shortly after the previous one, so countries that got hit by the coronavirus pandemic have already taken on a lot of strain. “Emerging market currencies as a basket are not anywhere near back to where they were before the pandemic. And so that actually gives—maybe not more of a cushion—but less of a height to fall from,” Brian Nick, chief investment strategist at global asset manager Nuveen, told Foreign Policy. Emerging markets won’t suffer damage in the same way. Rojas-Suarez divides them into two groups: For those that can source their own fuel and food and have relatively low debt burdens, the shocks can be weathered (and, in some cases, even profitable), but hard times are ahead for net importers of commodities—especially for those with high debt. The good news for emerging markets is that if the Fed continues as expected, with a slight raise today followed by another at the end of the year, then the damage has already been priced in. “​​If that’s roughly what we get, then I don’t think emerging markets are in for incrementally more pain,” Nick said.

Investors are piling into emerging market stocks and bonds at a near-record rate, as falling inflation and the reopening of China’s sprawling economy help reverse last year’s slide. Emerging equity and debt markets have attracted $1.1bn a day in net new money this week, according to high-frequency data tracking 21 countries from the Institute of International Finance. The speed of cross-border flows is now second only to the surge that followed the lifting of coronavirus lockdowns in late 2020 and early 2021, surpassing previous peaks over the past two decades. The strong inflows underscore a big shift in sentiment this year after a grim performance for developing markets for much of 2022. Falling global inflation has led many market participants to bet that major developed market central banks, including the US Federal Reserve, will soon stop increasing interest rates — relieving a major source of pain for emerging markets. Jahangir Aziz, an analyst at JPMorgan, said there was “a lot of gas in the tank” for a further rebound in inflows now that key economic uncertainties that weighed down emerging markets “are lifting”.

Emerging markets lit up green as Federal Reserve chairman Jerome Powell nodded at the progress made against US inflation, adding fuel to Wall Street’s bullish outlook on developing assets. MSCI’s emerging-market currency benchmark soared to the highest since April on Thursday, extending gains after Powell hinted that the Fed may have only a few more interest-rate increases to go. A similar gauge of developing-economy equities also jumped, bringing its year-to-date gain to 10 per cent. The won led the advance among Asian currencies with a rise of as much as 1.2 per cent. Investors and analysts have been broadly bullish on emerging markets this year, partially due to the odds that major central banks — including the Fed — will back off their aggressive tightening paths. “The market is hopeful that the Fed isn’t going to overdo it,” said Aaron Gifford, an emerging-market sovereign-debt strategist at T. Rowe Price. “With the end of the US tightening cycle getting closer, China reopening and a softer slowdown in Europe, it’s hard not to be optimistic on risk markets — including EM.”

Now, however, is particularly inopportune timing for this fight. That is partly because big foreign buyers have quietly trimmed their Treasury purchases in the last year, and this might accelerate if chatter about a possible default grows louder. It is also because liquidity has repeatedly vanished from the Treasuries sector at times of stress in recent years, because of underlying vulnerabilities in the market structure. This could easily reoccur in a debt-ceiling shock, since these structural problems remain (lamentably) unaddressed. But the biggest reason to worry about the timing is that the financial system is at a crucial stage in the monetary cycle. After 15 years of accommodative monetary policy, during which the US Federal Reserve expanded its balance sheet from $1tn to $9tn, the central bank is now trying to suck liquidity out of the system, to the tune of about $1tn a year. This process is necessary, and long overdue. But it was always going to be difficult and dangerous. And if Congress spends the coming months convulsed by threats of default — since the Treasury’s ability to fund itself apparently runs out in June — the risks of a market shock will soar. A recent report from the American lobby group Better Markets outlines the wider backdrop well. This entity first shot to fame during the 2008 global financial crisis when it became a thorn in the side of Wall Street and Washington regulators because it complained loudly — and correctly — about the follies of excessive financial deregulation. Since then, it has continued to scrutinise the more recondite details of US regulation, complaining, again rightly, that the rules have recently been watered down. However, in a striking sign of the times, it now has another target in its sights: the Fed. Most notably, it thinks that the biggest danger to financial stability is not just the finer details of regulation, but post-crisis loose monetary policy. This left investors “strongly incentivised, if not forced, into [purchases of] riskier assets”, it “decoupled asset prices from risk and ignited a historic borrowing and debt binge”, the Better Markets report argues. Thus, between 2008 and 2019 the amount of US debt held by the public rose 500 per cent, non-financial corporate debt increased 90 per cent and consumer credit, excluding mortgages, jumped 30 per cent. Then, when the Fed doubled its balance sheet in 2020 in the midst of the pandemic, these categories of debt rose by another 30, 15 and 10 per cent respectively. And the consequence of this exploding leverage is that the system is today highly vulnerable to shocks as interest rates rise and liquidity declines — even before you factor in a debt-ceiling row.

On 10 October, the Swedish Royal Academy announced the Nobel Prize in Economics and the prize was jointly awarded to Ben S Bernanke, Douglas W Diamond and Philip H Dybvig. Their work in explaining the role of banks in the economy, how a financial crisis is escalated by a misstep in the banking system, and how a potential crisis can be averted by devising appropriate policies earned them this prestigious award. Let's look at the background of Ben S Bernanke, and how his experience as the chairman of the US Federal Reserve during the financial meltdown in 2009 helped him come up with the theory. Ben Bernanke was the 14th Chairman of the Federal Reserve System, serving from 2006 to 2014. His career as the Chairman of the Fed was a colourful and challenging one for many reasons. The worldwide financial meltdown in 2007-09 triggered by the US subprime mortgage crisis was undoubtedly the most remarkable challenge for Bernanke during his tenure as the chairman of the Fed. Bernanke was the chieftain of the US monetary and financial system when the country suffered from the worst financial crisis in 2009, second after the great depression in 1929. He not only observed the collapse of century-old financial institutions such as Lehman Brothers and Washington Mutual but also remained silent during their death. Bernanke approved the mergers of large but moribund financial intuitions for the sake of economic recovery. More importantly, he rescued AIG (American International Group, the world's largest insurance company) from bankruptcy at the expense of taxpayers. The web of financial transactions of AIG with other financial institutions was so deep-rooted that letting AIG go bankrupt was akin to the collapse of the entire financial structure of the US. No doubt, Bernanke was praised, and equally criticised, for his role during the subprime mortgage crisis. However, it was obvious that his bold steps helped evade the damaging effect of the crisis to a great extent. Bernanke's academic and professional experience equipped him with the required skills and policy acumen to tame the negative impact of a crisis. In particular, the focus of Bernanke's work was to analyse the economic and political causes of a financial crisis. He dissected the 1929 great depression in the light of monetary policy and other critical external forces. Bernanke followed the footsteps of his predecessor, the famous Milton Friedman, who pointed out the policy mistake of the Fed during the Great Depression. He argued that the central bank's tight monetary policy and sudden and early increase in interest rate disrupted the flow of liquidity in the market, which subsequently fueled the crisis. For Friedman, Fed's conservative attitude during the crisis not only fuels the crisis but also prolongs it. Perhaps inspired by this idea, Bernanke adopted an expansionary monetary policy during the subprime crisis. Monetary easing continued for quite a long time in the post-crisis period to provide enough time and space for economic stability. Bernanke lowered the interest rates to zero with the aim to prevent the adverse effects of the 2009 financial crisis. He blamed his predecessors for their misguided monetary policies that eventually resulted in the crisis. Bernanke draws the evidence that in a span of eight years from 2000 to 2008, the federal fund rate was revised 42 times. While Friedman attributed the cause of the crisis to monetary policy alone, Bernanke, however, illustrates that it is not the monetary policy that mostly affects the real economy; rather, it is the relationship between the banking industry and the manufacturing sector that is more important. For Bernanke, the effect of the financial sector's activities on the manufacturing sector is more pronounced than the relationship between the monetary policy and real activity. Bernanke analysed the Great Depression in light of this theory. He showed that the fragility of the financial sector was a major cause for the unwanted lingering of the Great Depression. Before this, US banks were small and fragile. The prevailing laws discouraged large-scale financial institutions, including branch banking. The entry requirement for new banks loosened to ensure competition among banks. Bank lending was heavily concentrated in a few sectors including agriculture and housing. In such a financial structure, even the slightest negative external shock is enough to destabilise the entire banking system. Bernanke specifically blamed the 'bank run' for the Great Depression of 1929. Banks collect funds from depositors in the form of current, fixed, and term deposits. Current deposit is special because banks are obliged to return them whenever the depositors wish to withdraw. Hence, the deposits are mostly short-term. When banks distribute these deposits to entrepreneurs as loans, they turn into a long-term investment. This results in a 'maturity mismatch' (short-term deposit vs. long-term investment) which is sensitive for the financial sector. Since all depositors do not withdraw funds altogether from the bank, maturity mismatch does not cause any threat to the banking system. However, it becomes a major problem if the depositors flock together at the bank counters to withdraw their funds. For example, if there is a lack of confidence in the financial sector, depositors simply go to the bank to withdraw their funds. Since banks cannot meet the demand of all the depositors at once, the depositors may have an idea that whoever reaches the counter first will receive the funds, and those who arrive late lose their deposit. This motivates depositors to withdraw their funds even if they do not need them immediately, leading banks to the state of bankruptcy. This situation is referred to as a bank run. Before the Great Depression of 1929, the US economy was stable. Credit flows to the agriculture and housing sectors were high. Manufacturing firms began to borrow more through fixed-rate securities during the recession. At the onset of the Great Depression, the downward trend in agricultural commodity prices and low yields reduced farmers' income. This led to sluggish demand for goods and services. A lack of demand resulted in low profits for the industrial sector. Agriculture, housing and manufacturing enterprises are unable to repay bank loans as promised. This caused many small banks to collapse. 'Bank run' on the one hand, and the contraction of the supply of money on the other led many small banks to insolvency. The banking sector seriously suffered from inefficiencies; debt became costly. Small businesses were unable to take advantage of bank loans. Moreover, the conservative attitude of banks during the economic downturn further restricted the flow of credit. This accelerated as well as prolonged the great depression of 1929. According to Bernanke, this vicious cycle can turn a small or medium financial crisis into a Great Depression. In light of this theory, Bernanke showed that the Great Depression of 1929 was caused not only by monetary policy mistakes but also by the collapse of the financial sector. From this vantage point, Bernanke argued that there is no room to underestimate the role of banks in the economy. Indeed, barriers prevailing in the banking sector need to be eliminated so that financial services can be delivered to users at a low cost, Bernanke urged. No doubt, his postulation will improve our understanding of the causes and consequences of financial crises and help avert a potential crisis in the future. Such an idea, during a time of financial fragility, is definitely worth a big recognition.

Elon Musk wants the Federal Reserve get a grip on the US regional banking crisis, or else the world's largest economy could undergo its worst shock in decades. Financial blog Zero Hedge on Saturday wrote on Twitter about the crucial role played by small- to medium-sized banks in the US financial system – a hot topic after this month's abrupt collapse of Silicon Valley Bank, a lender to tech startups and the first to be taken over by regulators since the financial crisis in 2008. Small- and mid-sized banks account for 50% of commercial and industrial lending and 60% of residential real estate lending, among other loans, Zero Hedge noted with accompanying charts. "If the Fed does not contain the regional bank collapse, there will be another great depression," it wrote, referring to the economic crisis that ran from 1929 through 1939. "This is a serious risk," Musk responded to Zero Hedge. In 1933, at the height of the Great Depression, roughly 25% of the 12.8 million people that made up the US labor force were out of work, according to the Labor Department. This wasn't the first time Musk has chimed in on his own social media platform about SVB's collapse. Last week, he compared the bank's failure to the 1920s Wall Street crash, which preceded the Great Depression. "Lot of current year similarities to 1929," the Tesla CEO said in response to a thread by Ark Invest CIO Cathie Wood. Silicon Valley Bank failed this month after customers rushed to pull deposits in the wake of the bank's$1.8 billion loss on a sale of a bond portfolio. The portfolio's value was severely hit by rising interest rates enacted by the Federal Reserve as it tries to pull inflation to its 2% target. First Republic Bank has emerged as a high-profile hot spot in the unfolding regional banking crisis. The stock crashed again on Monday following another S&P Global downgrade of its credit rating further into junk status. The Wall Street Journal also reported that JPMorgan CEO Jamie Dimon was leading talks among big banks to provide even more aid to stabilize First Republic. Last week, a $30 billion rescue plan was created for the San Francisco-based lender by rival banks. Fitch Ratings last week said a risk for First Republic was its "concentrated" focus on wealthy customers in urban coastal markets. Fitch had also downgraded First Republic's credit rating to so-called junk status.

Sheila Bair, a top banking regulator during the 2008 financial crisis, says the stunning implosion of Silicon Valley Bank is exactly why the Federal Reserve needs to halt its war on inflation. “The Fed needs to hit pause and assess the full impact of its actions so far before raising short rates further,” Bair, the former chair of the Federal Deposit Insurance Corporation, told CNN on Sunday in a phone interview. “If they paused, it would have a settling effect on the markets,” said Bair, who led the FDIC through the 2008 failure of Washington Mutual. Silicon Valley Bank is second only to Washington Mutual in terms of the biggest bank failures in US history. Before Friday, investors were anticipating a major interest rate hike of a half percentage point at the Fed’s March 21-22 meeting. Bair said a hike of that size would not be “well advised” given the Silicon Valley Bank collapse. Similarly, Goldman Sachs told clients late Sunday that “in light of the stress in the banking system,” the bank no longer expects the Federal Reserve to deliver a rate hike next week. Goldman, however, still expects rate hikes of a quarter point in the Fed’s May, June and July meetings, though it added there is “considerable uncertainty about the path.” To fight inflation, the Fed has aggressively lifted interest rates at a pace unseen since the early 1980s. Those interest rate hikes have contributed to the collapse of Silicon Valley Bank in at least two key ways. First, higher borrowing costs rocked the frothy parts of the US economy, especially the tech industry that Silicon Valley Bank catered to. Secondly, the Fed’s rate hikes undermined the value of the Treasury bonds that banks rely on as a central source of capital. “When money gets tighter, financial assets lose value. That has to be carefully managed,” said Bair, who led the FDIC during a wave of bank failures during the 2008 global financial crisis. As of the end of last year, US banks were sitting on $620 billion in unrealized losses (assets that have lost value but haven’t been sold yet), according to FDIC data. Those assets could lose further value if the Fed keeps raising rates.

The global financial system is facing a crisis of confidence. Which makes this week’s meeting of America’s central bankers critically important. None of the 12 members of the Federal Reserve Board’s Open Market Committee were elected to their posts. The vast majority of Americans don’t even know their names, except perhaps for the chairman, Jerome Powell. But as they try to decide whether to raise interest rates and, if so, by how much, America’s central bankers are deciding on the fate of the American – and much of the world’s – economy. And they’re sitting on the horns of a dilemma. On one horn is their fear that inflation will become entrenched in the economy, requiring more interest-rate hikes. On the other horn is their fear that if they continue to raise interest rates, smaller banks won’t have enough capital to meet their depositors’ needs. Higher rates could imperil more banks, especially those that used depositors’ money to purchase long-term bonds when interest rates were lower, as did Silicon Valley Bank. That means that raising interest rates could cause more runs on more banks. The financial system is already shaky. The two objectives – fighting inflation by raising rates, and avoiding a bank run – are in direct conflict. As the old song goes: “Something’s got to give.” What will it be? The sensible thing would be for the Fed to pause rate hikes long enough to let the financial system calm down. Besides, inflation is receding, albeit slowly. So there’s no reason to risk more financial tumult. But will the Fed see it that way? The Fed’s goal last week was to stabilize the banks enough so the Fed could raise interest rates this week without prompting more bank runs. The Fed bailed out uninsured depositors at two banks and signaled it would bail out others – in effect, expanding federal deposit insurance to cover every depositor at every bank. On top of this, 11 of America’s biggest banks agreed to contribute a total of $30bn to prop up First Republic, another smaller bank caught in the turmoil. This “show of support” (as it was billed, without irony) elicited a cheer from Jerome Powell and the treasury secretary, Janet Yellen, who called it “most welcome”. (Of course it was welcome. They probably organized it.) But investors and depositors are still worried. Other regional banks across the US have done just what Silicon Valley Bank did – buying long-dated bonds whose values have dropped as interest rates have risen. According to one study, as many as 190 more lenders could fail. On Monday, First Republic remained imperiled notwithstanding last week’s $30bn cash infusion. Trading in its shares on the New York Stock Exchange was automatically halted several times to prevent a freefall. Multiple recent downgrades of banks by ratings agencies like Moody’s haven’t helped. Reportedly, the Biden administration is even in talks with Warren Buffett, the chairman of Berkshire Hathaway, who invested billions to bolster Goldman Sachs during the 2008 financial crisis. Central banks must ensure that instead of a race to the bottom, it’s a race to protect the public Meanwhile, on the other side of the Atlantic, the European Central Bank last week raised interest rates by half a percentage point, asserting its commitment to fighting inflation. Yet the higher interest rates, combined with the failure of the two smaller American banks, have shaken banks in Europe. Just hours before the European Central Bank’s announcement, the banking giant Credit Suisse got a $54bn lifeline from Switzerland’s central bank. Yet not even this was enough to restore confidence. After a several days of negotiations involving regulators in Switzerland, the US and the UK, Switzerland’s biggest bank, UBS, agreed over the weekend to buy Credit Suisse in an emergency rescue deal. Finance ultimately depends on confidence – confidence that banks are sound and confidence that prices are under control.

Some GND [Green New Deal] proponents have attempted to circumvent this obvious fiscal problem by arguing that the massive government borrowing required to finance the GND can be repaid through money creation. (A variant might be that no actual borrowing would be necessary: The Federal Reserve could simply create money through a keystroke, literally, to pay the GND bills.) The government can always print dollars to repay its (dollar) debts, a policy stance commonly referred to as Modern Monetary Theory, although government use of the printing press to acquire resources is old and familiar. Modern Monetary Theory is little more than the latest example of the old argument that there is available a free lunch, as illustrated by the argument from a prominent proponent that “anything that is technically feasible is financially affordable.”123 Some critics of this argument note that it is correct narrowly— yes, government can repay its nominal debts if it creates the currency in which the debt is denominated—but that it would represent poor policy for various reasons.124 The critics clearly are correct that government debt denominated in dollars can be “repaid” through money creation. But that observation is independent of the larger issue of whether the government borrowing needed to finance a GND would be possible in a world in which the market believes that the resulting debts will be repaid through money creation. Consider the dynamic effect of such government borrowing on the interest rate that it must offer.125 • A basic condition for the stability of government borrowing is that the real rate of return to government debt must exceed the growth rate of real government debt in the long run. If the market expects the debt to grow over the long term more quickly than the real return to the debt, then interest rates sufficient to induce the market to offer real resources to the government must increase, perhaps massively. • The credibility of the government promise to repay its debts in real terms cannot be assumed to be independent of the magnitude of the debt itself, in that incentives to renege on promised debt service must rise as the debt rises. Moreover, potential lenders to the government would assume that dollar-denominated debts promising extremely high interest returns (say, 50 percent) in fact would not be repaid in real terms, as the incentive to renege would become overwhelming. • • If incentives for the government to use money creation to repay nominal debts are seen as strengthening significantly, interest rates would rise to reflect the risk of default in real terms, that is, repayment in dollars buying fewer real goods and services. This last point brings us to the obvious inflation problem attendant upon Modern Monetary Theory. Unless massive money creation is assumed to lead to a decline in the income velocity of money— crudely, the rate at which dollars are spent—which is a deeply problematic assumption, then a sharp increase in the money supply must create an inflation, unless somehow there is an increase in the real resources available to the private sector.126 But the GND assumes a massive resource shift toward the government, in this case through the mechanism of government borrowing. Accordingly, a sharp increase in inflation is the inexorable implication of Modern Monetary Theory. To the extent that an inflation is anticipated, it is a tax on non-interest-bearing money, which is another way of seeing that a GND financed through borrowing to be repaid with money creation must increase velocity, as individuals attempt to avoid this tax by reducing their holdings of money. To the extent that the inflation is not anticipated, it is a subsidy for nominal debtors, financed by a tax on nominal creditors, who would receive debt repayment in nominal dollars that purchase less than anticipated in real goods and services. Notice that government is always a net monetary debtor, so the upshot of Modern Monetary Theory is a massive wealth transfer to the government—that is, to the interests benefiting from government borrowing.127 The proponents of Modern Monetary Theory as a financing mechanism for the GND respond that the inflation problem can be avoided by using taxes to remove money from the economy, thus easing the inflationary effect, a proposed transformation of fiscal policy into a substitute for monetary policy.128 This is little more than saying that the GND borrowing would be financed through explicit taxation, with the large adverse excess burden effects discussed above. At a more general level, the proponents of GND finance with a system of debt “repayment” through money creation are arguing in a nutshell that the government will be able to borrow real resources from the private sector and then repay the debts without transferring real resources in return. No one can believe that markets are that myopic. There are no free debt lunches.

The Federal Reserve could increase the size of its interest rate hikes and raise borrowing costs to higher levels than previously projected if evidence continues to point to a robust economy and persistently high inflation, Chair Jerome Powell told a Senate panel Tuesday. “The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated,” Powell testified to the Senate Banking Committee. “If the totality of the data were to indicate that faster tightening is warranted, we would be prepared to increase the pace of rate hikes.” Powell’s comments reflect a sharp change in the economic outlook since the Fed’s most recent policy meeting in early February. At that meeting, the central bank raised its key rate by just a quarter-point, downshifting after a half-point rise in December and four three-quarter-point hikes before that.

In seemingly his most hawkish remarks to date, Federal Reserve Chair Jerome Powell confirmed that the central bank will keep hiking interest rates until inflationary pressures head lower in “a clear and convincing way.” “What we need to see is inflation coming down in a clear and convincing way, and we’re going to keep pushing until we see that. If that involves moving past broadly understood levels of neutral, we won’t hesitate at all to do that,” Powell, who was confirmed by the Senate last week to a second four-year term at the helm of the Fed, said Tuesday during a Wall Street Journal event. “We will go until we feel we’re at a place where we can say financial conditions are in an appropriate place, we see inflation coming down. We’ll go to that point. There won’t be any hesitation about that,” he added. Earlier this month, the Fed green-lighted a rare half-percentage-point interest rate hike and announced plans to shrink its $9 trillion asset portfolio beginning next month in an effort to blunt inflation, which has surged to a four-decade high. The key benchmark federal funds rate now sits at a range between 0.75 percent and 1 percent, the highest level since the Covid-19 pandemic began more than two years ago. Powell stated following that increase that similar fifty-basis point moves were likely to come at ensuing meetings. But on Tuesday, he also cautioned that higher rates going forward could eventually start to have a larger impact on growth. “This is a strong economy and we think it’s well positioned to withstand less accommodative monetary policy, tighter monetary policy. There could be some pain involved in restoring price stability, but we think we can maintain a strong labor market,” Powell said, reaffirming the Fed’s 2 percent inflation target.

Here we confront the key, perhaps fundamental, concern with such large-scale government programs: namely, does the structure of the economy produce the needed real goods and services that those UBI benefits are destined to purchase? In other words, even if UBI does not threaten solvency, is the enormous expenditure on the program warranted? What are the real macroeconomic effects of passing UBI and will it ensure a minimum standard of living for all? In my view the answer to these questions is “no” due to some perverse and unintended program effects. Since collecting taxes is a separate operation from spending, it is appropriate to consider gross (rather than net) expenditures first. I consider the impact of taxes and other reductions in government expenditure below. If the program is implemented as an “add-on,” rather than a replacement for existing government programs, spending on UBI could be as high as 20–35% of GDP annually (Tcherneva 2017). UBI would be an enormous fiscal impulse by any measure. The worry is not that it would compromise the government’s budget, but that the expenditure represents vast purchasing power and command over real resources, equivalent to a fifth or more of the US economy. Would the economy produce the needed additional output to satisfy this new demand? If not, how would the resulting real resources be distributed and priced, in order to soak up the additional purchasing power? If output does not adjust sufficiently, the program would prove to be inflationary. Worse, according to UBI advocates, we should expect a sizable fall in labor supply. One of the presumed benefits of the grant is that it empowers the recipients to refuse poorly paid or otherwise “bad” jobs. If UBI advocates (e.g., Standing 2011) are correct and there is a mass exodus from precarious working arrangements, the inflationary effect of the grant would be exacerbated. Once the value of the grant drops, recipients at the bottom of the income distribution will be once again compelled to work. And if the economy continues to provide poorly paid and precarious work arrangement, they will not be “liberated” from their “bad jobs.” Worse still, the grant may accelerate the Uberization of jobs since it represents a large subsidy to firms. Why should an employer offer a living wage, if the government has “promised” to do so via UBI?