Hello and welcome to our latest video #MacroMemo. We have a few important subjects to discuss this time around. One is the U.S. debt ceiling, which is coming to a head as I record this, and so we'll talk about that. We'll talk a little bit about U.S. regional banks as well. That's been a point of conversation for several months now.

It's been a source of stress in the U.S. economy, but specifically, we'll take a look at it in the context of – and comparing to – the Savings and Loan (S&L) crisis of the 1980s and early 1990s, which was a previous banking crisis with some parallels that are worth evaluating.

We’ll of course get into the economy and just what the economic data is saying. We'll do something similar with inflation and we'll finish with an evaluation of the possible infrastructure boom in the context of that Inflation Reduction Act that was passed a year ago. And we’ll try to reconcile some pretty radically different estimates as to just how much infrastructure money and money in general might get spent. You see figures that are a few hundred billion, you see figures that are several trillion.

That's a big difference. So we'll talk our way through that. Okay, back to the top, let's go with the debt ceiling. As you may know, the U.S. has a rule that limits how much debt can be issued. That needs to be explicitly increased every time the debt reaches a certain point. And that point is now being hit. At this point, the best guess is that June 5th would be the point at which the U.S. runs out of money and in theory, bad things start to happen.

The good news is that as I record this, and this could change quickly, it does look like there's a deal between the White House of President Biden on the Democrat side and Republican House Leader McCarthy. And so that's very promising. They have committed to some spending restraints. So the government spending would be flat in 2024.

It would rise by 1% in 2025. Some programs are exempted from those restrictions, including defense and pensions and health care. There are some other tweaks as well. But really the big story is one of some government spending restraint, which is a win for the Republicans and a loss for the Democrats, but something that needs to be negotiated to get an increase in the debt ceiling.

The debt ceiling will be lifted for two years. In fact, it will be eliminated for two years. So it just won't apply and they'll revisit it two years from now.

This deal is likely to get through. The vote is May 31st. There are some procedural questions, though. For instance, this does need to go through one committee first.

And that committee is dominated by Republicans. Some have said they don't support it. One said that they were promised when they were appointed that if any of them opposed it, it wouldn't go through. That's not legally what needs to happen. There are some Democrats who can support it on that committee and get it through, which I think is the most likely scenario.

But it could still be a little bit messy on a few fronts. Normally you get unanimous support from the party that runs the House of Representatives – that would be the Republicans this time. It doesn't look like they will get that, they would need some Democrat votes. That's unusual. They probably will get those votes. Bottom line is, this vote probably does go through, the debt ceiling is probably fixed.

There are a couple of hurdles that do remain. In a scenario in which that deal didn't get done – June 5th is the best guess for the deadline, though it isn't precise – our thinking is they would prioritize debt servicing and debt payment and have a government shutdown that would limit spending in other directions.

I think that would bring people back to the table and get a deal fairly quickly. The risk of a technical default is still quite low. The main point here is that a deal is more likely than not at this point, which is very good news indeed, and markets have generally been responding quite favorably to that.

Okay. On from there. Regional banks in the U.S. have had trouble for a while. Let's just take a quick compare-and-contrast to the Savings and Loans (S&L) crisis of the 1980s and into the early 1990s. There really is a commonality here in the sense that in both cases it was higher interest rates that did a lot of the damage.

This time around regional banks held a lot of bonds. Those bonds declined in value as rates rose, so losses resulted from that.

In the 1970s, 1980s and early 1990s, it also involved higher interest rates. In this case, S&Ls were a type of bank that was heavily involved in the mortgage market. They had a lot of long-term mortgages on their books and in retrospect, they'd lent at too-low rates because interest rates went higher, their cost of funding increased and they were taking a loss on those mortgages.

So some similarities there – but I do think that the S&L crisis of the 1980s and so on was ultimately a much bigger problem. We can walk our way through some important differences.

One would be that S&Ls were 15% of the U.S. banking market back then. Regional banks, the ones struggling today, are about 6%. So that's a much smaller share, just over a third of the size. S&L had an absolutely massive duration mismatch, they borrowed as short as they could borrow.

They were checking deposits for where they got their money from and then they lent pretty much as long as they could lend, in the sense of 30-year mortgages. It's hard to have a bigger gap than that between the duration of your borrowing and your lending – and that gap isn't generally as large for the regional banks today.

When you think about rising rates being a catalyst for the problems in both instances, an increase in rates was much more radical in the 1970s and early 1980s, so that was just much more damaging than the situation today. S&Ls had sort of funny rules that limited them and proved quite problematic.

For instance, they were not allowed to offer more than a 5.5% deposit rate, and that may have sounded reasonable in a world of 3, 4 and 5% interest rates. But when suddenly interest rates were 14, 15 and 20%, that was not competitive at all. As a result, they were simply unable to retain their deposits.

Regional banks today are struggling to retain their deposits, but they're not limited in their ability to compete with money market funds and GICs and so on. They can offer a competitive interest rate if they if they care to, they're not limited in that sense. It culminated in two thirds of S&Ls being insolvent by the early 1980s.

They did not have any capital left. Government let them keep operating, which in retrospect was perhaps a mistake, but two thirds of them were insolvent. Today, that's not the case. We've got a couple of banks that have been insolvent. You can certainly look at the mark to market losses on bond portfolios for regional banks today and say that some others are insolvent, could be insolvent, or much less capitalized than they should be.

But even the most pessimistic models today say that about half of regional banks could be below the minimum capital threshold they're supposed to hold. But there's a big difference between being below a capital threshold and not having any capital. It's actually quite a large difference. The purpose of that buffer is for problems like this, and indeed there is still a buffer in the vast majority of the banks.

So, it's a long way from insolvency. In the S&Ls situation, regulators responded to initial problems in the wrong way. Instead of greater regulation, they deregulated. They basically said: “Go take more risks and hopefully you can go build up a capital base.” A lot of these S&Ls were not skilled at this, but did precisely that and invested in real estate and in oil and things like this.

A lot of the industry was based in Texas. Then you had a real estate bust there in the 1980s. You had an oil bust in the 1980s, and a lot of S&Ls lost a lot of money and it took years to resolve. It was a big problem and a costly one for taxpayers.

Certainly, some commonalities. But at the end of the day, this seems to be a much smaller problem today. I think it is right to think in the context of this being resolved over a number of years, not just a number of weeks or a number of months. It takes time to reregulate a sector and to fix some of the problems that exist.

At the end of the day, the scale of the problem is a whole lot smaller, and whereas S&Ls really don't exist anymore today, you'd expect regional banks to exist several decades from now.

Okay, on from there, let's just briefly talk about the economy. Just a couple of thoughts here. One would be Germany just released its second quarter GDP print, and it was down.

Germany has now recorded two consecutive quarters of declining economic output. It's not the official definition of a recession, but it's not a bad shorthand or proxy. So Germany is recession-esque right now.

Beyond that, we’re still getting very mixed readings. Some things look just fine and some things not so fine.

In a nutshell, as we track second quarter U.S. GDP data, you get quite a wide range of estimates from some pretty credible sources right now. You have the Atlanta Fed tracking 1.9% annualized growth. That's decent growth. Your blue-chip consensus, that'd be professional economists, they’re forecasting an average of 0.4% growth. That would be pretty weak.

You have the St Louis Fed's GDP Nowcast, which is forecasting a decline of 0.3%. So apparently, credible forecasters think that second quarter was anywhere between totally normal growth and a recession. Obviously that's a big range. We are perhaps at an inflection point, but at a minimum, at a point of high uncertainty in terms of what is happening to the economy.

For the record, we are still forecasting a recession. We still think it's most likely to be in the second half of this year. But as it stands right now, the second quarter is proving quite blurry.

Quick thought on inflation: as the April inflation data came in, it was mostly disappointing. It didn't show as much progress as one would have liked and as we had seen over a lot of the earlier months.

So it created some concern. I will say we think we will see a resumption of declining inflation. In fact, we're tracking some real-time inflation metrics and those have actually fallen quite nicely into May and into late May. We should start to see a bit of progress in May, perhaps a bit more progress as the June data comes along.

Fundamentally, we expect inflation to continue to fall from here, if not snapping all the way back to 2%. What’s fascinating is that we recently were able to replicate some research we found and essentially break down the unit price of products in the U.S. and find out why the price is higher.

If businesses are charging more, are they charging more because they're earning bigger profits? Are they charging more because their labour costs went up, or are they charging more because other costs increased and they're just passing those along?

Fascinatingly, when you do that work, you actually find that 51% of the increase in inflation, at least in the context of a business expense statement and revenue statement, has come from higher labour costs.

Slightly over half is higher labour costs, while 34% is because business profit margins have increased. The small remainder is from other sources.

I must say it was a surprise to me that labour was such a large share, after all, haven’t wages underperformed versus inflation? Haven't wages responded to inflation? They haven't led inflation, and so the whole thing was initially quite surprising.

I think the way to think about it is that wages have actually kept up with inflation. When we look at wage growth and we adjust for productivity and we adjust for inflation and crucially, we go right back to just before the pandemic, we find that wages have kept up with those things. Ultimately, wages are a part of the inflation story.

If that sounds wrong, it's because for the last 2 to 2.5 years, we've seen wages underperform inflation. But in the initial shock of the beginning of the pandemic, we saw wage growth that actually substantially outpaced inflation. So that sort of reconciles the difference. The other thought is this isn't an effort to place blame.

If you talk about why inflation got so high, you need to look elsewhere. It was too much money being printed and too much fiscal stimulus and commodity shocks and supply chain problems. Wages weren't the original source, but wages have picked up in a way that they do now represent a significant chunk of why higher prices have stuck around, if that makes sense.

It's not a blame game exercise. It doesn't say who's at fault or where the causality lies, but it does say that the increase in wages is a big part of why prices are still higher. We do need to watch wages quite closely, I think that’s the takeaway.

I'll finish with infrastructure. This is mostly U.S. infrastructure, just because we've seen widely varying numbers. You might recall the Inflation Reduction Act, which was grossly misnamed. It had very little to do with inflation, much more to do with infrastructure and green infrastructure. But when that came out about 9-10 months ago, the Congressional Budget Office (CBO)in the U.S. said that it would generate about $369 billion of spending for green infrastructure.

Some private analysts, though, said it could be $3 trillion. I think it's pretty important to try and figure out which of those numbers, if either, is more credible and you can reconcile the difference in a few ways. One would just be that the CBO, first of all, was only talking about the government spending part, not the idea that the private sector might spend as well.

But critically, this program essentially is a subsidy. If nobody does infrastructure, then the subsidy is worth $0. If everybody does infrastructure, the subsidy is theoretically of an infinite value. So it's really hard to pin down just how much money it's worth. There are quite varying estimates, as some people think that the uptake could be something like three times bigger than the CBO thinks.

So that helps you get from $369 billion to more like $1 trillion. The other big part is simply that a subsidy means there needs to be some private sector money at the table, too. So you get a couple of bucks of private sector spending and maybe a dollar of government subsidy to support that. For every dollar of government spending, there's more money being spent on the private sector side.

It gets a little blurry just because not all the private sector money is necessarily new. There would have presumably been some infrastructure happening one way or the other. So you do need to be bit careful with the numbers. But the bottom line is that when we tally it up, we're comfortable.

I should say as well, the Inflation Reduction Act has some tax hikes as well that subtract off the top. But when we tally it up, we're comfortable with the idea that perhaps it's worth up to $1.3 trillion of additional stimulus.

Now, that's a lot of money. It is spread over ten years, though. So you're talking more about $130 billion or so per year over that period of time. That's quite significant and certainly a boon to green technology and to the environment and to carbon and so on.

It's a boon to the infrastructure sector in general. However, it's not a huge impact on the economy. It would be up to a 0.5% boost to the level of economic output per year over the 10-year period. That’s not 0.5% faster growth per year. That's point 5% faster growth one year, followed by an economy that's a bit bigger for the next nine years and then it presumably shrinks back down.

Not trivial whatsoever – worth watching, and needs to be factored into forecasts. Not a totally crazy game changer either.

At the same time, you can say it's a big infrastructure plan. There's going to be a lot of spending, it's going to be green oriented, it's good for the environment, and yet it's not a wild game changer in terms of the rate of economic growth over the next few years.

Okay, I'll stop there. Thank you very much, as always for your time. Hope you found some of this useful and interesting. Please tune in next time. Thank you.