James Carville, President Clinton’s political adviser, famously said that when it came to winning elections, what mattered most was “the economy, stupid.”
If Carville’s adage holds true in next year’s mid-term elections, President Biden could run into serious difficulty in maintaining control of both houses of Congress. This would seem to be particularly true at a time that the risk of economic overheating and a spike in the pandemic is occurring against the backdrop of a U.S. equity, housing and credit market bubble.
Over the past year, the highly expansionary stance of both fiscal and monetary policy has produced a very strong economic recovery. But it has done so at the cost of creating troubling asset and credit market bubbles that could burst in the run-up to next year’s elections.
Unlike in 2008, when the U.S. suffered from a housing and credit market bubble, today it seems to be suffering from an “everything” bubble. Equity valuations today are at around double their long run average, or at a level that has been experienced only once before in the past 100 years.
At the same time, U.S. housing prices are presently rising at an annual 16 percent rate and now exceed their 2006 peak. Meanwhile interest rate spreads on high-yield and highly leveraged corporate borrowing are now at close to all-time lows.
Today’s asset and credit market bubbles seem to be based on two highly dubious premises. The first is that today’s ultra-low interest rates will last forever. The second is that today’s strong economic recovery will not be interrupted by a renewed period of economic weakness.
As former Treasury Secretary Larry Summers keeps reminding us, Biden’s highly expansionary budget policy runs the real risk of causing economic overheating. That in turn could force the Federal Reserve to raise interest rates well before the November 2022 elections in order to meet its inflation target. Such a rise in interest rates could be the trigger that causes the equity and housing market bubbles to burst.
The main reason for thinking that the Biden budget stimulus could lead to economic overheating is that it is very large in relation to the gap between the country’s present output level and the level that could be attained at full employment. Whereas the Congressional Budget Office estimates that the so-called output gap is currently around 3 percent, the Biden budget involves the U.S. economy receiving around 12 percent of GDP budget support in 2022. Combined with today’s unusually expansive monetary policy, that could make inflation’s recent pick-up to a 30-year high anything but transitory.
The one thing that could spare the economy from overheating would be a renewed economic lockdown as a result of the current surge in the Delta variant. By suppressing demand and causing unemployment to rise, the Delta wave could cool inflationary pressures and stay the Fed’s hand in raising interest rates. But it would do so at the risk of undermining the second premise of continued strong economic growth on which today’s equity and housing market bubbles rest. As was the case in March 2000, any abrupt slowing in economic growth could be the trigger that bursts today’s housing and equity market bubbles.
In the run up to next year’s mid-term elections, the best Biden can hope for is for the current Delta wave to be sufficiently strong to cool the economy by enough to tame inflation but not strong enough to burst today’s housing and credit market bubbles. For that to occur, Biden will need the luck of the Irish.
Rather than relying on luck, it would have been better for Biden’s 2022 election prospects had he heeded Carville’s famous adage. Maybe then he might not have opted for an excessively expansionary budget policy that is contributing to a very strong economic recovery in 2021 but is also setting us up for a hard economic landing in the upcoming election year.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.