On Wednesday, the Federal Reserve raised its benchmark interest rate for just the third time since the global financial crisis in 2008-2009. The Fed’s move, which was expected, reflects the fact that the U.S. economy is growing at 2 percent per year and that the Fed believes “the economy is doing well.” This represents a return to normal after years of very low rates that were designed to stimulate a post-crisis recovery.
The Fed’s view contrasts sharply with that of President Trump, who called job creation “terrible” during the 2016 campaign and claimed that he could double growth to 4 percent. His economic plan seeks to remedy stagnating worker productivity and calls for tax cuts, overhauling the tax code, extensive deregulation, and nearly $1 trillion in infrastructure spending. This plan seems to please traders in the stock market, whose value has increased by almost 15 percent since the presidential election.
But Trump’s plan carries a significant risk — and not only for the United States but also for many developing economies. And the impact of higher U.S. interest rates on developing economies may complicate U.S. foreign policy goals. Here’s why.
By proposing a stimulus of tax cuts and government spending when unemployment is low and the economy is already growing, Trump raises the risk of overheating the economy and increasing inflation. This would lead the Fed to raise interest rates more rapidly in an effort to reduce inflation.
[interstitial_link url=”https://www.washingtonpost.com/news/monkey-cage/wp/2017/03/02/this-is-what-will-happen-if-financial-markets-panic-about-trump/?utm_term=.ef5591a3001a”]This is what will happen if financial markets panic about Trump[/interstitial_link]
Higher interest rates in the United States would affect not only American consumers and businesses but also developing economies as well. In many developing countries, there has been a renewal of free-market centrist governments — for example, in countries such as Argentina and Brazil, which had previously relied more on state-led capitalism.
The challenge for these countries is that they do not have a huge tax base, and so their governments must look elsewhere to finance spending. These more centrist countries tend to rely on borrowing from the global bond market, as opposed to domestic funders like central banks.
When U.S. interest rates increase, global investors will prefer higher-yielding U.S. Treasury bonds, which are often considered the safest assets. This makes it harder for market-oriented developing countries to raise capital by selling their own bonds in the global market. Global investors will prefer to invest in higher-yielding U.S. Treasury bonds, which they consider to be the lowest-risk assets available in global capital markets.
After the financial crisis, when U.S. interest rates were very low, investors sought higher-yielding alternatives in global bond markets, making it easier for developing country governments to sell their bonds. If U.S. interest rates continue to move higher, investors will be less willing to finance debt in developing countries, and those countries will find it harder to borrow money to fund their spending.
My research and other studies show exactly this pattern: Swings in global investor sentiment can make it difficult for governments in developing countries to borrow. To avoid watching investment go elsewhere — sometimes called “capital flight” — these countries have to entice investors somehow.
One way that developing countries do this is via fiscal austerity. Kaj Thomsson and I have found that when developing countries rely on international bond markets, their governments are more likely to exhibit fiscal restraint during national elections. Although politicians often like to use fiscal stimulus to boost the election-year economy, these countries are going in the opposite direction: trying to signal their creditworthiness to investors with austere budget policies that make it more likely these countries will repay debts. But this puts incumbents at risk: Voters will punish them if fiscal austerity creates economic hardships.
So rising U.S. interest rates may undercut the recent trend toward political pragmatism in Latin America, where Argentina’s Mauricio Macri, Brazil’s Michel Temer, and Peru’s Pedro Pablo Kuczynski have promised to put their countries on a more market-friendly path, in part by seeking capital from global bond markets.
If these governments have to offer higher interest rates to compete with rising U.S. interest rates, that could crowd out other government expenditures. Fiscal austerity means that these governments may be unable to provide a rising middle class with greater economic security, improved public infrastructure and better education and health services.
If these pragmatist governments falter, the region could undergo a populist resurgence, reminiscent of the “pink tide” of the 2000s, with leaders such as Mexico’s Andrés Manuel López Obrador hoping to upend mainstream politics by tapping into voters’ wavering confidence in public institutions. With more than half of Latin American countries facing presidential or legislative elections by the end of 2018, rising global interest rates may prompt political turnover.
If there is a populist resurgence in Latin America or elsewhere, the Trump administration would have to deal with governments that are less inclined to embrace Western ideals. For example, it would be harder for Trump to renegotiate trade agreements. Simply put, there would be fewer countries with whom he could cut a better deal.
In this way, making America great again could prove costly. Trump’s plan to catalyze economic growth may lead to higher interest rates at home and greater economic and political volatility abroad.
Stephen Kaplan is an assistant professor of political science and international affairs at George Washington University. He is the author of “Globalization and Austerity Politics in Latin America.”