Japan Rearms + Guns vs. Butter + Global Defense Spending Boom

PATTERSON:
I’m Rebecca Patterson.

MALLABY:
And I’m Sebastian Mallaby.

PATTERSON:
Welcome to The Spillover.

MALLABY:
Rebecca, you’re back from Japan just in time to record another episode of The Spillover. How was your trip?

PATTERSON:
Overall, great. The Way Home, obviously. It’s a long trip from Japan to the U.S. I had a new hitch though. We had a sinkhole in the LaGuardia runway, so I was dashing around airports at my change in Minneapolis, Minnesota, trying to find a plane that wasn’t canceled. But I did get home. Other than that, it was amazing.

I was at some meetings with the Trilateral Commission. We meet twice a year around the world, and then I had my older daughter with me, and we had a few days to just be Tris, which was wonderful. And with the dollar yen exchange rate at around 160, it was like the whole country was on sale, which meant I could order more Wagyu beef with my Shabu Shabu, which is my favorite Japanese dish. Have you had Shabu Shabu?

MALLABY:
I certainly have. I lived in Japan, and yeah, actually, I love Japanese culture. I spent the first two months of my three and a bit years in Japan, staying in the family of a guy whose job was to design and paint kimono, you know, the traditional Japanese dress for Japanese women.

This was in Kanazawa, a sort of smallish town on the Japan Sea Coast. And the thing I remember, my first impression of Japan was that zero people would jaywalk. So, you know, they’d be waiting to cross the street, and there would be no cars coming in either direction.

But if the light was red, they were not going to cross.

PATTERSON:
It’s still true. It’s still true today. My daughter, who was born and raised New Yorker, was amazed at this.

And I’m like, you can’t. You absolutely cannot. So it’s still true.

MALLABY:
Well, I did cross the street because my mom was not with me to tell me not to. I normally feel like a pretty law-abiding guy, but in Japan, I kind of felt like a rebel, which was a weird reversal. But anyway, I think you said you were with the Trilateral Commission out there.

I have to say that name sounds a bit James Bondy to me that, you know, I’ve heard jokes over the years about these are the guys with the black helicopters who run the world behind the scenes. You want to comment on that?

PATTERSON:
I guess. No, there were no helicopters, black, white or otherwise, to be seen. But it is a pretty special group.

It’s a membership organization, public and private sector leaders from around the world. And we get together twice a year to talk about global issues. And there’s civil but good debate.

And then people see collaboration and solutions. And I still actually believe that there are issues like that where it’s beneficial. And the interesting thing at this particular meeting in Tokyo was the amount of time we spent on the global remilitarization trend and kind of the intersection of that with AI.

So I thought that it would be interesting today for us to talk a little bit about that. You know, you lived in Japan. I’ve traveled to Japan many, many times over the last several decades.

And it feels like Japan is kind of a great case study to talk about the increase in global defense spending, how governments are thinking about this these days. Does that sound like a fair plan?

MALLABY:
Sounds like a great plan.

PATTERSON:
Well, before we get into Japan specifically, maybe I can just sketch out what the broader issue is. You know, I won’t spend a lot of time on it because I think we already know, you know, it’s the Russia aggression in Ukraine. More recently, it’s the war in Iran.

It’s continued worries and tensions between China, Taiwan, and within the area there. It’s questions about the US’s role in NATO under President Trump. So governments around the world are increasingly embracing guns versus butter.

If we go back to our high school economics days, the governments want guns, but the voters want cheaper butter. In the case of Japan, they want cheaper rice. Rice prices have skyrocketed over the last few years.

And all this is happening when governments, frankly, can’t afford more guns or butter. Debt levels are very high. The IMF, in its April fiscal monitor, it’s now forecasting that global government debt as a share of GDP is going to hit 100 percent by the end of this decade.

So, you know, governments have competing priorities and there really just aren’t any silver bullets, no pun intended. So what do you spend the money on? What’s the role of the private sector with governments in this?

How is it going to affect economies, financial markets? I thought that would be what we can drill into.

MALLABY:
Yeah, so we can see these budget pressures show up in the numbers. I guess the go-to source on this is the Stockholm International Peace Research Institute, or SIPRI, and they come out with a report every year in April. And the most recent one is telling us that in real terms, inflation-adjusted global defense budgets went up by 2.9 percent in the most recent year. And when I first read that, I thought, yeah, whatever, 2.9 is something, but it’s not extraordinary. But there’s a big pair of caveats to that number. The first is that the numbers were dragged down by the cessation of U.S. support to Ukraine in the war. And if you had not had that thing, you just looked at the other countries taking the U.S. out of it. You actually had a jump of 10 percent in real terms, more or less, in terms of defense budgets. And then on top of that, caveat number two is that you’ve got certain geographies where it’s really a very big jump.

So the EU, in terms of rising defense expenditure, the rise is in the double digits. Germany is literally 24 percent. Canada is over 20 percent.

So these are really significant, hefty moves which are going to make an impact on budgets and what countries can afford and the size of the deficit.

PATTERSON:
Right. And then the question is, how do they pay for it? You mentioned budgets.

MALLABY:
Yeah. The IMF says that roughly two-thirds of the defense spending increases are financed through borrowing, right, rather than through either higher tax rates or spending cuts. So on average, the budget deficits are growing by a lot.

The IMF puts this at around 2.6 percentage points of GDP. And so that means higher national debt. That means higher inflation.

That pushes up interest rates. That’s not good for consumers. It’s not good for business.

It’s not good for anybody who borrows. JP Morgan put out an estimate recently that the total increase in the federal debt over the next decade could push the treasury interest rate up 90 basis points. So almost a full percentage point.

That’s the total deficit growth. But defense is a meaningful part of that.

PATTERSON:
Right. And everything we’re seeing in real time from Iran to Ukraine, et cetera, suggests that this isn’t stopping, right?

MALLABY:
Yeah. So NATO members are talking about increasing defense expenditure by more, again, maybe up to three and a half percent of GDP in terms of hardcore military spending, and then another 1.5 percent of GDP on other national security-related things. We all know the Trump administration’s budget request of an amazing 1.5 trillion for the military in the current budget cycle. And so that’s at a time when you’ve already got the deficit as a very high level of around 6 percent, which is pretty amazing for peacetime. So it’s just going to make it more extreme. The UN had a projection, which you can take for what it’s worth, but between now and 2035.

So if you look at quite a long way, they reckon that defense spending worldwide is on a path where it could wind up being five times higher than the baseline at the end of the Cold War, right? Five times higher. And so, you know, even if you think that the UN is way off, that it’s not going to be five times higher, it’s going to be two and a half times higher, that’s very high, right?

That’s really affecting fiscal dynamics.

PATTERSON:
Sebastian, you know, these numbers get so big when we’re talking trillions, sometimes it’s hard to wrap your head around it. The comparison I like to use is the military spend versus AICAPX, because at least in the United States, we talk about AICAPX nonstop now. And the estimate this year is around $1 trillion total for USAICAPX.

And so, if we think about the White House budget proposal, it’s 50 percent larger than the AICAPX this year. So that’s kind of an amazing number. And we know that the AI alone is supporting growth and pushing up interest rates.

So this is just going to add to that. You know, with the White House thing, I’m skeptical $1.5 trillion gets passed ultimately, but it doesn’t even matter, really, because the direction is clear. Whether we’re talking about the U.S., Japan, Europe, defense spending is going to continue and probably accelerate from here, and it’s a broad trend. Last year, the global number for defense spending came in around $2.6 trillion, and that’s more than double the USAICAPX spend this year. So these are very big numbers, and they have meaningful economic implications.

MALLABY:
Yeah. And to the extent that this enormous spending on rearmament is not affecting the budget deficit, that means it’s got to come out of spending cuts or higher taxes. So, for example, when the Trump administration proposed that $1.5 trillion budget with a T, as you like to say, they also proposed cuts to green energy, cuts to housing, cuts to health programs, and these things, obviously, that’s not necessarily going to be popular. So what we’re seeing here is that across the rich democracies, you’ve got weak governments fighting for voter’s approval, and then they have to confront this rearmament, which creates these additional stresses. The public does not like higher interest rates. They do not like more inflation.

The public is not keen on having higher taxes. It doesn’t want to have spending programs cut. So what I’m saying is there’s going to be these major political spillovers, probably, in addition to the economic ones.

PATTERSON:
Yeah. And I think that’s a great way, Sebastian, to get back to Japan. I mean, Takaichi was elected prime minister in Japan in part because of this voter frustration.

They were frustrated about inflation, about those rice prices, among other things, and they wanted someone who was going to do something different, and she came in. Japan is not a NATO member, but part of Takaichi’s campaign was as a defense hawk, and she has quickly sped up defense spending. It reached 2 percent of GDP in 2025.

That was two years ahead of schedule, and overall, their defense budget, it sounds like small numbers, but they’re not. It went from 1 percent of GDP to 2 percent of GDP. It had been 1 percent of GDP since the 1970s.

So this is a pretty big change, and what you just said about Moore’s coming. Moore’s coming in Japan, too. Takaichi is going to, her government, is going to be revising and releasing revisions to its three core national security strategy documents.

It’s a mouthful at the end of this year, and that’s also faster than had been originally planned. She wants to get this thing done, and the documents are important because they shape the spending plans for the coming years. I wouldn’t be surprised if those plans basically reflect a desire to get defense spending up closer to that trend we’re seeing in the NATO countries, something closer to 3.5 percent of GDP. Again, how is she going to pay for it? Well, we can talk more about that in a minute, I guess.

MALLABY:
Yeah, it’s amazing. When I lived in Japan in the early 1990s, the politics was such a different place. The history, of course, and just to quickly recap that, is that after the Second World War, neither the American victors nor the Japanese people themselves had much appetite for Japanese militarism.

So Article 9 of the Constitution that was adopted during the American occupation, in fact, the Constitution was mostly written by the American occupiers. Article 9 makes Japan a pacifist country. It’s not supposed to have either an army or a navy or an air force.

Now, of course, the Korean War comes shortly later in 1950, and by 1954, Japan has created what it calls the Japan Self-Defense Force, which does actually have a navy, an army, and an air force. But it’s strictly for defense, and they really mean that. Japanese naval ships never leave Japanese waters.

They’re really confined to the periphery of Japan. Japanese soldiers never go abroad, not even for a United Nations peacekeeping mission until the early 1990s. So that sort of gave rise to this joke about the Japanese, which I think maybe was applied a little bit to Germany as well at the time, which is, you know, these countries are economic giants, but they’re also political dwarfs.

PATTERSON:
Yeah. And so your time in Japan in the early 90s, I mean, that was really kind of when you had some early challenges to this post-war pacifist legacy, right?

MALLABY:
Yeah. And some of that was coming because of pressure from outside Japan. So, you know, the rest of the world thought that Japan should have sent troops to the first Gulf War in 1990, and Japan just sent money, and that was considered a bit cowardly.

So the pressure to at least send a Japanese naval vessel or two to go and help with the minesweeping after the war, you know, that was external pressure. But there was also this internal thing where the country was split between a sort of Japan Socialist Party tradition, which desperately wanted to cling on to that pacifist legacy from the end of Second World War to, on the other hand, the Liberal Democratic Party, which governs Japan for nearly all of the time. And the LDP included a faction that believed quite strongly in recapturing sort of national pride.

And this would find expression in visits by senior LDP leaders to this shrine called the Yasukuni Shrine in central Tokyo. I used to actually go there for weekend walks with my first child in Australia. And it’s quite a pleasant place, which you don’t hear in most of the news stories.

But symbolically, it, you know, it’s the place where the war dead, including some war criminals, are buried. And so the message it was sending those visits was, you know, we’ve had enough with this pacifist post war settlement that was forced on us by American occupiers. And we want to be quote unquote, a normal country, which was kind of code for, you know, we don’t have to be pacifist, we can be proud of our own traditions.

We want to be a normal country.

PATTERSON:
Right. And that quote unquote, normal country is now moving into a new phase, it seems like under Takaichi. And that’s partly because of the rise of China and some of China’s posture in the region.

And it’s America’s, I think, increasingly uncertain commitment to allies overseas. I think it’s left Japan feeling really vulnerable.

MALLABY:
Yeah. And the rise of China is especially relevant for Japan because they have this historical enmity, right? The kind of occupation of Eastern China a bit during the Second World War, the famous or infamous Nanjing massacre.

When I was in China back in March, I remember sitting down for lunch with a researcher from a university who was an AI researcher and we were supposed to be having a tech conversation. But he actually spent sort of half an hour of it haranguing me about Japanese imperialism and militarism and how China had to be strong to fight the Japanese. So there’s that sentiment, which is actually cultivated by the government.

And there was some reporting just recently I noticed about the summit between Trump and Xi, where it was claimed that the moment in the bilateral discussions when Xi really became passionate was when he was complaining to Trump about Japanese rearmament. So you have this animosity on both sides. And that’s what’s driving Takaichi’s rearmament.

PATTERSON:
Yeah, I definitely picked up on some of the Japan-China tone during the last week. I was over there as well and agreed with you on the deep historical groups. It’s interesting because it reminds me somewhat of the rivalry between Germany and Russia.

It’s not exactly the same. But when you think about Putin’s invasion of Ukraine, how the Germans see it, it’s not just an attack on the sovereign country and a violation of international law. It’s a threat to Germany itself.

So Germany, in part because of Ukraine, I think that kind of sped up the government’s desire to get rid of the debt break and start rearming. In Japan, Takaichi’s government is not that popular, but Takaichi herself. She’s a very authentic, charismatic person.

She plays drums. She’s the first female to be prime minister there. So her personal popularity is really unique among the advanced economy leaders right now.

But she’s still got a big hurdle here. The debt GDP ratio in Japan is the highest among the advanced economies. I think it’s around 240 percent right now.

So how does she deal with it? In Germany, Friedrich Merz paused the debt break. That was his way to get around it.

In both cases, they’re trying to get political support for this just by pointing to losing faith in the U.S. military umbrella and these threats from overseas. So we’ll see.

MALLABY:
Yeah, and as I understand it, Takaichi has a special problem because she has to take on that legacy of post-war pacifism. And so she has to go head on and say Article 9 of the Constitution, we might need to rethink that, at least in the margin. The attitude to nuclear weapons, of course, Japan was the one country to actually experience two nuclear bombs in Hiroshima and Nagasaki.

And so there’s an understandably strong feeling about that. Takaichi has to use that popularity to get change on those issues. At least that’s her agenda, right?

PATTERSON:
Right, right, right. There’s two things specifically. So Article 9 of the Constitution and then one of the so-called three non-nuclear principles.

So just to get everything out there on the table here, back in 1967, Japan declared these three non-nuclear principles. So they wouldn’t produce, they wouldn’t possess, they wouldn’t permit the introduction of nuclear weapons on Japanese territory. And that even applies to things like American nuclear submarines pulling into a Japanese port or nuclear weapons on an American ship.

So she’s argued that this ban on the introduction is completely unrealistic if the U.S. is going to continue to provide some sort of extended deterrence for Japan. So she’s worried about that. So that’s one of the reasons she’s pushing ahead on this.

MALLABY:
And when you were in Japan, you saw some anti-war protests, I believe. I mean, how is her push going over?

PATTERSON:
Yeah, I was on my way to a sukiyaki dinner, I think, and driving by the, as one does, that’s so good.

MALLABY:
All discussions of Japan shall be punctuated by references to exotic and delicious food.

PATTERSON:
Yes, okay. So driving by the diet, which is their parliament, and it was, you know, just when people are getting off work, going home to make dinner for their families. And there were hundreds of people lining the sidewalk, very well-behaved, tons of police there, keeping them well-behaved, some very loud rave music in the background, which was kind of curious and surprising, but whatever, they were in a jovial mood.

But it was a large anti-war protest. And so I was just so struck by that, that when I found that, basically, for the last several months now, these protests have been going on around the country, some of them much, much larger, thousands and thousands of people. So, you know, Takaichi, I assume, believes that her personal popularity can overcome this part of the population that really wants to stay pacifist.

MALLABY:
It’s such a fantastic description of the contradictions, at least to an outsider of Japanese culture, you’ve got this pacifist demonstration. And at the same time, there’s rave music. And at the same time, people are highly polite.

It reminds me of like, you go on the Japanese subway, it’s insanely crowded, and there are these people whose job is to physically shove people into the train, squash them in there. But they’re very nice about it, and they’re wearing very clean white gloves with which to push you in. It’s just this funny mixture.

But look, I guess what I take away from this is that, you know, as you say, Takaichi is the popular leader, she plays the drums, but she’s going to have to use some of that political capital to get past these kinds of historically derived resistances to our policy. So pushing a rearmament does take political energy, political capital. And, you know, depending on the contracts which country we’re talking about, that can maybe, you know, reduce the support for a democratic leader who, you know, given the state of Western politics, may not be all that strong in the first place.

But I guess, I mean, just to sort of nail this in terms of that demo you were watching, the question is, I suppose, you know, how much of a political obstacle is it really? Is this sort of, you know, elderly demonstrators who remember the pacifist tradition, and it’s kind of like the, you know, the final fist shake of the silver hair post-war generation, or did it feel more important?

PATTERSON:
You know, I don’t want to overstate my one data point.

MALLABY:
Go on.

PATTERSON:
But that’s not, that’s not good research. What I saw was a mix of ages, honestly. There were quite a few older people there, but it was a mix.

I did, when I was doing my internet sleuthing later, I found a Yomiuri Shimbun poll that came out just earlier this month. And it suggested that 60% of voters are supportive of revising Article 9. Now, Article 9, that’s not the three principles.

Article 9 talks about explicitly defining the self-defense forces. Right now, the self-defense forces are just sort of implied, and it wants to make it explicit that they are allowed. And so, at least that part of what Takaichi wants to change, I mean, she has some serious opposition, 35%, but 60% are saying, no, we’re okay with that.

So, there’s some push she’s going to have to make.

MALLABY:
So, that’s talking about Article 9 and trying to push on the pacifist tradition. What about on the anti-nuclear tradition? Did you get a sense of that there?

PATTERSON:
Yeah. That was, it was interesting. And I don’t think we want to get into this today, because there’s just so much to unpack there.

We spent a lot of the trilateral meeting talking about the intersection of AI and military today. And again, there’s a lot to talk about with that. But on the nuclear specifically, we did spend some time on that.

Not surprisingly, Japan has a very emotional appreciation for the destruction caused by nuclear weapons. And we actually heard on the record at the meeting comments from a gentleman named Rumi Tanaka. He was 13 years old.

He’s still alive today, he was 13 years old and lived in Nagasaki, three kilometers from the epicenter of that bomb when it struck. And afterwards, when he was able to get up, he said there was the sound, the bright light, the wind. He was able to get up.

All the homes obviously around him collapsed, were destroyed. And he had to spend time searching for bodies of his relatives. It was incredibly powerful, incredibly sobering.

And he and an organization he’s part of that are survivors of the two bombs that dropped in Japan at the end of the war. They won the Nobel Peace Prize in 2024 for their work. They’re really just trying to educate people about the dangers of nuclear weapons.

They’re worried that people will forget, because it was so long ago that it almost feels theoretical today. But really in the just early days after those two bombs fell, you had something like 240,000 people die. So it’s just an incredible amount of destruction in a very, very short timeframe.

So he thinks that we’re in a world today that’s less stable, there’s not a lot of nuclear weapons out there. And now on top of it, we have technology that can increase the risk at the margin at least that a weapon like that could be used. And again, I think that’s a topic for another day, but it’s it’s certainly an interesting one.

So yeah, nuclear featured highly in the conversations.

MALLABY:
And that’s just, you know, one more thing, one more kind of political current, that if Takaichi wants to get her agenda through, she has to expend maybe some political capital on that. But so I mean, bottom line, I guess the question is, will she get these changes through both to the Article 9 pacifist clause in the Constitution, and in terms of allowing nuclear armed American ships to go into Japanese ports? What’s your sense of those things?

PATTERSON:
Yeah, I mean, the logistics aren’t straightforward. She needs a two thirds majority in both houses of the diet, plus a majority in a national referendum. So she’s got a super majority in the lower house now, but she’ll probably need to wait until the next upper house election.

And that’s set right now for 2028, I believe. So she’ll need probably to get even more solid support there. And who knows what will happen to her popularity between now and then.

And again, even after that, you have a referendum. So it’s not a guarantee that any of these changes happen. But if they can get the Japanese economy through this current stretch, relatively unscathed, if her popularity holds, I think it’s certainly possible.

MALLABY:
Yeah, I guess there’s a sort of interesting general question here, which is the extent to which we’re in this period now of quite fast changing geopolitical landscape, a lot of new stress in terms of threats that you outlined before Ukraine around and so forth. And the question is, to what extent do the new circumstances drive changes in policy? And to what extent do the old traditions have this ability to survive and influence how things turn out?

So if you look at Japan, any outsider would just take a logical look at it and say, look, you guys actually do have an army. So what’s this pacifist thing? Give me a break.

You guys do need the American nuclear umbrella when you’re up against China. So surely you’re going to allow American nuclear submarines in this is a no-brainer. And the answer is it’s not quite a no-brainer, because these traditions take some time before they can be swept aside.

And then if you try almost to flip the point and think of the opposite example, the United States has a pretty military, pretty martial tradition. It fights a lot of wars. You get a president who campaigns on a MAGA platform of ending wars and avoiding foreign entanglements.

And yet here we are with the Iran war. So it feels as though, in that case also, pre-existing traditions outweighed the political agenda of the new incumbent.

PATTERSON:
Yeah, Iran’s an interesting example. So I agree with you. Americans generally, my perception is certainly that Americans are very proud of their military and their tradition.

At this point, the MAGA base is still very supportive of President Trump and the Iran war. But if you look at the opinion polls of the country more broadly, I think it’s nearly 60% of the overall population is against this particular war. But yeah, I mean, my brother was in the Navy.

My father was in the army. Those are the sorts of things in America you introduce yourself and you share that history of your family with pride. And I think that is something that’s quite, I don’t know if it’s unique about the US, but it’s certainly defining about the US.

But just before we leave military and nukes, one last thing I just wanted to know quickly from my trip. There was a lot of sensitivity in Japan during these meetings about humans in the loop when it comes to AI and technology generally and military weapons. And one of the discussion points, I just wanted to share this.

I just thought this was interesting. President Biden and Xi Jinping two years ago signed an agreement that humans would always be in the loop with nuclear weapons. And when you had President Trump and Xi Jinping meeting more recently, there was no discussion in the formal talking points from their summit underscoring that agreement.

And I think there was quite a bit of angst and disappointment among the Japanese and other countries leadership, quite frankly, that that didn’t happen at this meeting. I just think nukes and AI, this intersection is a good topic we should come back to on another episode of the spillover. But maybe for now, why don’t we shift to some of the macroeconomic spillovers from this move towards guns and butter?

I don’t think it’s going to be guns or butter. I think it’ll be guns and butter at the same time.

MALLABY:
Yeah. And I guess one interesting thing is the extent to which some governments may try to get both.

PATTERSON:
Yeah.

MALLABY:
I mean, certainly in sort of the short term, it seems inconvenient for some governments to say, well, we absolutely need to rearm because there are these big threats out there. But at the same time, they’re thinking to themselves, I quite like this because it’s a bunch of extra spending, which is going to stimulate the economy and give me a sugar high in the economy, bring me political gains in terms of my own popularity in the medium term. And that’s putting it a bit cynically.

But even if you take Japan, there is a case for saying that Japan has been underperforming for a very long time. And a big demand stimulus is exactly the shot in the arm that the system needs to escape the deflation that has marred it for a long time until recently, and so on. So for Takaichi, and I’d say also actually for President Trump, there’s this kind of happy dual agenda where you say, let’s rearm, and you get the hawks onside with you.

And then by the way, let’s stimulate. And there, you know, you wouldn’t necessarily get that past your domestic policy establishment. I mean, thinking that especially of Japan, where there’s a lot of worry that, you know, Japan has this very high debt to GDP ratio already.

And so adding further fiscal debt on top is just sort of impermissibly irresponsible. And I think for Takaichi to get past that kind of opposition, it’s been convenient to say, oh, but we need to do this for military reasons. And she probably believes that, but she also would like to sideline that traditional kind of fiscal hawk wing of the Japanese debate.

And you know, there’s some fairness in this claim that you can do both, because at least if you had an economy that was operating with unemployment and a certain amount of spare capacity, you get quite high fiscal multipliers from additional defense spending. Meaning, every time you spend a dollar on defense, it kind of creates $1.5 of economic activity, partly because defense spending is very domestically concentrated, you tend to buy your arms, you know, where you can from domestic producers. So there’s a lot of second, you know, knock on effects in terms of stimulating economic activity.

But the catch is that point about, hey, it’s got to be that you have some slack in the economy, because if you do this at a time of full employment, right, then you are just bidding up demand, you’re putting more demand in the economy to build more weapons. But the weapons building has to suck workers from some other sector of the economy. So you get a bidding war for labor, labor costs go up, it’s inflationary, and it’s not really usefully adding to any stimulus.

And at that point, the sort of populist hope that you can do both guns and butter and they aren’t virtuously self-reinforcing, that comes unstuck. And the cold logic of the fiscal hawks are losing to the military hawks.

PATTERSON:
So then the next question is, do the military hawks lose to the Bonne vigilantes? And, you know, I think the Bonne vigilantes are definitely awake, and they’re testing, right? They’ve gone to the front line of this war, so to speak.

We talked about that, Sebastian, remember, in our very first episode of the spillover. We talked about what we called the fragile four, Japan, the US, France, and the UK, and high deficits and debts and populations that would kick out the politician if they didn’t give them more of the same. But you are seeing this with the war in Iran.

Obviously, it is creating some inflation pressures because of the supply shock with the Strait of Hormuz closed. But it’s also creating expectations that we’re going to need more bond issuance from governments to finance these larger deficits. And so you’re seeing interest rates rise along the entire yield curve across many of these countries.

The US 30-year Treasury bond yield is back above 5%. You’re seeing Japanese government bonds at record highs on the long end. And even with the Federal Reserve, you know, at the beginning of this year, the markets were discounting that they would cut rates maybe two or three times.

Now, the market is discounting looking at Fed futures that you could get a rate hike by sometime early next year. And so the financing issue isn’t the whole thing, but it’s part of it. And it’s definitely affecting inflation as well as growth expectations.

You know, in Japan’s case, you know, all that spending with the debt GDP at 240% already, it’s not sitting well with investors. I think there’s a risk that the bond move could get disruptive.

MALLABY:
Right. So you have this spillover where you start with rearmament. The rearmament means more government spending, which means more government stimulus to the economy.

That pushes up inflation, which pushes up bond market interest rates, which then also forces central banks to respond and tighten the short end of the curve with higher policy rates. So this is a whole set of dynamics, which are occurring, I think, Rebecca, at a time when we also have a similar dynamic coming out of the Iran war and what that’s done to oil prices.

PATTERSON:
Yeah, it’s a real challenge for the central banks. You know, in the case of Japan, the Bank of Japan has been pretty cautious, partly because the war just creates so much uncertainty. You don’t know how long it’ll last.

You don’t know what will be the growth inflation pressures ahead, but they can’t remain on hold very long because inflation there is running relatively high, but they’re stuck, right? If they don’t raise interest rates, if they stay cautious, then you’re probably going to see that translate into more weakness in their currency. The yen and a weaker currency, all else equal, pushes up inflation even more, and that hits households, which makes Takaichi unhappy.

But if you raise interest rates to inflation in check, that’s going to increase your debt payments on that 240 percent of GDP debt pile, which makes your fiscal outlook even worse. So they have to pick between, frankly, two outcomes with some pretty nasty tales, if you will.

MALLABY:
Yeah, so there’s crunch here. I mean, we’ve gone from contemplating the happiest scenario where the guns and the butter, you can have both, and it’s a happy, virtuous cycle to actually the opposite. You very quickly get into these very difficult choices.

PATTERSON:
Yeah, and the U.S. is in a very similar position, obviously, and Kevin Warsh is going to have his hands full. I guess he’s in his seat today after getting confirmed on Friday. So inflation in the U.S. has been above target for about five years now. Growth is resilient. Financial conditions clearly are easy. Equity markets are at all-time highs.

So it makes sense that the FOMC has moved to a more neutral posture and that the futures market are pricing in the possibility of hikes. But just like Japan, if the U.S. raises rates, if interest rates keep going up, you’re going to have more of the government spending going to interest payments on the debt. And that squeezes the rest of the fiscal space.

So there’s less money left over for other government priorities. And it’s not just the U.S. and Japan, obviously. Other central banks around the world are feeling this.

I think one of the big ones is that as these expectations for the Fed have changed, right? So U.S. interest rates go up. That makes the dollar more attractive, relatively speaking.

So other currencies weaken. And when other currencies weaken, like the yen, it causes more inflation risk. And that inflation risk and the currency weakness has gotten so bad in some countries that central banks are now intervening in the currency market to try to stop that from happening.

But there’s a limit to how far they can do that. So this has become a global problem. It’s not just the fragile four.

MALLABY:
Yeah. Well, I’ll just throw in one last spillover, maybe, and then we can exit the world pool and wrap up. You know, it strikes me also that we’re looking at a U.S. equity market where there’s this big excitement about the three humongous tech IPOs which are coming down the pike. We’ve got SpaceX first. OpenAI probably second. Anthropic soon after that.

And of course, you know, this depends slightly on stock market conditions and an environment of rising interest rates. It’s a good normally for the market now. You know, maybe equity investors laugh that off.

Maybe AI is such a special case that it’s kind of interest rate shock proof. But that’s one more thing I think to be watching.

PATTERSON:
Yeah, no, I agree. If the 10-year U.S. Treasury yield gets back up around or above 5 percent, that tends to be a psychological level. That could certainly spook equity markets and not be very kind to these IPOs.

Right now, it does feel like investors are hiding in these AI stocks. To your point, they’re seen as less sensitive to short-term interest rate changes, and it’s a structural trend. So they’re perceived, rightly or wrongly, as not as sensitive to what’s going on with the Gulf War and those supply shocks.

But it doesn’t mean they’re immune. And if growth takes a leg down, we see the consumer confidence numbers falling. If interest rates keep rising, it’s going to eventually feed into everything, including AI.

But again, the IPOs that, I mean, SpaceX alone going into the indices, that could be an interesting conversation for an episode, too, Sebastian.

MALLABY:
Absolutely.

PATTERSON:
But maybe for now, let’s wrap. And we always talk about something interesting, funny, striking from the last week we saw. Mine’s a little nerdy, but I wanted just to call attention to it.

So the New York Fed has this global supply chain pressure index. It’s a mouthful. That it launched a few years ago, probably around the pandemic or Ukraine.

And I was just checking it recently. It’s not surprisingly with the Iran war. It spiked.

But it spiked a lot. We’re back to levels seen in late spring 22, right after the war in Ukraine started. And we’ll get the next read of that in about a week.

And I would expect it’ll keep going up. And to me, that’s an important indicator for people to be watching. Because if you want to think, when does inflation pressure come down?

When could the Fed ease, for example, that’s going to be one of the markers that we should be keeping an eye on. So I would just put that on everyone’s radar screen.

MALLABY:
You know, when I listen to you sometimes, I’m reminded of writing about Alan Greenspan, who would win most arguments by citing some data series that nobody else had ever heard of. So you would say Midwestern trucking rates are going to be affected by the fact that the bridge across the certain river, you know, incurred a bit of damage last weekend.

PATTERSON:
And, you know, so anyway, look, if you’re comparing me to I am I’m just chuffed.

MALLABY:
I am hugely pleased with that comparison. Thank you, Rebecca Greenspan. So my one this week is a little different.

It’s, you know, I was struck by the new papal encyclical on AI, in which the Pope declared that, you know, if we head down the road that we seem to be on right now, artificial intelligence will be, quote, an instrument of domination, exclusion, and death, which I thought was pretty punchy language. Yeah, you know, coming from the leader of 1.4 billion Catholics in the world, you know, obviously, there’s a big AI backlash anyway. And this is only going to add to it in the US.

I did a bit of Googling and I found that 20% of Americans are religiously Catholic. And another, I think it’s 9% say that they are culturally Catholic. So you got 29% of the population who one way or another feel Catholic feel some allegiance to the Pope.

And he is giving a pretty clear message on artificial intelligence and whether it should be allowed to carry on accelerating forwards.

PATTERSON:
It’ll be interesting to see the next polls that come out on how Americans feel about AI if that shifts things at all. Well, that’s a good one, Sebastian. And I think we should take that and wrap.

If anyone out there wants to stay up to date on the latest episode of this fill over, please sign up to receive an email alert when our new episodes drop at CFR.org slash newsletters, or click the link in our show notes. If you have an idea, or you just want to chat with us, please email podcasts at CFR.org. And be sure to include the spillover in the subject line.

This episode was produced by Molly McAnany, Gabrielle Sierra, and Jeremy Sherlick. Our video editor is Claire Seaton. Our audio producer is Markus Zakaria. And research for this episode was provided by Liza Jacob.

You can subscribe to our show on Apple podcasts, Spotify, YouTube, or wherever you get your podcasts. Thanks.

This transcript was generated using AI and may contain errors or inaccuracies.