Japan’s Heavy Metal PM + Political Threats to Markets + China’s Sad Horse

PATTERSON:
Hi, I am Rebecca Patterson.

MALLABY:
And I’m Sebastian Mallaby.

PATTERSON:
Welcome to The Spillover. Every week, Sebastian and I are going to examine the most important global events and their ripples at the intersection of economics, financial markets, technology, geopolitics, and policy in hopefully, a clear and concise way.

MALLABY:
Today, Rebecca, we’re going to speak about four countries, I think. Japan, which has just had a big election, Britain, which has had a big political scandal, America, which is kind of an ongoing political scandal perhaps, and France, which is pretty close to the brink at most times politically.
And what these have in common, apart from exciting politics, is perhaps the fact that they’ve got three D’s. They’ve got debt, they’ve got bad demographics, and they’ve got a need for more defense spending, and that’s putting pressure on them. And we’re going to dissect what that means for financial markets.

PATTERSON:
Well, Sebastian, you know I love alliteration, so kudos for three D’s. And I don’t want to ruin it, but I need to add one more thing. So we have debt, demographics, defense.
I think we also need to think about angry populations. Populations that have gotten to a point where they take it for granted that the government’s always going to give them more, and that’s adding to this debt crisis or slow-bleeding debt crisis that we might be facing.

MALLABY:
Yeah, totally. And that pressure is what we’re going to get into. We’ve had a long period when maybe you could think about financial markets and politics in a slightly different way.
Politics is emotional, politics has populace. Politics can be kind of demagogic, but finance is supposed to be blue-eye shades analysis and maybe not so much anymore. Maybe that emotional politics is spilling over into markets more.

PATTERSON:
Right, and that’s exactly what we want to talk about today. We want to give some examples to the folks listening to us today or watching us, whatever they’re doing, examples from these fragile four, France, UK, Japan, the US, to show how the politics is spilling into markets with those three D’s plus the angry populace pulling it all together. So that’s going to be the first part of our conversation.
And then I think we should talk about why can’t we just fix this? If these problems are so bad, we hopefully elect pretty smart people. Why can’t they fix it? What is making the problem worse and worse and worse? And why is it different today?
We’ve been talking about overhangs of debt for decades. It hasn’t been an issue, yet. So what’s different?
And then, I think, Sebastian, it would be fun if you and I have to pick who of these fragile four we think could crack first.

MALLABY:
Ooh, yeah.

PATTERSON:
So we’re going to make a bet, we’re going to make it public, and we’ll see what happens. Okay?

MALLABY:
Sounds good.

PATTERSON:
All right, let’s do that. So, before we get there, I would love for you to put on your professorial history hat and explain a little bit why this isn’t 30 years ago, 40 years ago.
I mean, you wrote one of your many bestselling books about Alan Greenspan, our former Fed chairman. And I remember reading back in the 1980s how he thought then the US debt presented imminent risks for a crisis for the United States.
That was the 1980s, and we haven’t had a debt crisis in the US. So, help everyone listening to this understand, why should we keep listening right now? Why does this matter now? Why is it different? What’s different?

MALLABY:
I think, actually, the clue is in your anecdote about Greenspan. So what happened from the eighties onwards is that you had disinflation, inflation came down, stabilized, and at the same time, therefore, interest rates came down, the cost of having debt went down.
So Greenspan’s worries in the eighties were disproved by his own successful tenure as a Fed chairman for the next 18 years. And what we’re seeing now, though, is that’s reversed itself. We’ve gone in a way from a period where in a nutshell, you could say it was the age of magic money.
This is between the financial crisis in 2008 and roughly 2021 when inflation was actually too low, therefore having debt was very cheap. You could have plenty of debt and it didn’t seem to be going to be destabilizing.
So the markets were calm about debt. You had low volatility in markets, and that was the era of magic money. And we’re not in that anymore.

PATTERSON:
No, no. And I think the break, the end of magic money was the pandemic. Right? So, we had everything shut down. The government panicked. They don’t know if it’s going to be a recession or not. So they’re giving people checks and companies checks so we get stimulus.
Everybody’s at home, they want to buy more goods, there’s not enough supply. So both of those things fuel inflation. And then, of course, right afterwards we have Russia invading Ukraine that causes additional inflation, particularly for food and energy.
So we’ve gone from, I love this wording, the magic money era to the age of inflation. And it’s not inflation like my parents‘ inflation of the late seventies, early eighties where we were in gas lines because gas had gotten so expensive.
It’s a different type of inflation. We’ve settled at a structurally higher level cost of everything, and inflation’s come off its peak. But the fact is prices are still going up.

MALLABY:
I mean, I think that’s the key thing that we thought during the pandemic when the Fed was a bit slow to tighten, “Oh, well, that was a mistake. It was a bad mistake, but this inflation is just going to come down again.” And then it hasn’t.
I mean, if you look at certainly three of our fragile four, that would be the US, Japan, and the UK inflation is clearly above target. France, actually it’s not. But if you take the four-year average since the Ukraine War started, French inflation is above 3% because energy prices went up, drove inflation up, then it came down. So, basically, structurally French inflation is high.
And what this means is that we’re in this period when debt is expensive, Greenspan’s worries come back from the 1980s, countries which have a lot of government debt are going to pay a lot of interest. That in turn will expand their budget deficits.
And then that feeds through into excess demand, which means more inflation. And you’re kind of stuck in this bad equilibrium and it’s tough to get out.

PATTERSON:
Right. It was interesting, literally, an hour before we came here to the Council on Foreign Relations to record this today, the Congressional Budget Office in D.C. put out an update on its views of the US fiscal outlook.
So, they’re now forecasting that the US, one of our fragile four, will be spending 26% of its revenue just on interest payments of the debt by 2036. So 26% versus 19 now. And that tells you what’s going on.
So you have a pie of revenue that you collect that you want to spend on stuff to help the economy, but more and more of that pie is being used for interest payments, which don’t add anything to growth. So it’s like dead money.
And the structural inflation, just one other thing I’d add to that, is that the other thing that’s structural today, beyond just prices settling at a higher rate and making it difficult to come down and how that feeds into the debt and deficits, the other structural issue is, I hate to use the word, de-globalization, I think it’s too strong, but supply chains shifting, people prioritizing resilience over speed and efficiency.
Obviously, that’s inflationary, too. And I think that’s structural.

MALLABY:
Right. So in all these ways, we’re stuck in an equilibrium, which turns out to be more durable than we thought during COVID. And there are three ways out.
When you’ve got government debt that is too high, you can either default, which is massively chaotic, and everybody wants to avoid that. You can have austerity and we’ll get into that. But that demands that governments actually do tighten their belts.
It was done in the nineties. Italy ran a series of big budget surpluses when they were getting ready to join the Euro. So it can be done. But in today’s politics, can it be done? I don’t think it can.
And then the last one is inflation.

PATTERSON:
There’s another one. Right.

MALLABY:
If you don’t do austerity and you don’t default, inflation is the only way out, which is why I think markets expect inflation and that drives up interest rates. And then that is like a doom loop.

PATTERSON:
Exactly. Right. Just to double down on your point, you think about what is a politician’s job goal? A politician’s job goal is to get re-elected. How do you get re-elected? You keep your voters happy, and that usually means financial well-being.
Well, how do you make sure they have financial well-being? If the job market isn’t as strong as you would like and there aren’t a lot of better prospects that way, and inflation is running high structurally, you got to give them goodies.
And so, rather than try to do austerity, they’re doing more stimulus. And I don’t know what’s going to stop that, although I want us to talk about it later.

MALLABY:
Well, should we get into the specifics of how we see this spilling over into markets?

PATTERSON:
Yes.

MALLABY:
Let’s start with Japan. You follow Japan closely.

PATTERSON:
Sure, sure. I’ll kick us off with Japan. I’ve been having a lot of fun watching the new Japanese Prime Minister, Prime Minister Takaichi. It’s pretty amazing, A) that you have a woman leading Japan. That in itself is a pretty big deal.
But secondly, she got a super majority, a two-thirds majority in the lower house. So now she has a lot of runway to push through whatever policy she wants, which might even include reform to the Constitution of Japan, which is a huge deal.
But I thought what we’d do, Sebastian, for each of our countries is just pick an example. There’s a bunch now. But in the last few years as we’ve gotten into this age of inflation, we are seeing more of the linkages, the spillovers between the politics and policy and the markets, especially the bond markets.
So my example in Japan, I would go back to end of July, beginning of August 2024, the Bank of Japan raised rates unexpectedly. And when they did that, you had interest rates go up across the yield curve in Japan, and you had the sudden strengthening of the Japanese yen.
And Japan is unique among the fragile four for something called the carry trade. So, go back to your magic money period. In the magic money period, Japan was trying desperately to have positive inflation.
So they not only had zero interest rates for a period, they had negative interest rates. The wonky of us like to say NERP and ZERP for zero interest rates and negative interest rates.
And then they also had yield curve control. So they were actually manipulating the yields all along the curve to keep borrowing costs as low as possible and try desperately to stimulate some inflation. Okay.
So in the Bank of Japan surprise markets and raised rates, all these people who had borrowed in yen because it was basically free money and bought higher yielding stuff elsewhere around the world thought, “Oh my gosh, maybe I need to unwind some of these trades.”
And so, when you saw the yen strengthen, you saw everything from the Turkish lira to the Brazilian real to the US dollar get weaker suddenly because all these trades were being unwound at once.
And when you think about how long that trade went on, literally decades, there are hundreds of billions of dollars, maybe over a trillion dollars in yen carry trades around the world. Not that they’ll all get unwound immediately, but there’s that risk there.
So, the fragile four in Japan’s case isn’t even just about the fact that they have debt over 230% of GDP. It isn’t that the 10 year and 30 year yield in Japan is rising quickly, very quickly.
But it’s also this yen carry trade unwind that has the potential to have major spillover effects around the world if they keep raising rates because Takaichi does more stimulus.

MALLABY:
Say a bit more about Takaichi, because now we have super majority. You missed a key opportunity, Rebecca, to say that Takaichi was a heavy metal drummer.

PATTERSON:
I know. That’s so cool.

MALLABY:
I think it’s almost like automatic. You should have Takaichi, comma, heavy metal drummer. I mean, it’s just irresistible.

PATTERSON:
Yeah, it is. It’s good. As Macron would say, “For sure.”

MALLABY:
But I think more seriously, the thing about Takaichi is she represents a repudiation of what for years has been the key economic consensus in Japan, which is that the Ministry of Finance and the technocrats of the Bank of Japan were super believers in austerity, particularly the Ministry of Finance.
And they would not allow excess stimulus. And now, this politician, through personal appeal, has gotten this huge majority basically on an agenda of repudiating the technocrats.

PATTERSON:
Yeah. Her goal is to push forward a stimulus package, which includes defense, and we’ll get back more to that later. She wants to get 2% of GDP spent on defense in months, but then also a lot of spending on things that could grow the economy, infrastructure, AI, et cetera.
And then she wants to help consumers who are grumpy because they feel like inflation’s too high for their cost of living. So she wants to help them out and do the structural spending.
For now, the financial markets are reacting as if this is all going to end fine because she could reflate the economy, they can get growth faster than interest rate costs.
So if your GE growth is higher than your R, you’re going to avoid a debt crisis. That’s putting it very simply. But that’s kind of the framework, that’s the hope. That’s what we’re seeing in equity markets.
I hope she’s right, but I think there’s a pretty big risk because what she’s doing, as you started out with today, Sebastian, it’s going to push interest rates higher.
And so the interest costs on their debt go up, the bond yields keep going up, borrowing costs for companies go up. So I don’t know if this is the golden reflation age of Japan, or we’ll get to the UK in a second, but is this her Liz Truss moment?

MALLABY:
Right. Well, maybe we should do the UK next.

PATTERSON:
All right. So, UK example. Do you want to do that one or am I doing that one?

MALLABY:
You know, I do live in the UK, Rebecca. Can I, do I get to…?

PATTERSON:
Yeah, that true. You are a Brit. All right, fair. You go.

MALLABY:
We’re both in New York right now. This is where I work. But I actually live in London.

PATTERSON:
Okay. All right, all right, all right.

MALLABY:
And so I have vivid memories of the famous Liz Trust moment. I guess that was 2022?

PATTERSON:
Yes.

MALLABY:
And she’s newly elected or newly chosen Prime Minister as she’s installed. First thing she does is this huge tax cut. I mean it’s like the biggest tax cut package in like 50 years I think. Great bravado.
And within a few days she’s been compared to a lettuce because her political durability appears to be similar to the shelf life over lettuce.

PATTERSON:
I still love that one. I mean, Brits are very clever. That was very clever.

MALLABY:
But the last clever thing was that she did trigger a financial crisis.

PATTERSON:
Yeah, she did.

MALLABY:
Sterling sell off. A mini crisis in one corner of the money market.

PATTERSON:
I remember that. So I was at Bridgewater at the time. The pound fell to a record low against the dollar and the sell-off in the pound, a little bit in the stock market, but especially the bond market forced the Bank of England to step in and do intervention.
So they had to add liquidity to the system at the same time that they were raising rates. So that’s an interesting fun one to explain. Are you tightening or are you easing?
And they’re like, “No, no, no. They’re separate. We’re raising rates for monetary policy, but we’re adding liquidity to prevent a financial crisis.” I mean, that’s the world we’re in with this age of inflation and debt,

MALLABY:
Right. Precisely. One political misstep in a world which is already fragile because it’s so indebted just creates this complete crisis. The Prime Minister falls.
And we’ve had an echo of that just in the last week or so, when a sort of out of left field political shock comes. You know what I’m…?

PATTERSON:
Yeah, I know where you’re going.

MALLABY:
Talking about it. I’m talking about the Epstein scandal. The reason we’re talking about it is that Keir Starmer, the prime minister of Britain, had to fire two of his key people in his operation because they were associated with the choice of Mandelson, who had been the prime minister’s choice for ambassador in Washington.
He had been involved in Epstein, therefore he’s fired. Then the people who advocated for his selection get fired, and all of a sudden the UK government appears to be in free fall.
Keir Starmer, who was already a bit wobbly, is very wobbly now. And he’s kind of a dead man walking in the eyes of many political observers in Britain.

PATTERSON:
But then tie that to the debt problem in Britain. So, if Starmer’s out, why would that create debt fears?

MALLABY:
Because the spin over here is that if Starmer loses his footing, the Labour Party, which he leads is going to move to the left. Move to the left means bigger budget deficits. Bigger budget deficits means problems for the bond market as we’ve discussed.

PATTERSON:
Right. So, that explains why year to date, every major currency has gone up against the US dollar except the pound.

MALLABY:
Should we do France?

PATTERSON:
Oui. [foreign language 00:17:03]

MALLABY:
Tres [foreign language 00:17:03], Rebecca.

PATTERSON:
I lived there for a whole year, but I think you’re partly French.

MALLABY:
I am partly French.

PATTERSON:
So, I would guess you’re a bit more fluant than I am. That’s not even a word. I made it up.

MALLABY:
Anyway, the point about France is it’s a total mess. Both my paternal country, Britain, and my maternal country, France, they’re both kind of fragile as we’ve been talking.

PATTERSON:
Yes, yes.

MALLABY:
And, specifically, in the French case, what you’ve had is five prime ministers in the space of just over a year.

PATTERSON:
I mean, it is feeling more and more Italian, the number of prime ministers they have. Yes.

MALLABY:
Right. And the consequence of, it’s one thing to lose a prime minister, that’s just a bit careless. But when you lose two or three, it becomes a bit too-

PATTERSON:
Embarrassing.

MALLABY:
Yeah, embarrassing. And what it’s telling us is that they just cannot do anything sensible on their budget. And if you can’t get the budget under control in France, you’re headed for a fiscal crisis.
Already French interest rates, long rates are higher than in Spain. So, Europe has kind of flipped. What used to be the periphery, the weak economies have now become the core. And the core economies like France have become periphery.

PATTERSON:
It’s amazing. I mean, we’re holding up Greece and Spain now as role models for the rest of Europe. And a decade ago who would’ve thought?

MALLABY:
Yeah. And now we’re worried, very worried about France. And that leaves the United States.

PATTERSON:
Well, before we get to the US, there was a twist this week that I happened to notice in the news. And, again, this is part of what I want to bring into this podcast.
We are so overwhelmed by 24/7 information these days that it’s easy to miss things or not know how to put them into the bigger mosaic. So, this is what I saw this week that I thought was super interesting, and I’m reading this now because I can’t even keep it all in my head.
The French Central Bank governor announced that he’s going to resign earlier than he needed to. And he said, “Oh, I’ve been in the seat for 11 or so years. I’m tired.” Fine, fine, fine. But that’s not what’s happening here.
In the current environment he’s doing it so Macron can put in a new governor of his choosing before the next general election. Because if he doesn’t do well in that election, you could have a governor who might tilt a certain way in European Central Bank meetings that’s not in his interest.
To me, it’s important, and it ties to all this because even though the ECB, the European Central Bank, is a lot of countries voting, you still want your representative for your country pushing for whatever your agenda is. Right?
It’s not totally independent. And, obviously, Central Bank independence is coming up quite a bit in some of our fragile four.

MALLABY:
Yeah, we’ll get to that.

PATTERSON:
Okay. So you asked, should we get to the US?

MALLABY:
Well, actually Central Bank independence might be a good segue way.

PATTERSON:
We’ll see when the nominee, Kevin Warsh, gets through a Senate confirmation. It’s not clear when that’ll happen now that Senator Tillis has said he’s not going to allow any confirmations until they resolve the White House investigation of the Fed and current Chairman Jerome Powell for their fed renovation.
It’s a mess. So we don’t know when he’ll be confirmed. But let’s assume he gets confirmed given President Trump’s strong rhetoric about the Fed and the need for the governor and chairman, pardon me, the chairman, to cut rates and lead that effort.
Kevin Warsh, assuming he’s confirmed, he’s going to have an unbelievable battle. If you think the data say you should cut rates, how do you prove you’re doing it for the right reason?
If the data says you shouldn’t cut rates and he cuts them and he has to spin a story, then the market’s going to react as if independence is gone.
So, he’s going to have a particularly tough job. And, again, it all comes back to debt. President Trump and Treasury Secretary Bessent have been very clear that they want lower ten-year yields in the United States, help borrowing costs and help mortgage rates.

MALLABY:
And if they can’t get that, the debt trajectory is looking pretty worrying, right?

PATTERSON:
Well, it looks worrying regardless. So in the US, let me go to my example. So we’ve done examples for the other countries. In the US, I think the easy one to talk about right now, and then I’ll come back to where we are with the debt.
So the easy one is last April Liberation Day. So after the White House went out to the Rose Lawn, had its big poster with proposed tariff rates bigger than anyone expected on more countries than anyone expected. And the initial market reaction was panic, frankly.
People thought if this becomes reality, we could have a recession. And investors sold the dollar, they sold US stocks, they sold US bonds. So it was like fleeing an emerging market. And it was so bad that it forced the administration to walk it all back in about seven days.
But it showed you that even the biggest debt market in the world, the United States, the government debt market is about $30 trillion, multiples bigger than the next biggest market. Even that market isn’t immune to some of the political policy pressures given that debt load.
So I think that’s why that’s a useful example because it shows even the big guy, the elephant in the room, you can still have a Liz Truss lettuce moment.

MALLABY:
I think looking ahead, the other thing that worries me about the US position is that this being under the surface, this huge shift in the nature of foreign flows into the US.
It used to be that central banks around the world were delighted to stock up on US dollar reserves in the form of treasuries. And that was a lot of the foreign buying of US assets. They’ve actually sort of stopped and now they’re buying gold. I mean, it’s much less of it anyway.

PATTERSON:
Yeah. So, you’re still seeing net positive flows from overseas into the US treasury market. And there was a fear last April that you wouldn’t. And so it was a happy surprise that we are still seeing a net positive flow.
However, to your point, you are also seeing central banks adding to their gold reserves by a lot faster rate than they had historically.

MALLABY:
And I think I’m right that a bigger share of, or a rising share of the money coming in is really the AI trade. It’s foreigners buying equities, specifically tech equities.
And if AI turns out to be a bubble and that trade reverses the impact on the US dollar, which already went down by 10% in the past year, it could go down quite a bit more.

PATTERSON:
Yeah. So the dollar is an important thing to keep an eye on here because even though capital continued coming into US debt markets last year and US equity markets last year, to your point, I think primarily for tech exposure, the dollar kept falling last year.
It stabilized a little bit the second half of the year, but over the year completely, it lost 10%. It’s down again so far this year, again against everything except the pound.
And that weaker dollar all else equal adds to this structural inflation that we’re talking about. And that inflation, all else equal, keeps pushing up interest rates, which makes the debt harder to manage.

MALLABY:
Right. Okay.

PATTERSON:
So we want to keep an eye on the dollar, for sure. So we covered our examples of how the politics and policy are getting into the markets. Now we’re going to talk about what do these fragile four have in common. How about demographics?

MALLABY:
Yeah. All right. I think the thing to say about demographics is that there’s one country which is way worse than all the others in terms of the dependency ratio of the number of non-workers to workers. And that is Japan.
It’s like off the charts, right?

PATTERSON:
Right.

MALLABY:
And then the others are a bit high. But the big point is Japan is the one to be frightened by.

PATTERSON:
Yeah. Japan’s population actually started shrinking, if I’m remembering correctly, in 2008. So this has been going on for some time.
And so you have two issues. You have fewer people working, so there’s less tax revenue going into the government from them. And you have a bigger part of your population, elderly part of your population that’s depending on government support, whether healthcare, social security, what have you.
And so, the government has to put more of its money towards them rather than bridges, railroads, infrastructure, education, things that can grow the economy faster and they’re not gaining as much revenue to begin with.
So, the demographics absolutely exacerbates the debt problem. And it’s hard to turn around if you don’t like foreigners.

MALLABY:
Right. Okay. We’ve done demography. The next one is debt.

PATTERSON:
Yes. So, debt, what do they all have in common? Persistent budget deficits, generally, pretty large budget deficits and large and growing debt levels.
And, again, we can go back to our Greenspan comment earlier that this isn’t new, but what is new is that the absolute levels of debt and deficits are higher. We’re running deficits despite positive growth.
Usually, you have a big deficit if you’re in a crisis and you need to claw out of it. And then when the times are good, you have austerity. And so you can manage things over time. We’ve thrown that out, that playbook’s gone.
So the debt’s high. And then the risk, of course, is that we’re going to hit a wall. And I think what I worry about in the case of the United States is social security.
Now you see these crazy headlines about it going bankrupt. It doesn’t go bankrupt. But there are credible estimates that by 2033 or so, maybe even a little earlier, the trust fund for social security will run out of money.
And what that means is the new money coming in is just from payrolls. And so, people who are receiving social security will have to take big cuts. They might lose 20, 25% of the benefits they were expecting. So if you think voters are grumpy now, just wait until 2033, which is not long from here.

MALLABY:
They’re not going to tolerate it. And they’ve got huge voting power. They show up at the polls. And so the idea that you’re actually going to impose that enormous cut is politically, it seems unlikely.
I think you can almost sum up all of this debt discussion and the new age of inflation with the following. I read this amazing number. So, this is an IMF study. It’s kind of weird coming from the IMF, but I’ll give it to you anyway.
So the average 70-year-old today apparently has the cognitive ability of a 53-year-old in the year 2000, right?

PATTERSON:
Modern medicine, technology, all that good stuff?

MALLABY:
Yeah, we take care of ourselves better.

PATTERSON:
We’re healthier. Yeah.

MALLABY:
We work out, whatever, just a better diet. I mean, you know.

PATTERSON:
Yeah. Some of us, yes.

MALLABY:
Some combination of these things apparently has just prolonged healthy cognition way beyond where it was before. And so we are capable of continuing to support ourselves, work, earn money and so forth.
But electorates still demand the government assistance, the retirement support and so forth that they had been getting 40, 50 years ago. I mean, they don’t want to cut in that.
And so it’s that tension between we live longer, we live healthier, but we want to pretend that we don’t. We want the benefits that assume that we don’t. That is the nub of the problem.

PATTERSON:
Which we increasingly can’t afford. Okay, let’s keep going. So the next thing we all have in common, all our countries is the defense situation.
And I think it’s pretty easy to see why countries are spending more on defense. There’s a push and a pull, if you will. The push is coming from the White House here in the United States, especially with NATO members. President Trump is saying you need to get your defense spending up to X percent of GDP or else.
And then there’s also this realization around the world that the world has gotten to be a less certain place. And sitting here at Council on Foreign Relations, we hear about that daily. I think we were at a dinner together last night here in this room where we talked about that.
So, whether it’s worries about Russia/Ukraine, and what else might Russia do, especially within Europe, whether it’s Asia, the Pacific, China, et cetera, or even the Middle East, you are seeing more countries around the world.
Takaichi is not alone saying, we’re going to increase spending on defense and do it quickly.

MALLABY:
Right. I mean, I just think you can say it very simply. The Europeans, and that includes two of our fragile four. France and Britain, are terrified by Russia plus Greenland. The Japanese are terrified by China. That’s why Takaichi wants to spend more on defense.
And Trump kind of seems to be scared of himself or something because the US already has the biggest military and he’s just been sending out messages on Truth Social saying, “One trillion US defense budget, not enough. it should be 1.5 trillion.”

PATTERSON:
Right. And just so we know, what does that mean? Well, the Committee for a Responsible Federal Budget says that if Trump got his 1.5 trillion defense budget, it would add 5.8 trillion to our debt. So, it’s meaningful.
Now I am going back to the Ghostbusters movie. You never want to cross the streams when you’re trying to kill the ghost. But we are crossing the streams here. Right?
So we are spending more and more in defense versus what we’re spending on other things.

MALLABY:
Which tells us, by the way, that if we’re thinking about fixing the problem, trying to constrain defense spending is not actually the top priority. It’s really about that trap that we’re in with electorates that just want unsustainable amounts of spending on them and they don’t want to pay more taxes.

PATTERSON:
Right, right. And then I guess the last thing they all have in common is the angry populations. Maybe it’s not fair to call them all angry. Needy, grumpy. I don’t know. We can get out-

MALLABY:
But that is much better.

PATTERSON:
We’ll get a thesaurus out. But really, after the, and I don’t want to say handouts, the government support that people did need after 2008 and during the pandemic.
But with that period of magic money, zero interest rates, zero inflation, and these handouts, people kind of got used to it and they don’t want to give it up.
And so now you have just costs that have gone up since the pandemic, inflation that’s better but still running higher than people would like, and they think they should get more.
And you see that reflected in polls. There was one that came out of Gallup this week that showed a third of respondents, and this was global, globally, said either the economy or finding a well-paying job were their number one concerns. And that was a lot higher than what we’ve seen in the past.
So, cost of living, affordability, whatever you want to call it, that’s also part of the problem since the politicians don’t like pushing back.

MALLABY:
Okay. So, putting all this together, who is your pick for which of these fragile four is the most fragile?

PATTERSON:
Yeah, I thought about this for a while and I think the US debt and the treasury market is definitely getting a lot of attention, probably the most attention. But if I had to pick which of our four is most likely to crack, I think I’d take France.
And I love France. I lived in Strasbourg, I did graduate study there. I’m a big Europhile. I want Europe to succeed, but I don’t think France is doing what it needs to succeed.
So, we already talked about their demographics. It can’t devalue its currency to inflate its way out of it because it’s part of the Eurozone. So it can’t control its own currency. It can’t print its way out of it.
We see what happens when they try austerity. I mean, they are trying, the politicians propose stuff. There’s riots in the streets, they get fired and we get a new prime minister. So that austerity thing is not happening so far.
And they don’t have the capital market. So Takaichi is saying, we’re going to spend money and grow our way out of it. Without having other reforms in Europe to deepen and broaden the capital markets to support innovation, I’m skeptical they can do that either.
So, I’m picking France. I’m not saying that everyone watching should go out and short French bonds, that a crisis is coming tomorrow. But I do think of the four, if we see something break and it becomes bigger than a one-week head of lettuce crisis, it’s probably going to be France.

MALLABY:
Okay. So I would give an honorable mention or a dishonorable mention to Japan.

PATTERSON:
Okay.

MALLABY:
Just because it does have the biggest debt to GDP ratio, and it has by far the worst demographic problem. And it’s just elected a prime minister, who, in a way is great because she has a breath of fresh air. She’s charismatic, she has a big majority. I kind of agree with her on defense. You need to defend yourself against China. I want her to succeed.
But, there is a Liz Truss sort of element to this. Just a complete disregard for the technocratic consensus that you’ve got to be careful on the macroeconomic management precisely because you have this demography and you have this debt to GDP ratio.
And she just wants to grow her way out. That was what Liz Truss says. That’s my runner up.
But I agree with you about France. And I would add beyond the reasons you gave, they have the biggest fiscal adjustment that they need to do. So I’ve read these studies that say-

PATTERSON:
France does.

MALLABY:
Yeah. So, in most of these countries, the other three in the fragile four, if the government could tighten its belt by 2% of GDP, either raise taxes or cut spending to the tune of 2% of GDP, you’d be on a sustainable path with the debt.
In France, it’s not 2%, it’s 3%. So it’s like a 50% worse challenge. And you can’t raise taxes in France because they already have a government that’s spending 52% of GDP. This is insane.

PATTERSON:
Yeah.

MALLABY:
Right? So they have very little space to maneuver. And then you’ve got that dysfunctional politics, which you described. So I’m putting France first, too, as well.

PATTERSON:
Poor France. Okay. Let’s go over what we told people today. And then we want to end every podcast with something else that we read or saw or did this week that we think other people should know about. So, we don’t want anyone to hang up, yet because that’s going to be the fun part.
All right, but first let’s just do a quick wrap. I think in terms of what we were trying to communicate today, if I had to pull it all together, a couple key points.
First, age of magic money was part of the problem, part of what got us here. And an age where aging healthier populations demanded more and more for their governments and no one wants to give it up and that’s over.
We’re now in an age of structurally relatively higher inflation. It’s not likely to go away. And that plus the larger debt levels makes it a lot worse today. And the fact that they all need to spend more on defense.
So, demographics, defense, angry population, age of inflation. Of our fragile four, we think the one that we need to worry about is France. Although, Japan we’re going to, time will tell. Is this going to be a beautiful reflation or a Liz Truss moment?
And it’s too early to say. Although, I will say the equity markets right now in Japan are outperforming and suggesting people are really hopeful.
So, anyway, that’s what we covered today. And now in terms of our fun thing or interesting thing for the week.
So, Sebastian, at the end of this week, we have a major holiday coming up. I’m not talking about Valentine’s Day. I did get you a present.

MALLABY:
No,

PATTERSON:
Because it’s Lunar New Year, so I want you to open that right now.

MALLABY:
Oh my goodness. Lunar New Year present. It’s my first one ever.

PATTERSON:
Okay. Do you know what that is?

MALLABY:
I’ll hold it up.

PATTERSON:
Yes.

MALLABY:
I do not know what it is.

PATTERSON:
So, this is a Chinese sad horse. I had to pull some strings to get this.

MALLABY:
I see. You can see it’s sad.

PATTERSON:
Yes. So, basically, China makes a lot of things at scale including children’s toys, and they had made these for Lunar New Year. And they accidentally put the smile upside down and it went viral.
They’re selling tens of thousands of these horses and hour in China because a lot of, especially young people who are having a hard time getting jobs say, this sums up how they’re feeling in China right now.
So, I love this as kind of an analogy for China. Mass production of a lot of stuff. Mistakes happen. It’s kind of resonating with a part of the population that’s holding back Chinese growth.
Consumers are sad horses right now. But, hopefully, it makes you smile, not sad.

MALLABY:
It makes me smile. And your fun fact is way more fun than I was. I was going to say something kind of interesting, but I’m not sure it’s that fun. Anyway, I’m watching because-

PATTERSON:
All right. Interesting fact.

MALLABY:
I’m obsessed with artificial intelligence.

PATTERSON:
We all should be. Yes.

MALLABY:
There is a summit coming up in India next week. It’s going to be a huge jamboree. All the leaders of all the tech companies are going to show up.
And in the last few of these, there’ve been three of these big summits since Bletchley Park in England, I think it was 2024. And they’ve been about AI safety.
This time it’s going to be about AI sovereignty because people have just like in the world of Trump, they just don’t talk about safety anymore. The will to talk about that to regulate AI is gone.
Instead, nations are racing to create their own AI. They want to have sovereign AI, they want to control their own AI. So, that’s what I’m watching.

PATTERSON:
And when is that again?

MALLABY:
That is next week.

PATTERSON:
Next week. All right. So, after that’s done, I’m spending a week out west in Silicon Valley. So, I’ll get some color there. And I think we’ll have to pull all that together and have a good conversation, for sure.

MALLABY:
Sounds terrific.

PATTERSON:
All right. Well, that’s been fun, Sebastian. We did it.

MALLABY:
First podcast.

PATTERSON:
Our first episode. Yay.

MALLABY:
Right.

PATTERSON:
Thanks for joining us. Now we have to tell you things we’re supposed to tell you.
This episode was produced by Molly McAnany, Gabrielle Sierra, and Jeremy Sherlick. Our video editor is Claire Seaton. Our audio producer is Markus Zakaria. Our video producer is Justin Schuster. Our audio engineer is Todd Yeager. Research for this episode was provided by the wonderful Liza Jacob and Daniel Hadi.