Gita Gopinath on Why Interest Rates Have Surged All Around the World

There's been a massive selloff in the bond market and rates are rising all around the world. Japan, Korea, the UK... You name it. Gita Gopinath, Harvard economics professor and the former first deputy managing director of the IMF, has long warned that bond markets are "in a fragile place." She sees a confluence of demographics, high levels of public debt, and the intense capital needs of the AI boom creating inflationary pressure all around the world. Today we speak with Gopinath about the seeming disconnect between stocks and bonds and why investors may be wrong to assume that governments will have their back the next time there's a major shock. Read more:US Bonds’ Return to Pre-War Calm Fuels Bets It’ll Be Short-LivedChina Sells $885 Million of Green Bonds in Hong Kong Debut Only http://Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox each week, plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlots Subscribe to the Odd Lots NewsletterJoin the conversation: discord.gg/oddlotsSee omnystudio.com/listener for privacy information.

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• 0:00Tracy Alloway?

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• 1:52Speaker 01

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• 2:07Tracy Alloway?

  Hello and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway.

• 2:11Joe Weisenthal?

  And I'm Joe Weisenthal.

• 2:13Tracy Alloway?

  Joe, the big story in markets right now has to be one of the big stories, the bond market sell-off. By the way, as I say that, I just got this massive feeling of deja vu because I'm pretty sure we've done a few episodes where I've started out saying the exact same line.

• 2:28Joe Weisenthal?

  Well, I mean, one, obviously, this is sort of one of the trends of our time, which is that after a decade pre-COVID, where we just sort of assumed the rates were going to head lower, there's been a regime change, as economists sometimes like to say, and so now we have rates pushing higher again. They've come back a little bit in the last couple of days, but that's not really the point. The point is, it is this global phenomenon around the world, rates going up. I would still say probably the big story in markets is AI and memory and chips. But if it weren't for that, everyone would be talking about interest rates higher in almost every country in the world.

• 3:04Tracy Alloway?

  So here's the thing, I actually think AI and the rate sell-off is kind of connected. So, you know, we're talking about yields going up generally in developed markets. And we've seen that recently. I know we saw, for instance, the long end of the UK gilt market hit like the highest since 1998. The 10-year US Treasury yield was kind of inching up towards 5%, but it's come down. Mostly, a lot of those yields have been moving in line with the oil price, right? So a lot of people will say that this is just because oil's going up, that's inflationary, maybe we'll get higher rates. And so this is why yields have been backing up. However, there is an argument, I'm seeing more and more people make this one, that what's going on is actually

• 3:48Tracy Alloway?

  a repricing of something, you know, less transitory.

• 3:52Joe Weisenthal?

  Yeah.

• 3:52Tracy Alloway?

  Am I allowed to say that word anymore? Less transitory and something more secular.

• 3:56Joe Weisenthal?

  Yeah.

• 3:56Tracy Alloway?

  In what's happening with the rates market, something that's more about the massive amounts of capital that AI is actually consuming and having a crowding out effect on sovereign bonds. Or maybe something that's more about, you know, the ability of the developed world. To actually finance itself in the longer term. And so you're starting to see some of those bigger themes creep into the discussion about the bond market sell off. This idea that it's something else is happening here, something more than the oil price.

• 4:25Joe Weisenthal?

  Totally. Actually, just speaking of the nexus between interest rates and AI, Torsten Slok has a good chart out, came out this morning, pointing out essentially that one thing with AI is the sort of FOMO aspect, not among investors per se, but about companies and not wanting to let their models be six months behind. And so they'll pay whatever the cost is to catch up. And therefore he argues that perhaps higher rates do not have the slowing effect that they might have had in another cycle. Because it's like, well, yeah, it's no fun to finance this data center at higher rates. But if the alternative is being consigned to the permanent underclass, when the other company builds the most advanced model, you're going to do it nonetheless.

• 5:08Joe Weisenthal?

  And so, yes, between oil, between the AI boom, between demographics and the challenges of sort of resourcing for care of the elderly and the infirm, between all of these things, that we are in this real secular shift and we have to understand it better.

• 5:26Tracy Alloway?

  Yes, so I am very happy to say we do in fact have the perfect guest to talk about all of this. We're going to be speaking with Gita Gopinath. She is, of course, a professor of economics at Harvard University, but also famously the first deputy managing director of the IMF. So truly the perfect guest to speak to, someone who's been talking about, you know, a secular change in the bond market for quite some time. Gita, thank you so much for coming on All Thoughts.

• 5:50Speaker 03

  A pleasure, Tracy. And Joe, great to be on your show.

• 5:52Tracy Alloway?

  So what's your take when you're staring presumably, you know, on a minute by minute basis at a chart of the US 10 year yield? What are you thinking?

• 6:01Speaker 03

  I mean, firstly, I think it's absolutely right to start with the conversation about what's happening in bond markets. Because frankly, despite all the many different shocks going around in the world, I actually do think the one that's most worrisome is what we see with public debt levels everywhere in the world. In the US, we've seen yields go up. It's a combination of things. You just talked about all of them, which is one is the fact that inflation is now expected to be higher. And there is a sense that the real rate at which the economy will stay, you know, at a somewhat stable level of inflation is higher. So the kind of the real interest rate has drifted up.

• 6:44Speaker 03

  The R star has drifted up from pre pandemic when it was like half a percentage point. Now it's a one percentage point. But on top of that, you have the premier that's coming from the risk of inflation, from, very importantly, the last fiscal deficits that the US is running and is projected to continue to run into the foreseeable future. And of course, the third element, which is the AI boom and the expenditure, the capital expenditure that's being undertaken for that is also shifting the R star up to maybe even higher than one percentage point. So because of all these reasons, we've suddenly moved away from the pre pandemic period

• 7:28Speaker 03

  of low for long interest rates and what we were talking about, you know, the end of, I think we are at, have the end of secular stagnation at this point. Secular stagnation was about the fact that there was not enough investment happening, especially in the private sector. That is no longer an issue anymore. So because of the combination of inflation, AI boom, fiscal deficits all over the world, high public debt everywhere. You know, we are seeing yields go up and that's true in the US too.

• 8:01Joe Weisenthal?

  I want to drill into all of these specific things. But let's start with like the high level of public debt. That was a thing that people were talking about quite a bit prior to the pandemic as well. And rates just kept going lower and lower, including famously in Japan, where debt to GDP levels are even much higher than they are in the Western world. And that was sort of famously known as the widow maker trade because rates kept going lower. What changed between pre 2020 and post 2020, such that this suddenly, in your view and perhaps the market's view, this became an important thing that was not perceived by the market as being important pre COVID?

• 8:45Speaker 03

  A few things changed. One, the AI boom was unexpected. That was not something that was being priced in markets pre-pandemic, for sure. That big increase in demand for capital coming from the private sector is, one, a big change. The other big change is the fact that fiscal deficits are now projected to stay at levels that nobody was expecting the US to run close to 7% fiscal deficits for the foreseeable future. That is another important factor. And the third is the composition of who's the marginal buyer of this debt. So we had a period when central banks everywhere were buying government debt, and that also

• 9:30Speaker 03

  helped keep interest rates low. In fact, that was part of the strategy of how to, you know, strengthen the economy. Quantitative easing was part of the toolkit. And so that helped keep the interest rates low, but that's changed. And now we have the central banks everywhere who have either stopped buying or they're running it down like it's happening in Japan. And the marginal buyer are the more volatile investors. hedge funds in the US are the market makers over here. And so whenever there are any shifts in global market conditions, you see a lot more rate sensitivity than you would have seen if it was mainly official credit flows.

• 10:13Speaker 03

  And by the way, that's also true about capital flows coming into the US. Previously, the buyers of US treasuries used to be foreign central banks. They're not doing as much anymore. It's mainly coming from non-bank financial institutions from the rest of the world. And so they're also much more volatile and flattish. You're going to see just generally higher volatility in the yield curve.

• 10:36Tracy Alloway?

  Can you talk a little bit more about the AI boom? Because we hear people talk about a crowding out effect. And I think this is actually like something that is just starting to get a lot of attention. But the proportion of issuance in the corporate bond market that's coming from AI companies or AI related, you know, investment right now is just insane. And you mentioned Torsten's Sloc chart. Torsten is going to be at our upcoming.

• 11:01Speaker 03

  That's right.

• 11:02Tracy Alloway?

  We're recording this on May 27th, our upcoming live show in New York. And so I've previewed some of the charts he's going to be sharing there. There's a chart there that shows basically the proportion of AI in the corporate bond market. It's now 50% of all investment grade issuance year to date. And in even junk rated debt, it's creeping up to like almost 40%. So this is a significant amount of debt that's being issued into the market. Is it reasonable to think that investors are maybe going to think like, well, I'll buy some big tech mega cap IG debt versus a US Treasury?

• 11:39Speaker 03

  At least when we look at the pricing in markets, that seems to be the case, especially when it comes to equities, everybody wants to have a piece of the AI boom. And yes, I think there is that sense that, well, this is a sector where we could really see real gains, especially in terms of productivity increases and profitability. And that's going to help, that's going to be something that they want to be a part of. So there is that demand for corporate bonds and for US equity, which is coming again, both from domestic investors, but also from international investors where AI is the trade. I mean, that's where all the dynamism is, and that's where people want to park their

• 12:24Speaker 03

  money. Now, we pointed at all the reasons why rates are likely to stay high, but I just want to point out that we, since we still have the ongoing Iran conflict and we still have the Strait of Hormuz closed. If that is not resolved in any time soon, like, you know, the next month or so.

• 12:45Joe Weisenthal?

  Yeah.

• 12:45Speaker 03

  And you see a even steeper increase in oil prices and crude prices going up to, say, a hundred and sixty dollars a barrel, which is what some of the projections would be in that case. Then we could see much more demand destruction than we are seeing today. And we could be back in that space where at least at a short end, interest rates are being cut pretty rapidly.

• 13:06Joe Weisenthal?

  On this question, going back to the effect that the AI build out is having across rates and bonds and so forth. I want to sort of get some clarification here of what either you or what economists mean when they talk about, say, like crowding out, because there's one version of it that is like, there's a lot of debt being issued right now by very highly rated companies. They probably yields a little bit more than US government bonds. That is attractive for investors perhaps. And maybe that has some sort of crowding out in the financial markets. The other way that one can, that I tend to think of crowding out is that the AI build out, it's like, they're taking up all of the wind turbines.

• 13:49Joe Weisenthal?

  They're taking up all of the trucking capacity to get the goods to the data centers. They're taking up all the skilled contractors and laborers within the regions that these data centers are being built. And that creates inflationary pressure that adds to the strain. And therefore, all things being equal, that says higher inflation, therefore higher rates for longer to maintain that. Which of those two models, whether it's the sort of financial markets version or the sort of real economy version, is a more useful way of thinking about that linkage between private and public sector spending slash debt?

• 14:26Speaker 03

  So both of those are in play right now. So that's the difference between what's happening to real rates versus what's happening to nominal rates.

• 14:34Joe Weisenthal?

  Okay.

• 14:34Speaker 03

  And what's happening to the pricing of the Fed rate path, right? So the first channel that you mentioned, which is just the fact that there is so much of. Demand from the private markets, from AI investors, for AI companies for capital, is going to raise real rates, even if there is no effect on inflation or inflation expectations are not moving, you should expect to see real rates rise. And that's certainly we're seeing some of that. And then the other is the effect that's working through the demand for the different inputs that go into AI, and that's creating an inflationary pressure, which would then need higher nominal rates. And that is also, you know, playing out.

• 15:19Speaker 03

  I think right now, I suspect that the real rate piece is more important. The inflationary part is being driven a lot by what's happening with energy prices and pass through from energy prices into also core inflation. So I think that's the more of the higher inflation, higher rate path story is coming from other forces on inflation as opposed to what's coming from AI itself. And then you have the real rate path, which is going up also because of the general risk environment that we're in, but also because of what's coming from this increase in capital demand coming from the AI sector.

• 16:14Joe Weisenthal?

  There are some market stories where you want every detail. Tracy and I have made quite a few podcasts on that basis, but sometimes you've only got 10 minutes and need to know what's moving markets and why. That's the Barclays Brief Podcast. Every week, experts from Barclays Markets and Research get you up to speed on what matters and what to watch next. About the time it takes to grab a coffee. So search Barclays Brief wherever you get your podcasts.

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• 17:09Tracy Alloway?

  So one of the reasons we wanted to speak with you is because you do have that very significant policy experience. And so when faced with, you know, potentially rising real rates because of an AI boom, what should policymakers be doing here? Because, you know, certainly in the US, we've already seen some Fed officials or outgoing Fed officials start to argue that they can look through the AI boom and its impact on inflation. But if real rates are, you know, structurally rising, if our star is structurally higher than it was before, is that the right move?

• 17:42Speaker 03

  So, I mean, what matters crucially is what we believe are the main drivers of our star at this moment. Is it coming because of higher productivity growth, which is then leading to higher investment and therefore demand for capital? You know, all of that is good, is a kind of the good kind of increase in our star, because that's an economy that is going to, is projected to grow at a faster rate. And that helps, that helps on many fronts, including in terms of bringing debt to GDP down. The other reason our star is going up is because of the increase in fiscal deficits and just general high levels of government borrowing in the US. That is less appealing because that tends to be not necessarily growth enhancing,

• 18:27Speaker 03

  that, you know, the money that's being raised is not for productive, necessarily productive infrastructure investment that's going to generate enough growth. So that's more problematic because it's just generating our star without generating the higher growth that comes, that should come with it. And that can be a problem. From a policymaker's perspective, of course, you have to firstly be able to tell where, what is driving the R star? Is it a good kind or is it the bad kind? But regardless, if our star is drifting up and you have an inflation target of 2%, you are looking at higher nominal interest rates, right? So, right now, the Fed has an R star forecast of about 1%.

• 19:09Speaker 03

  If you put 2% inflation on top of that as their target, we're looking at 3% nominal rates, which is a clear shift away from what it used to be pre pandemic. Then you have to check to see whether the R star increase is actually slowing the economy down or the increase in your nominal rates are slowing the economy down and how much higher than that R star do you have to be to be able to bring inflation down because there is obviously above target inflation in the US at this moment. That is now the big question, whether the air productivity boom is going to mean that you don't need that much of a above R star interest rate. Or do we have too many other forces coming from energy prices passing through into core

• 19:51Speaker 03

  inflation, the lesser, lower levels of immigration in the country, just general trade disruptions, supply chain disruptions, and those are the main drivers in case, in which case maybe you need to keep interest rates even higher. So being able to tease that apart is, you know, I think that's where the, the tough decisions are.

• 20:11Joe Weisenthal?

  Hmm.

• 20:11Speaker 03

  But what is squarely the case is that we are looking at higher nominal interest rates, I mean, regardless of whether R star is coming from the good kind or the bad kind.

• 20:21Joe Weisenthal?

  You know, there is this fantasy, and hopefully it comes true, but there is certainly this fantasy of a lot of people who are into AI, which they would call like the disinflationary boom, right? So let's just imagine we have extremely powerful artificial intelligence that is capable of delivering incredible material gains for people. It makes healthcare really easy and quick. It can power robots that care for us. It can build things, et cetera. Meanwhile, the cost of commodities collapses, maybe the cost of labor collapses. Is that a scenario in which it's worth contemplating and thinking about?

• 21:02Joe Weisenthal?

  So everything gets really cheap because it all gets super automated, but also our standards of living rise dramatically because the AI takes care of it for us. Is that conceivable? Like, from an economist's perspective, is there such thing as the disinflationary boom or the deflationary boom even?

• 21:21Speaker 03

  So this is about, you know, making a distinction between now and what comes next.

• 21:27Joe Weisenthal?

  Yeah.

• 21:28Speaker 03

  Now, clearly, it is about the high levels of investment.

• 21:31Joe Weisenthal?

  Right, right. Clearly, right now, it's pushing everything up. But let's imagine 10 years from now and we've done it. We have this incredible, and somehow we've solved all the sci-fi scenarios so that the AI doesn't want to kill us all, etc. Let's just imagine the rosy scenario in which we have this like incredibly.

• 21:48Tracy Alloway?

  Like there are some under-discussed risk factors in this.

• 21:50Joe Weisenthal?

  No, but right, like, let's just say.

• 21:52Tracy Alloway?

  Assuming the robots don't kill us.

• 21:54Joe Weisenthal?

  Assuming we solve that and the AI works on our behalf and it does what we want it to do and it can create incredible material gains while also delivering it cheaply because it's just one AI, etc. Is that a contemplatable scenario from an economist's perspective?

• 22:09Speaker 03

  There is absolutely a scenario where we could be in that wonderful place with high productivity growth.

• 22:17Joe Weisenthal?

  Yeah.

• 22:17Speaker 03

  At the same time, we don't have civil unrest or.

• 22:20Joe Weisenthal?

  Right.

• 22:20Speaker 03

  You know, rogue forces.

• 22:23Joe Weisenthal?

  Yeah.

• 22:23Speaker 03

  Using AI for ill. That is a scenario, but I do not know a single person who will put a probability on that scenario and say that that's going to happen, you know, with a significant amount of certainty.

• 22:37Joe Weisenthal?

  Yeah.

• 22:38Speaker 03

  There is a very high degree of uncertainty and there are several who also believe that it's yet to be seen whether there is going to be any major productivity gain of the kind that, you know, there are analysts who believe that productivity could go up by two percentage points a year over and above what's where it is right now, which is around two percentage point a year. I mean, that is huge. There is no evidence right now of that kind of a productivity wave coming through. So it's early, but you know, I use the technology and I find it terrific. I mean, it is, it's been really great for my own productivity. It's not affecting my wages or anything so far, but it's, it's there.

• 23:20Speaker 03

  It is, it is a very valuable technology, but there is a lot of uncertainty and which is what is very curious about the markets, right? Because on the one hand, it is impressive where the stock markets are. Again, at a close to a record high. And maybe, you know, one can explain that by this, by saying that, well, there is a scenario where everything goes perfectly well. But there are so many other scenarios that could play out between now and next year or even two years from now. And you barely see that price being priced in markets. So I mean, that's frankly most surprising than just looking at what's happening with just the level of, you know, of the stock market.

• 23:59Tracy Alloway?

  So, okay, we keep talking about the stock market and, you know, debt issuance in the corporate bond market and how everyone wants a piece of AI. Does that basically mean that we're seeing, I guess, maybe scarcity of capital versus the global, we used to call it a global savings glut in the early 2000s, right? Which ended up, per Bernanke, pushing yields lower. Does anyone still talk about a savings glut? Or should we all be talking about, you know, like, capital scarcity?

• 24:29Speaker 03

  No, we don't have a global savings glut anymore. And proof of that is real rates going up, interest rates going up. So that's, so that's that. What we certainly seem to have in the US is, I don't know what to call it, but gluttonous demand for US equity.

• 24:45Tracy Alloway?

  Yeah.

• 24:46Speaker 03

  Coming both from domestic investors, but also from foreign investors. It's, I mean, we're at 40 trillion in terms of foreign holdings of US equities.

• 24:58Tracy Alloway?

  Wow.

• 24:58Speaker 03

  That is at a historic high, even if you look at it as a share of the rest of the world's GDP, it's about twice as high as what it was just before the 2000 dot com bust, I guess, at the peak of the dot com. The world has never been that invested in US equity markets. It's like it's the only game in town. So, you know, if there's a glut, if there's a gluttony, rather, I would say it is for US equities. We're all in this together. And, and as we know, in terms of what's coming into the markets right now, I mean, we have some very big IPOs and that will make us even more all tied at the hip when it comes to AI and stock markets.

• 25:40Joe Weisenthal?

  Speaking of big IPOs, Tracy, this reminds me, and I'm saying this to message our producers, we should really do an episode soon about.

• 25:50Tracy Alloway?

  Are you including voice memos? To producers.

• 25:52Joe Weisenthal?

  I'm now including voice memos to producers. No, I really want to do an episode soon about the fact that all the big index funds are going to have to include companies at basically their peak where you think like historically, okay, like a company like Apple, like it enters the S and P 500 and I don't know, maybe a $20 billion market cap, and then it's a multi trillion dollar market cap. This will be the first time that the index fund owners are going to eventually have to buy these really big companies without having ever experienced any of the gains from the run up. And I think that's like going to be a historic moment for both markets, indexing and ETFs.

• 26:35Tracy Alloway?

  This has been one of my long running criticisms of the big benchmark index providers, which is like, they always say that they're not making investment judgments. They're just holding up a mirror to the market. But like, actually, a lot of these decisions are like incredibly embedded with judgment calls, and they do end up having an impact on the entire market.

• 26:54Joe Weisenthal?

  Yeah, we, this is, uh, this is, I think, going to be a historic time for sort of index investing. Anyway, I know that this is a divergence. I just needed to get that voice memo into our producers.

• 27:04Speaker 03

  Yes. I mean, when we, but you know, hey, there are now more ETFs than there are actually companies being created on the market. So if one, if you wanted to spend a lot of time picking and choosing, you could be, you could be selective too.

• 27:17Joe Weisenthal?

  Yeah, I want to switch ETFs, but then I have to take a capital gains hit. So I can't, you know, this is the, the, anyway, we're, we're getting pretty sidetracked here. I want to talk more. I mean, there are many phenomenons or many things going on at once. But when we think about these pressures, one of, and it relates to AI, but it also relates to commodities itself, is this idea of essentially national resource hoarding and the decline of sort of free trade. And so the fact is, it's like, maybe at one point, we could say, you know what, a country could say, you know what, it's great that America is building a bunch of fighter jets. So we don't have to have our own indigenous fighter jet industry, et cetera. How much, when you look at what's going on with the rates picture and pushing

• 28:02Joe Weisenthal?

  up inflation and so forth, is this phenomenon in which no country fully trusts other countries to deliver goods for them? And therefore, there's a lot of replication or duplication of capital investment happening in every country all at once simultaneously?

• 28:20Speaker 03

  We're seeing a lot of that. I mean, we moved squarely, firmly, decisively away from a pure efficiency-based Yeah. model of I'm gonna buy from the cheapest place and I'm going to sell if I'm the cheapest source to one where everybody is building up their own capacity as much as they can. And of course, depending on the country and depending on how much of fiscal space you have, that can be a small group of things or a big group of things. For sure, energy security is, everybody's paying attention to it. How do we make sure that we don't have to import fuel from the rest of the world? And how can we have our own fuel at home, either through renewables? Whatever we need to do, or maybe just returning to coal for now. Mm-hmm.

• 29:05Speaker 03

  That is, we're gonna see, we're seeing that. Defense expenditure, we need to be able to not just spend more on defense, but make sure that we can actually produce more of the weapons that we need. Semiconductor chips, rare earths. Yes, there are, you know, I think there's so little trust in the world right now in terms of relying on your trading partners. Yeah. That countries are just going to be spending a lot more on this. It's just that it depends on whether you are a country that can afford to raise the finances for it or not. And, but everybody is heading in that direction. So if you look at the list of, you know, all the sources of demand for capital, that is a very, very long list. Yeah.

• 29:50Speaker 03

  And if you look at the sources of supply of capital, there's just one category, which is aging demographics. And that's, you know, we often tend to blame old people for the fact that we need to spend so much on retirement and on health for the future. But the truth is, the reason interest rates are not much more high than they would have been is because of the supply of savings coming from aging demographics around the world.

• 30:13Tracy Alloway?

  Well, you mentioned fiscal space, and I know you've talked previously about the need to, you know, reduce some entitlement spending if governments are going to be serious about reducing deficits. And yet, we've seen numerous attempts in the developed world to actually cut back on government spending, and it seems very, very hard to do in elected democracies, right? Like, it is not a popular platform to be elected and say, "What we really need is austerity for the longer term, and all of you are going to have to suffer in the near term." How are policymakers, like, realistically supposed to navigate that tension, assuming that they're up for election every two to four years?

• 30:54Speaker 03

  I mean, we have the additional problem that I think policymakers actually are not really keen or particularly worried about where their debt to GDP is. If you look around the world, again, except for places where the bond markets are simply just not letting you do more spending, even in the US, I don't believe there's anybody in Congress who's truly worried. There are, sorry, not, there are a couple in Congress who are worried about the US debt level, but not enough, given where debt levels are and given the foreseeable path of spending that's happening. But again, to just step back and see, it's helpful to look at what has happened historically and when have countries been able, and how have they been able to bring their debt to GDP levels down. It's a couple of things.

• 31:39Speaker 03

  It is, one is just a spurt of growth that has come about either because you are some sort of a commodity exporter and you've just had positive terms of trade shock, and because of that, you, your debt to GDP comes down.

• 31:53Tracy Alloway?

  You hit the jackpot, basically.

• 31:55Speaker 03

  Yes, exactly. You got lucky. Or productivity growth, boom, higher, above-average growth, and I believe that's what we're betting on this time with AI. The hope is that with AI, we will get growth from 2% up to 4%, and then that will certainly solve a lot of our problems if we have that on a persistent basis. Countries, especially developed countries, have tended to rely on that. And then you have inflation.

• 32:22Speaker 03

  If you go back even further and also obviously during right after the pandemic, inflation helped bring debt to GDP levels down. And then, of course, the third is what we see with developing countries is you end up with default and restructuring and crises. And then again, you bring debt to GDP down that way. So those have been the typical path. We've never had to worry about debt crises in developed economies. But now more and more, and I think this is also a new feature of the world we live in, is the developed world is moving into that space where their debt costs and their borrowing costs are far more volatile, far more sensitive to market conditions. I mean, the stock cases, the UK, where you see that on a day to day basis.

• 33:05Speaker 03

  But, you know, you see that in other countries too, in Europe and some of it in France. And more generally, even Japan, where for the longest time we didn't have to worry about borrowing costs, those have squarely moved up. The 10 year rates have moved up. You know, Germany's 10 year rates have moved up. Yeah. So everywhere we are seeing developed economies also now having to face higher borrowing costs. The US, I think, is still the exception in the sense that even though 10 year yields are at, say, four and a half percent right now, just given the level of supply of debt and what's expected to come out in the future, markets are still treating it as have giving it some privilege, even if it was not as big as it used to be in the past.

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• 34:36Joe Weisenthal?

  What does, in your view, a debt crisis look like in a country that borrows in its own currency? Because, obviously, politically, maybe the debt ceiling doesn't get raised. There were certainly political ways to default. But economically, the US never theoretically has to run out of dollars, per se. In fact, I would say it's the same thing with the UK. You'd say it's the same thing with Japan. They can't run out of yen the same way, in the same way that, say, an emerging market that borrows in a foreign currency could theoretically run out of dollar

• 35:16Joe Weisenthal?

  reserves, which is why we watch reserve levels when we talk about sort of on-the-edge emerging markets. To you, what does a debt crisis look like in an advanced economy in which all of its debt is denominated in its own currency?

• 35:31Speaker 03

  A crisis in a developed economy would look more like a credit crunch that then leads into a financial crisis. So we would see a sharp increase in borrowing costs. That will affect many other asset classes. You would see a slump in investment. The economy, so it's debt overhang, the high levels of debt that you have to roll over on a daily basis. That overhang, which slows growth, slows dynamism, that is what a typical crisis looks like. And, yes, you can have financial crises. One of the wonderful things about the last several years, despite all the shocks, we haven't had a financial crisis in a developed, or in an emerging market, in a big emerging

• 36:16Speaker 03

  market. And that has been very helpful to bring back a fast recovery of the world economy every time after every shock. And we talk about resilience. So in a case where we end up with just debt levels that are really high, it's just costs going up everywhere. And that will eventually slow down economies, if not just trigger a financial crisis right away, given how sanguine financial conditions have been.

• 36:44Joe Weisenthal?

  You mentioned that one of the things that's changed pre to post pandemic has been the change in marginal position of central bankers with respect to the bond market and the fact that they've gone from being, although even in the US, I mean, quantitative easing ended in the 2010s, et cetera. But what happens if, say, we talk about some central bank in one of these developed markets? And they say, you know what, we're just gonna, we're gonna cap the long end. We're gonna, we're gonna buy bonds until the rates are, you know, they don't go above 2% or 3% or et cetera. Seems very plausible that something like that could happen in a developed market before too long.

• 37:25Joe Weisenthal?

  What would be the sort of fallout if a central bank explicitly came out and said, we are going to buy government debt and just hold down the rates in a very explicit manner like that?

• 37:37Speaker 03

  If a central bank comes out and says that we are, you know, different from our mandate of price stability and full employment, regardless of what's happening there, we are going to go out and buy long-term debt. Then that's what's going to happen is you're going to see inflation expectations drift up. And then the nominal rates are going to go up. And real rates will also go up because of the risk associated with inflation. Premium will go up. And that will be, you know, the end of the wonderful era that we've had of central bank independence and that's helping to keep interest rates low. So that strategy just doesn't exist.

• 38:20Speaker 03

  You can play with it for a little while, but eventually it gets priced into markets. So, I mean, unless of course it is a tool for monetary policy because you've hit the zero lower bound.

• 38:30Joe Weisenthal?

  Sure.

• 38:31Speaker 03

  And you still need to simulate the economy, then you do that. But right now we are far from the zero lower bound.

• 38:36Joe Weisenthal?

  Right, the op, that is, we currently have the opposite.

• 38:38Speaker 03

  We have the opposite. So it is, countries try, have tried it in the past. And these are usually the countries that the IMF works with because they eventually find themselves in crisis. But what typically happens is you get a tiny period when it looks like this is helping. And then you just. Get much higher interest rates and you just don't get any of the benefits of the central bank buying your debt.

• 39:01Tracy Alloway?

  You know, you mentioned earlier that we haven't really had a major financial crisis in recent years. And if we could just broaden that idea out a little bit, I think that the resilience of the global economy and certainly the US economy has been surprising to a lot of people. We've had multiple shocks, but overall, certainly in America, people just keep spending, everything kind of keeps ticking along. Is there something that economists are maybe like underestimating when it comes to why it seems like, again, the global economy to a lesser extent, but certainly the US economy seems so resilient in the face of all these once in a lifetime shocks that we keep seeing?

• 39:47Speaker 03

  There have been a combination of things that have helped and some of it have been surprises. Again, since we're talking about debt, that increase in debt has come about because of the very large amount of support that governments around the world gave during each of these crises. So during the pandemic, I mean, advanced economy spent about 25% of GDP. If you look at the combination of not just outright support, but all kinds of loan guarantees and equity infusions and so on, that was huge. That was, those were much higher levels than anything we'd seen in, you know, in recent times. And because of that, households and businesses came out of the pandemic with stronger balance sheets

• 40:32Speaker 03

  than they did going in. And that has helped hold up demand also and also has helped, therefore helps hold up profitability in a lot of businesses because of that strength that came from all that large amount of support. That was one. Second is the AI boom is a big player right now. If we didn't have AI and if we didn't have the increase in demand coming from AI, we would be looking at just much lower growth rates in many parts of the world at this time. And we would also see trade being much weaker. I mean, trade is being held up a lot by AI inputs flowing around.

• 41:10Speaker 03

  That's also been a big contributor. So we've had these positive offsetting events. Now, the question is, what happens to the next crises? In the next crises, countries do not have the fiscal space to provide that kind of support. And we may see much less resilience than we've seen the last few years. I mean, I think that's something we should keep in mind. I don't think we should take this resilience as some sort of an absolute structural shift that keeps economies growing at their, you know, long-term trends, regardless of how big the shock is that's affecting them.

• 41:46Joe Weisenthal?

  Yeah, you wrote a piece, I think recently for the Financial Times, which you talked about the bliss trade, I think as you called it. And can you clarify, because it sounds like, expand on this idea that there is this assumption of state's support. There's an assumption of a backstop. Things go bad, the government will be able to do something. And this is seems to be the core of your idea that this is mistaken.

• 42:12Speaker 03

  We have this mindset right now in the policy world, and therefore people who are investing in markets, that the state is there to fix a lot of the problems. And we see it right away. Even now, what's happening with energy prices going up is that there are many countries that are capping fuel prices, that are cutting energy taxes. The instinctive reaction is to protect households and protect their spending power. And when you do that, that helps corporate profitability, and that is going to be favorable for markets. So we've been in this environment, now either explicitly or implicitly, I mean, there

• 42:54Speaker 03

  there has to be this notion that the economy has been resilient.

• 43:00Speaker 03

  And it is a reflection of what I call bliss, which is big lasting state support, which has helped economies all over the world, not just in, you know, the US, but in many other countries. So the expectation is that that will continue. And going back to where we started with this conversation, just given how high debt levels are, that's just increasingly questionable, which means that I think governments are going to move towards far more orthodox approaches, including price controls, financial repression, the kinds of things that we haven't encouraged in a long time.

• 43:37Joe Weisenthal?

  You know, we've talked about some of the big structural phenomenons in the global economy, the AI boom, demographics, certain things with trade. There's one thing we haven't really talked about, which is I, something I think about, which is that if a country makes something physical, there is a very good chance that either right now or in the future, China will be able to make it cheaper and better. And this is no matter what it is, there are still some things that aren't the case. The most advanced semiconductors aren't manufactured in China. Boeing and Airbus jets and stuff, there's a few examples, but by and large, when you think about the stresses that are being placed on economies all around the world, how much is this particular dimension a factor?

• 44:22Joe Weisenthal?

  The fact that like any, almost any tradable good might at some point be most efficiently originate from China?

• 44:32Speaker 03

  Yeah, I read a lot of pieces on this, that somehow China will continue to run trade suppluses because everything it wants, it wants, it produces for itself and produces for the rest of the world. And so that's that. I mean, that makes little sense to me.

• 44:48Joe Weisenthal?

  Okay.

• 44:49Speaker 03

  Firstly, if you just look at China's spending behavior, they, you know, they run a surplus on their goods trade front, but they run a deficit on their services trade front. And so one of the reasons why China's overall deficit

• 45:06Speaker 03

  Current account deficit or trade deficit is around three percent of GDP. As compared to like ten percent of GDP before the great financial crisis. Is because they are big consumers of services around the world. Chinese tourism has been a big contributor to incomes around the world. And the service deficit that they run, so it's just that, right? So there's nothing, there's no sense in which. Hmm. China ultimately gets to do everything. Secondly, usually if you get to a point where if you're so good at manufacturing, making everything. You ultimately are going to have very high levels of investment. Given the level of savings in your country, that usually means that you start running trade deficits.

• 45:51Speaker 03

  Right? So it cannot be a story of China being very successful in its investment and being very productive. Because any kind of a high productivity investment boom story means the country running deficits. What has happened in China is basically very, a lot of consumption suppression. Because of that, you're seeing uh surpluses that the, that the, the country is running. And we're also now seeing all the problems of very high levels of investment. That's come from the fact of the crash in the property market, which despite the last four years of interventions and government policies is actually looking quite bad. So the weakness in the property market, the weakness in consumption.

• 46:35Speaker 03

  If China is go, is running surpluses at this point, it is because investment has dropped in China. You have, that's come both from the property market crash, but also because of all the, you know, excess supply and the overcapacity that they've created. You've seen a decline in investment. So twenty twenty five was the first year when investment in China actually declined. Hmm. That explains why it's running a big trade surplus. Now, yes, there are a lot of exports coming out of China. Forget about the surplus deficit part, but just the fact that they are sending a lot of goods out of their country is a source of competition for manufacturers around the world. I believe that this is not sustainable.

• 47:20Speaker 03

  I don't think Europe or other Asian economies in East Asia are going to just say, well, that's okay, we are okay with China dumping all these goods on us. They're going to put tariffs on China. China is aware of that, which is also partly why they are trying to, you know, see how they can manage their own exports to some extent. They will move in that direction. But I, I, I'm not a buyer of the whole China produces everything and does everything on its own. And somehow we still continue buying from China. That makes little sense to me.

• 47:53Tracy Alloway?

  You know, just going back to the beginning of this conversation, I mentioned a bit of a deja vu feeling because we do have these bond sell offs from time to time. And we often record podcast episodes on them. And the idea of a debt crisis has also been a popular theme on many podcasts, not just ours. Do you have any sense of what a catalyst for, you know, this actually exploding into a real life debt crisis could be? Or are there certain levels or numbers or behaviors that you kind of watch out for from, from here?

• 48:27Speaker 03

  I think it's very important of what's going to happen with AI and the productivity boom that we are hoping for. That is going to be very important. If it turns out that there is very little showing up in productivity from AI, or we have a setback that comes from just discovering that, oh, there's so much of hallucination that it's just, you can't really use it for anything very important. If that's the case, then I, I could see a situation where the pricing of debt, it drops even more. It's a lot more concern about what's going to happen in terms of government's ability to repay all the debt that they have and not just now, but that's expected to come into the future.

• 49:13Speaker 03

  So for me, that's one thing. I mean, what's, it is important that there is growth in the economy and that that growth is coming from good places. At this point, it seems like the growth is coming from AI investment and the hope that it's going to generate all that productivity growth. If that story goes away, we have a problem in terms of the concerns around fiscal positions around the world.

• 49:35Tracy Alloway?

  All right, Gita, thank you so much for coming on Odd Lots. Truly the, the perfect guest for this moment in time. We really appreciate it.

• 49:42Speaker 03

  Thank you. No, it was a lot of fun.

• 49:57Tracy Alloway?

  Joe, here is my overwhelming takeaway from that discussion.

• 50:00Joe Weisenthal?

  Go on.

• 50:00Tracy Alloway?

  There is so much riding on AI.

• 50:03Joe Weisenthal?

  Yeah.

• 50:04Tracy Alloway?

  Like, like, honestly, like, the last answer is like, whoa, it kind of all depends on economic growth and whether we get that productivity boost via AI.

• 50:12Joe Weisenthal?

  Yeah.

• 50:13Tracy Alloway?

  Like, the idea that the entire sort of Western economic model, and I guess, social compact with governments, is now dependent on whether AI actually does what it says on, on the label, on the tin, is, is nuts.

• 50:26Joe Weisenthal?

  Yeah, I mean, the numbers are obviously just extraordinarily big, and they're affecting everything. And they're, obviously, it shows up in financial markets, but it also shows up in the real economy. It is a major force of sustained upward pressure. Yeah, I think there's no dispute of that. It's like, we're all watching along, sort of like, eating popcorn, and knowing that our fates will somehow, and I'm serious, you know?

• 50:51Tracy Alloway?

  No, Gita said it really well, which is like, we're all basically in the AI trade together, whether you want to be or not.

• 50:57Joe Weisenthal?

  No, I know. And it's like, you know, I look at my, like, very passively diversified retirement money, and I'm like, I'm such a genius these days, you know? Because it's like, because you don't even have to be in AI stock.

• 51:10Tracy Alloway?

  Conversely, though, do you feel pressure to keep spending on tokens in order to support equity market valuations?

• 51:17Joe Weisenthal?

  Yes, that's right. I keep, like, thinking of more tests that I could do with AI, because, like, oh, I need to make sure the tokens are boosted. No, it's really wild. It really is everything. And then you, the whole conversation is like, man, the last six years have been crazy.

• 51:32Tracy Alloway?

  Crazy?

• 51:33Joe Weisenthal?

  Like, seriously, no, seriously.

• 51:35Tracy Alloway?

  I have a voice memo for producers, which is, we need to clip that quote of Joe going, crazy.

• 51:40Joe Weisenthal?

  No, seriously, you just think of all the things that have happened in the last six years, whoo. And so I guess I'm not surprised.

• 51:46Tracy Alloway?

  Well, that also-

• 51:46Joe Weisenthal?

  The markets had a regime shift during that time.

• 51:48Tracy Alloway?

  I mean, that also gets to Gita's response about this idea that, like, there is this assumption in markets that, well, we got through the last, like, 18 once-in-a-lifetime crises just fine, and so we'll manage to get through the next one, but then the question is fiscal capacity and, I guess, political will.

• 52:05Joe Weisenthal?

  It's both of those. And it's like, you know, the way I think about it, and Japan, I think, is an instructive example here, which is that, like, when I think of fiscal capacity- I don't think of like a sort of like, oh, if you have 80% debt to GDP level, you have fiscal capacity. If you have 120%, you don't because we don't know where, if there is that number. But what you do know, and what we can say is that in a period of high inflation and in a period where physical, where resources are already constrained and governments have made a commitment, say to seniors that their, you know, that their standard of living will be X and governments have made a commitment to so and so, the defense that it's

• 52:47Joe Weisenthal?

  not going to drop below X, that once a lot of these certain sort of commitments have been made, if you get another shock in which you say, okay, let's just, God forbid, let's just say there were another pandemic in which a bunch of people temporarily, we tried to do the same playbook again. And it's like, okay, we're gonna replace your lost income for a few months. Well, at a time in which we're already very like resource constrained, you see how that just becomes, you know, there's a lag period where like instantly inflationary because we're already sort of, that's the difference of in 20, in early 2020 and late 2019, we were not pushing against our real resource limits in the way that we appear to be right now.

• 53:30Tracy Alloway?

  Yeah, I think that's right. Okay. Well, on that happy note, shall we leave it there?

• 53:34Joe Weisenthal?

  Yeah, let's leave it there.

• 53:35Tracy Alloway?

  This has been another episode of the Odd Lots Podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.

• 53:41Joe Weisenthal?

  And I'm Joe Weisenthal. You can follow me at the stalwart. Follow our guest, Gita Gopinath. She's at Gita Gopinath. Follow our producers, Carmen Rodriguez at Carmen Armin, Dashell Bennett at Dashbot, Cale Brooks at Cale Brooks, and Kevin Lozano at Kevin Lloyd Lozano. And for more Odd Lots content, go to Bloomberg.com/oddlots. We have a daily newsletter and all of our episodes. And you can chat about all of these topics 24/7 in our Discord, discord.gg/oddlots.

• 54:08Tracy Alloway?

  And if you enjoy Odd Lots, if you like it when we talk about bouncing bond yields, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

• 54:58Speaker 05

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