The use of economic statecraft is on the rise. With rivalries among major economies intensifying, countries are increasingly employing tariffs, sanctions and subsidies, contributing to a global realignment in trade flows. Meanwhile, elections in the US and Europe portend new debates over taxes, government spending, and the right fiscal formula to support growth and productivity. In the US, the 2017 Tax Cuts and Jobs Act’s tax reductions for individuals are due to expire in 2025, setting the stage for another round of changes to the tax code. Europe faces difficult budget choices amid calls for the bloc to double down on industrial policy and implement capital markets reforms to boost growth—the subject of a highly anticipated report from Mario Draghi.

In the face of rapid economic changes and a shifting political landscape, investors need to consider how fiscal policies will influence the evolving investment outlook. Glenn Hubbard and Jason Furman, former Chairs of the Council of Economic Advisers under Presidents George W. Bush and Barack Obama, join PGIM Fixed Income’s Lead Geopolitical Analyst Mehill Marku in this episode of The Outthinking Investor.

The discussion covers major economic challenges facing policymakers, the effects of tariffs on inflation, trade flows, and the broader economy, and the future of U.S. tax policies. Additionally, they explore efforts to boost Europe’s economic competitiveness, the importance of remaining vigilant against potential market shocks, and investment strategies to mitigate risks from fiscal and geopolitical uncertainties.

>> The Council of Economic Advisers has always punched above its weight. This tiny agency has a small staff and just three appointed members who directly advise the US President on broad economic policy and fiscal policy. Their focus shifts over time depending on the current issues and the President's views. When Glenn Hubbard became chair of the Council for President George W. Bush in 2001, the country was trudging through an economic downturn after the.com bubble burst. The longest expansion period post-World War II ended in March. Manufacturing activity dropped, the steel industry continued its spiral, capital expenditures slowed and unemployment rose. And just as the manufacturing slowdown was spilling over to services came the terrorist attacks of 9/11. Navigating the world's largest economy under these circumstances and the uncertainty at the time was an immense challenge. Twelve years later, Jason Furman was named chair of the Council of Economic Advisors under President Obama. By then, the country was in full recovery mode after the global financial crisis and the Great Recession. Most manufacturing and services sectors were booming amid a record-breaking streak of job growth. Unemployment was low, GDP was rising, and even the federal budget deficit was slowing from the previous record-breaking years. Consumer and investor sentiment were robust. Then in October of 2013, Congress failed to raise the debt ceiling and there was a partial government shutdown, the first in 17 years. Fiscal policy is complicated no matter the economic environment. It touches every aspect of revenue collected and budget spent by the federal government, from taxes and tariffs to growth and productivity. That makes it a moving target, but also an important factor in the market cycle. What can these two leading economists tell us about past challenges in fiscal policy that can inform future decisions? And how might investors use these insights to make more informed decisions for their own portfolios? To understand today's investment landscape, it's important to know how we got here. This is the Outthinking Investor, a podcast from PGIM that examines the past, the present-day opportunities, and the future possibilities across global capital markets. Glenn Hubbard is currently Professor of Economics and Finance at Columbia University in New York and author of the book "The Wall and the Bridge: Fear and Opportunity in Disruption's Wake". Jason Fuhrman is a professor at Harvard University. Mehill Marku is lead geopolitical analyst of PGIM Fixed Income. We place a lot of weight on fiscal policy and its impact on the economy and financial markets, but how much of prior fiscal policy is already baked into current and future scenarios? Glenn Hubbard makes this point with the Trump tax cuts, which will expire in 2025 unless Congress takes action.

>> Tax policy had made significant changes in the Tax Cut and Jobs Act, which was passed in 2017. There had been a very large cut in the corporate tax. Many economists, myself included, believed that raised investment that was very good for the economy. The Tax Act in 2017 also changed individual tax rates. That part is about to expire. And so I think there is an opportunity in Congress to imagine, do we want to keep all of that? How are we going to pay for tax cuts? And it does raise the spending side as well. Government spending through the COVID pandemic period went up a lot. And there's a question, I think, on both sides of the political aisle of how much of that can we dial back. While I would favor reform of our old age programs, Medicare and Social Security, to make benefits less generous for the well off among us, I don't think that's politically likely. But I do think it's politically likely that we're going to have a look at the COVID era spending. So I think that's going to be the fiscal debate. It will absolutely spill over to the rest of the world, because depending on the US fiscal policy stance, it affects the value of the dollar, it affects interest rates on treasury debt, and it has to happen. This isn't some economist saying, "Well, we need to talk about taxes." There will be a tax bill in 2025.

>> The tax cuts and ramifications for other budget items are surely on the table. The question is, how do we manage the tradeoff for various costs and benefits?

>> Imagine that I could hold up a coin, and the head side of the coin is something that everybody likes, which is growth. We all want growth. The tail side of that coin, though, is disruption. As an economist, I can tell you there isn't a model of economic growth that produces the growth we all love that doesn't also produce the disruption. The real world of politics, the reaction to that can take one of two forms. One is walls. Let me make the disruption go away. So it would be a politician going into the heartland and saying, "If the steel industry is in trouble, I'll just bring it back. If you don't like trade, I'll stop it. You don't like immigrants, I'll stop that." Those are walls. They have never been productive for economies, and they aren't now. Another is bridges. If the economy is fundamentally changed to the one we want, and the disruption I'm talking about is technological advances, globalization, in today's world artificial intelligence and machine learning, robotics. If all of that is going on, we need to give people the skills to compete. Traditionally, economists have used the word competition. We all love competition. We have to love something else, which is the ability to compete. And that's what a bridge is. Unfortunately, the politics of walls are so much easier. The wall is a bumper sticker. The bridge is not. But serious policymakers on both sides of the aisle have hit at this. How do you encourage work? How do you train people? And I think that's going to be the discussion we are about to have in 2025 as we open up the tax code.

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>> How this plays out for the economy will be impacted by this year's general election in the US. Jason Furman considers the likely implications if the Republicans and Democrats split control of Congress and the presidency.

>> You'll extend some of the tax cuts. You'll have an even harder time paying for them with tax increases like higher corporate taxes. And maybe you'll get a stalemate on some of the spending, but maybe you will get Republicans get more defense spending in exchange for Democrats getting more non-defense spending, which is the pattern we've seen over the last several years. And so you end up actually with a decent amount of spending. So I could see even higher deficits in mixed government, something that a lot of investors are counting on to restrain Washington. But I think those investors are forgetting how easy it is for Washington to do deals where one side gets its deficit increases in exchange for the other side getting theirs.

>> Part of the difficulty of managing the fiscal tradeoffs is not just in knowing where the economy is headed, but in fact, where it is currently. Even today, for example, it's difficult to measure hangover effects from the massive Covid stimulus packages in the US and globally.

>> There's been a big debate over the last couple years of do we need a brand-new economic model to understand what we are going through, or do the old models work? I think largely speaking, the old models work. But you need to be careful about which model you choose, and in some cases, you need some tweaks. To take the tweaks first, if all you did was look at the unemployment rate, you would have a hard time understanding that the labor market was really tight back in 2021 and 2022, and you wouldn't appreciate how much it has loosened over the last year or so. The tweak that helped solve that problem is instead of looking just at the unemployment rate, you look at the number of job openings per unemployed worker. That was sky high even when the unemployment rate was still high in 2021. There were help wanted signs everywhere. Made sense that nominal wage growth was incredibly fast at the time. Over the last year or so, the number of job openings per unemployed worker has fallen from 2 to less than 1.2 that is a labor market loosening of this larger magnitude than the labor market loosening that we saw in the financial crisis 15 years ago.

>> Tweaking the model by looking at job openings over unemployed workers helps explain much of the loosening of the labor market. It's important to get this right for more precise fiscal policy decisions.

>> Second, there's always a lot of different economic models. And one of the arts of thinking about the economy is understanding which model makes sense for a given situation. The Phillips Curve, which is the one I've been talking about, that links slack in the labor market to inflation, works decently well. Not as well as we'd like, but decently well. But there's other ways of thinking about inflation, too. The quantity theory of money is one that is not core to year to year understanding of inflation. But if you want to understand large bursts of inflation over longer periods of time, it's the way to make sense of Turkey or Argentina. And it to some degree, is the way to make sense of what happened in the United States in 2021 and 2022 when there really was a large expansion in the money supply. That happened not just because of monetary policy, but also because families got checks and parked that money in the bank. And with that, you got a lot of expected inflation. But that's also behind us. The money supply has been contracting. The deficit is large, but it's not growing, so it's not providing additional fiscal stimulus to the economy. And so we're back to the place where something more like that normal Phillips Curve relationship with the tweak of the job openings per unemployed is the right way to think about the economy. And that's an economy in which there's some gentle downward pressure on inflation.

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>> Complicating matters further, none of this happens in a vacuum. Currencies, for example, impact and are impacted by fiscal policy. As Mehill Marku notes, concerns about the US dollar maintaining its safe haven status have come and gone over the years with little effect.

>> The dollar demand, however, has really been quite strong. And I don't see actually the dollar weakening in the future, mainly because the dollar really reflects very resilient US economy, a much deeper and healthy financial system relative to those of the rest of the world. And it is also a trusted currency, and it benefits from the macroeconomic and geopolitical turmoil that happens in the world. Dollar becomes the destination of these flows. And then you look at the data and really there is nothing there that suggests the dollar has been weakened. And in fact, I might claim that the opposite is happening. And so if you look at data, currently 88%, for example, of foreign currency transactions are done in dollars. The dollar share of foreign holdings in central bank reserves stands at 58%. But all these debates happens because there are many people who say, "Oh, renminbi is going to replace dollar." let's say, and things like that. But renminbi is a weak currency. I don't think it's a trusted currency. And it is so because obviously China's economy is weakening. It's not a currency of destination because of the intensifying tensions between the United States and China. It is also because China is supporting Ukraine. And it is also because China is engaged right now in also rivaling with overall the G10 block of countries. Will emerging markets do well in circumstances of this volatile currency? I mean, it really depends on the nature and extent of the volatility, it depends on the macroeconomic environment. It depends really on fundamentals of different countries and also sometimes on positioning.

>> Geopolitics also weigh heavily on the global economy and on domestic policy, particularly in terms of trade.

>> Trade makes some sectors less prosperous in our economy and other sectors more prosperous. Even though we're more prosperous on average, not everybody wins. There's two ways to deal with that. One is tariffs. The problem with tariffs is, one, it's very inflationary. And the public just has said over and over they don't like inflation. Now, there are some legitimate uses of tariffs. National security is an example. If we really believe that China is a clear and present danger to our country's security, in some areas, those tariffs are okay. But I would warn you not to make it a soundbite. After all, we use national security as the excuse to put a steel tariff on Canada, which, last time I checked, is not a national security threat to America. So I think we have to be careful with the words "national security" but that's a legitimate discussion to have.

>> Broad based tariffs could create more problems than they solve, which Glenn Hubbard noted during his government service.

>> When I worked for President George W. Bush as chairman of the Council of Economic Advisors, he was contemplating steel tariffs. It would not surprise anyone that I oppose steel tariffs. Indeed, I may have been a lonely voice in that regard among the people who talk with him. But I thought, I'm not going to take him ECON101, be knows all of that. So I came in and I said, "I've got two charts to show you, sir." The first chart showed a declining share of workers in the economy in a sector. And he said, "Yes, that's manufacturing, and that's what I'm worried about." I said, "No, sir, I just showed you agriculture 1900 to 1940. Do you want to put the people back on the farm?" And I could tell from his face I was getting somewhere. And then I showed him my second chart, which was a map of job losses. And he said, "Well, wait, I'm protecting jobs." I said, "No, sir, you are protecting jobs in steel. But what about all the industries that use steel? What about car manufacturers? What about people who make appliances? Those people are worse off. Their workers will be worse off. And by the way, there are more of them than there are steel manufacturers." So I felt good about my argument. President Bush decided to put on the steel tariffs, and he asked to see me, and he said, "I agreed with everything you said." I said, "Well, I guess I wasn't very persuasive." And he said, "The problem is, Hubbard, you didn't answer the question that was really on my mind. You see, Vice-President Cheney and I had given a speech in Wheeling, West Virginia, where we talked about job losses and communities in steel. You didn't tell me anything that would actually help those people. You shot holes in the tariffs, and you did a good job at that, but you didn't help me." And that's what led me to think later on about things to help people, because politicians have these real questions. These are real people. These are communities that need our help and need our assistance. That said, tariffs aren't the right answer. So I felt I learned more from him that morning than he learned from me.

>> Besides the economic fallout, there are other potential long-term consequences of tariffs and trade uncertainty that put the world at greater risk and which investors should always be mindful of.

>> One thing that we should always keep in mind is that alliance relations, when they become transactional, they could be very risky, mainly because alliances are supposed to base on mutual interests that compass all the alliance members, not just one. If the credibility of the alliance system is undermined in a potential next administration, that obviously would have then further consequences and implications for Russia's war against Ukraine, for the way China behaves towards Taiwan, and even potentially the way the US would react to another geopolitical hotspot, namely the tension between the Philippines and China over disputed waters in the South China Sea. If I were to select five geopolitical risks, you have two wars, and then you have China-Taiwan tensions, you have the Philippines-China tensions, you have North Korea-South Korea tensions. All of these will involve, potentially United States as the largest economy and the predominant power in the world. But to mitigate these risks, if you were to think simply of, let's say, trade and investment and technological rivalry and measures that have been taken, actually mitigating these risks, it is easier to identify winners and losers. Second thing is that we have noticed that flows nowadays are really going to countries with which, let's say, United States or China are aligned with geopolitically. And again, you can identify where these flows are going and where they are not. So assuming all else equal, mitigating these risks just follow the flows. But when it comes to potential military confrontation between United States and China, this is really difficult. How do you mitigate this risk? Because a military confrontation between the worst two largest economies, two superpowers, two strongest militaries, will most likely dwarf the impact, let's say, that Ukraine-Russia war had on the global economy. The only way to mitigate really this risk is by just trying to buy safe assets. You buy gold, you buy dollars, you buy US treasuries, and potentially you also buy Swiss franc. So if you were to combine all these risks, as hard as it is, so I would say keep exposure to countries that are really benefiting from the trade and technological rivalry between United States and China, while at the same time belong safe assets, treasuries, dollar and gold.

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>> Europe has had its own struggles over the past few decades, adding another hurdle for investors with global investment mandates. Last year, the European Commission began to plot a more robust strategic direction. It hired Mario Draghi, the former Prime Minister of Italy and head of the European Central bank, to draft a report that will lay the foundation for a five-year strategic plan for the European Union. It's a considerable challenge. Effective fiscal policy is a key component.

>> The closest thing to a panacea in economics is higher productivity leads to higher living standards. It leads to a better fiscal situation. It can make a country safer, put them in a better position to deal with climate change. And Europe has a lot of strengths, but unfortunately, productivity isn't one of them. From the end of World War II through the 1990s, productivity and growth in Europe looked like it was catching up with the United States and getting to the same level. But since around 1995, it's diverged. And if you just look at the post-pandemic period, productivity growth has been about three times higher in the United States than in Europe. That's why it's so important that the single most respected person in Europe, economically at least Super Mario, as he's sometimes called, has put productivity front and center. Some of what is in the report is things that have been talked about for a while, Digital Union, Capital Markets Union. All of this, from an economic perspective, is trying to complete the single market so that Europe can operate with the economies of scale that have been critical to the United States and China in supporting industries like digital platforms, banking and green technologies. Completing the single market, that's not a brand-new idea that he came up with, but my hope is that his report lends more impetus to it. He has new ideas there, too. I think most of them are good. Some of them, to my taste, go a little bit further in terms of imitating US industrial policy and trade restrictions, some of which I think has been quite good, but some of which has been a little bit political, incoherent, and counterproductive. So I don't want the world to think the United States has this down. We just need to copy in terms of industrial policy. But broadly speaking, it's really ambitious. I'm thrilled that the Europeans are taking it so seriously, and if you can add even a couple tenths a year to productivity growth in Europe, it would go a long way towards solving a lot of European problems. But ultimately, some of the needed changes will require what is effectively constitutional change in Europe. This is not in his report, but I think eventually Europe's going to need a finance minister. It's going to need European-wide taxes. You can't have the scale of European-wide investment that's needed without that. But I think he must have judged that that was a bridge too far to push in this particular report. And so he has a set of things that are still quite ambitious but should be more achievable.

>> Europe's strategic direction and fiscal policy are closely linked, but far from predictable. Investors will need to remain vigilant in monitoring their sources and levels of risk, along with those of expected return.

>> What does this tell us? Complacency is a very risky strategy. Investors and analysts like myself should try to avoid falling into so-called rationality trap, meaning that we should never assume that an event that is not rational won't happen, even though it might be a low probability or an unlikely event. And I think this is very important when we think about other potential crises out there.

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>> Thanks to our experts Glenn Hubbard, Jason Furman, and Mehill Marku, for their thoughts on fiscal policy in today's global economy. The Outthinking Investor is a podcast from PGIM. Follow, subscribe and if you like what you hear, go ahead and give us a review. If you enjoyed this episode and want to hear more from PGIM, tune into our new podcast, Speaking of Alternatives, see the link in the show notes for more information.

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