Will the US stock market repeat the crash? Soros's 1980s debt warning rings again!

At the end of 1986, hedge fund giant George Soros wrote in his classic investment book "The Alchemy of Finance": "The boom in the stock market has diverted our attention from the fundamental deterioration of the financial condition in the United States."

At that time, he issued a dire warning about the threats posed by unsustainable public finances, a warning that astonishingly came true the following October when the U.S. stock market experienced the fastest crash in history.

On the eve of the presidential election on Tuesday, the price-to-earnings ratio of the S&P 500 index was 25 times, more than 50% higher than the long-term average. The Congressional Budget Office (CBO) predicts that by 2027, the ratio of U.S. public debt to GDP will break the post-World War II record. With the likelihood of the Republican Party achieving a significant victory in the U.S. Congress (winning a majority in the House of Representatives) increasing, this plan seems even less mature. The Responsible Federal Budget Committee estimates that by 2035, Trump's campaign plan will add another $15.6 trillion to U.S. public debt. U.S. Treasury yields have risen sharply.

Soros's warning from 40 years ago is once again significant.

However, this time, the problem will not be limited to Uncle Sam, as it is not just the financial condition of the U.S. government that is in trouble. The International Monetary Fund (IMF) estimates that this year global public debt will exceed $100 trillion, accounting for 93% of world GDP, and predicts it will reach 100% by 2030, which is still an optimistic scenario. The reality may be more like what the IMF points out: "Past experience shows that forecasts often systematically underestimate debt levels."

The "Impossible Trinity" of Fiscal Policy

What can the U.S. government do to prevent a repeat of the destructive outcome of 1987?

There is no simple answer. Vitor Gaspar, head of the IMF's Fiscal Affairs Department, refers to this dilemma as the "fiscal trilemma." The preferences expressed by today's voters are to increase spending, lower taxes, and maintain financial stability. Unfortunately, politicians always find that it is impossible to achieve more than two of these goals at once.

The traditional way to control debt is to tighten spending, which means sacrificing the higher public spending portion of the fiscal trilemma. France is the latest country to adopt this old-fashioned approach. French Prime Minister Barnier stated last week that the primary way to address the debt issue is to cut public spending. However, even his moderate proposal faced strong resistance, including a plan to reduce pensions by less than 1% over six months. After the dismal experiences of the 2010s, fiscal tightening is no longer a politically viable option.

This is why the new Labour government in the UK has turned to another strategy: increasing public investment to stimulate economic growth. In terms of the fiscal trilemma, the first budget announced last week by UK Chancellor of the Exchequer Reeves aims to increase public spending and financial stability at the cost of raising taxes by £40 billion.

The UK's new strategy has also failed to impress. The government's own fiscal watchdog, the Office for Budget Responsibility (OBR), stated that these measures would "temporarily boost output in the short term, but GDP will remain basically unchanged over five years," while pushing up inflation and interest rates; this is stagflation, not economic growth. As a result, the OBR expects that public debt, measured on a comparable basis, will continue to rise compared to previous years

Can the United States be an exception?

Finally, there is a way for the United States to resolve the fiscal trilemma: increase public spending, cut taxes, and hope that financial stability will resolve itself. Setting aside the minor issue of a 20% increase in U.S. price levels over the past four years, this formula has been quite effective recently. Investors have been captivated by the United States' still unparalleled geopolitical and financial hegemony, and so far, they have been willing to ignore the equally massive deficits and debts of the U.S.

However, even this spell will not be effective forever. At some point, U.S. bondholders—“bond vigilantes”—will also rebel. Since the Federal Reserve cut interest rates in mid-September, the yield on 30-year U.S. Treasury bonds has risen by about 70 basis points, and this reckoning may be closer than many realize.

However, the root cause of the debt crisis in developed economies is not fundamentally the fiscal trilemma. The historical levels of public debt today are essentially the result of two unrelated disasters: first, the global financial crisis, and second, the COVID-19 pandemic. The Group of Seven (G7) as a whole saw its debt-to-GDP ratio jump from 81% in 2008 to 112% in 2010, and then from 118% in 2019 to 140% in 2020.

This is not to say that these decisive turning points were solely caused by unforeseen factors. Government debt is always the result of policy choices, not simply acts of God. Two examples: after the debt crisis erupted, Iceland allowed its banks to fail, while Ireland bailed out its banks; the result is that a decade after the crisis, Iceland's public debt ratio is on par with that of 2007, while in Ireland, this figure is still three times higher.

During the pandemic, the UK's lockdown policies were relatively long and strict, while Sweden had almost no lockdown. As a result, during the pandemic, the UK's debt ratio increased by 20 percentage points, leading to today's severe fiscal imbalance. After emerging from the pandemic, Sweden's public debt ratio is lower than in 2019. Rather than trying to cleverly resolve the fiscal trilemma, governments might focus on how to respond to the next major crisis.

For investors, the question is whether the red alert issued by Soros 40 years ago will reappear, especially in the context of a U.S. market bull run just recovering. The U.S. fiscal outlook may be grim, and the bond market may be in panic; however, after Trump's victory, the S&P 500 index reached new historical highs.

This is another perspective. Warren Buffett's Berkshire Hathaway has sold stocks for eight consecutive quarters, accumulating over $325 billion in cash assets. If investors cannot be persuaded by this greatest currency speculator in history, perhaps they will turn to listen to this "Sage of Omaha."