Stagflation Part 19: Twin Deficits, a Third Inflation Wave, and the Bill for Free-Lunch Politics

deficit spending itself inhibits economic growth by causing the Federal Reserve to monetize the federal debt. The Fed lowering interest rates and increasing the money supply distorts the signal interest rates send to market actors. This distortion causes the boom-bust cycle that plagues the American economy—Ron Paul 

In this issue: 

Stagflation Part 19: Twin Deficits, a Third Inflation Wave, and the Bill for Free-Lunch Politics

I. One Imbalance, Two Record Deficits

II. The Debt That Slowed

III. The Export Boom That Imports Itself

IV. The Financial Repression Behind the Free-Lunch Politics

V. Three Markets, One Signal

VI. October: The Third Wave of the Inflation Cycle Affirmed

VII. Interventions Beget Interventions: From Minimum Wages to Struggling Labor Conditions

VIII. The Peso Rally is a Loan, Not a Fix

IX. Conclusion: The Bill Arrives 

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Stagflation Part 19: Twin Deficits, a Third Inflation Wave, and the Bill for Free-Lunch Politics 

Record deficits, a peso under siege, a banking system steering credit to the favored, and 7.8% inflation. Free-lunch politics wrote the check. The economy is paying it. 

I. One Imbalance, Two Record Deficits 

A country can consume beyond what it produces, but only by drawing on savings, borrowing from abroad, or running down existing resources. Free-lunch (social democratic) politics makes this imbalance politically attractive: subsidies, welfare spending, price controls, transfers, public works, regulatory mandates such as minimum wages, and deficit spending deliver immediate benefits while postponing the costs. The political rewards are immediate; the economic bill arrives later. 

Figure 1

The nine-month fiscal deficit reached a record Php 1.303 trillion, with Q3 alone registering an unprecedented Php 516.4 billion. (Figure 1, topmost and middle windows) 

The nine-month merchandise trade deficit also reached a record $47.158 billion, exceeding the previous 2022 record of $46.207 billion. 

Both deficits are now at record levels. The coincidence is not the argument; the underlying savings-investment imbalance is. 

But the deeper imbalance lies between national saving and domestic investment. 

Government deficits reduce public saving. Unless private saving rises sufficiently to compensate, national saving falls relative to domestic investment. The resulting savings-investment gap must be financed from abroad. This is the underlying connection between the fiscal imbalance and the external imbalance: the economy is absorbing more resources than its national saving can finance. 

The merchandise trade gap is only one side of the external imbalance. Remittances and services offset part of the deficit, but not enough to eliminate the external financing pressure. The current-account balance captures the broader relationship between national saving and investment, while the balance-of-payments (BoP) position, examined in Section VII, reveals the resulting external financing pressures. 

Part 17 documented eight months of twin deficits. One month later, both had widened. The imbalance was no longer merely persistent. It was growing. 

II. The Debt That Slowed 

September's national debt hit a record Php 19.66 trillion, but increased by only Php 53.46 billion during the month. That looks oddly restrained alongside a record Q3 fiscal deficit of Php 516.4 billion. The apparent disconnect deserves closer examination. (Figure 1, lower image) 

The slower monthly increase should not obscure the cumulative borrowing. National debt had increased by Php 1.952 trillion over the first nine months, the second-largest increase since 2021's Php 2.122 trillion. The nine-month fiscal deficit of Php 1.303 trillion was also 14.4% higher than the comparable Php 1.139 trillion figure. Even so, September's debt stock remained slightly below the Development Budget Coordination Committee's (DBCC) Php 19.77 trillion full-year 2026 target. 

A deficit is a flow; debt is a stock. How much of the deficit translates into additional reported debt, and when, depends on the financing mix, cash balances, debt repayments, and valuation adjustments. A smaller monthly increase in debt after a record quarterly deficit is not evidence of fiscal consolidation. It raises a more important question: where did the financing go, and through which channels was the government's borrowing absorbed? 

One place to look is the banking system. Net claims on central government (NCoCG) have been rising for years, reaching a historic Php 6.499 trillion in September, according to BSP data. This growing exposure matters because government financing does not take place in isolation from the rest of the financial system. Banks' expanding claims on government reflect the increasing absorption of financial resources by the sovereign.

Figure 2

Nor is this exposure confined to banks. In Q2 2026, net claims on central government held by other financial corporations (OFC) reached a record Php 3.18 trillion. BSP holdings stood at Php 491 billion, while banks held Php 6.339 trillion. (Figure 2, topmost pane) 

Combined, these positions totaled Php 10.012 trillion. This represented roughly 78% of the Php 12.84 trillion domestic debt stock. The broader point is that sovereign financing increasingly draws on financial resources held across the domestic financial system. 

This brings us to crowding out. As government borrowing competes with private borrowers—mostly elite owned corporations and banks—for domestic savings, it can push up borrowing costs, restrict private-sector access to credit, and divert financial resources from private investment toward government financing. The consequence extends beyond the immediate cost of borrowing: resources absorbed by the sovereign are resources that may otherwise have financed business expansion, productive investment, and capital formation. The government finances present spending demands while potentially constraining the productive capacity needed to support future growth. 

Financial repression can intensify this displacement. When political arrangements channeled through regulatory and monetary policies are redirected to favor sovereign financing or privileged borrowers, credit allocation becomes distorted. The issue is no longer simply how much the government borrows, but how institutional arrangements influence who gets access to credit, at what cost, and at whose expense. 

This concentration of financial-sector claims on the sovereign also creates the conditions for a sovereign-bank feedback loop. 

As financial institutions accumulate government exposure, their balance sheets become deeply intertwined with the government's fiscal position. 

As such, any deterioration in sovereign creditworthiness can transmit stress to financial institutions, potentially restricting private credit and increasing pressure for public support. Such support can further weaken public finances, reinforcing the original fiscal problem. The danger is not that this loop has necessarily reached its terminal stage, but that institutional arrangements are making the financial system have become chronically dependent on sovereign stability. 

Fiscal absorption, crowding out, and financial repression can therefore reinforce one another. The sovereign absorbs financial resources, institutional arrangements privilege its financing, and private capital formation becomes the residual claimant. 

The establishment blames peso depreciation for the record debt. That confuses an accounting consequence with the underlying economic problem. 

True, a weaker peso increases the domestic-currency value of foreign-currency-denominated debt, adding to the reported debt stock. But depreciation is a product of deeper external pressures, including the foreign-exchange demand generated by persistent financing requirements, capital-flow dynamics, and deteriorating confidence. Currency weakness is therefore not merely an accounting explanation of the debt problem. It is a symptom of the broader macroeconomic imbalance. 

III. The Export Boom That Imports Itself 

Philippine exports hit a record $9.87 billion in September, up 35.6% year on year. Electronics accounted for $6.92 billion, or 70.1% of total exports. Semiconductor exports likewise registered record year-on-year growth and a record share of total exports. (Figure 2, middle diagram) 

Much of this expansion rides the global AI boom, which has fueled demand for semiconductors, memory chips, and computing infrastructure. The Philippines is benefiting from this external investment cycle, but the concentration of export growth in electronics also exposes the economy to its reversals. 

But electronics were also the country's largest import category, at $5.80 billion, or 38.6% of total imports. The PSA's September tables show electronic exports increasing by $2.894 billion, against a $2.704 billion increase in electronic imports. (Figure 2, lowest tables) 

The export boom brings a substantial import bill with it. The relatively narrow difference between these incremental gross trade flows also underscores the importance of imported inputs in sustaining export expansion, although it should not be mistaken for a measure of domestic value added. 

The crux is: the concentration also creates and fosters vulnerability. If the AI investment cycle reverses, semiconductor orders and export momentum could drastically weaken. 

The current global technology selloff makes that risk harder to dismiss. 

Figure 3 

Meanwhile, consumer goods imports fell 4.25%, suggesting weaker household demand. Manufacturing's S&P PMI fell to 49.1 in October, its second consecutive month of contraction, with output, new orders, and employment all declining. (Figure 3, topmost visual) 

Exports are booming while domestic manufacturing contracts. The economy is riding an externally driven technology boom while its broader domestic production base shows signs of weakness. 

IV. The Financial Repression Behind the Free-Lunch Politics 

The government's financing requirements do not operate independently of the private economy. Financial repression extends crowding out beyond competition for savings. Through captive savings, directed credit, regulatory accommodation, and suppressed financing costs, financial arrangements can steer resources toward government and politically favored borrowers. 

Bank lending grew 11.4% in September, while M3 expanded 9.3% to Php 20.7 trillion. Slower money growth does not mean monetary contraction. M3 is still expanding on an already enlarged base, adding to the outstanding stock of money. 

Bank lending is also a channel of money creation. When commercial banks extend loans, they generally create matching deposit liabilities, expanding deposit money in the economy. Loan repayments, conversely, extinguish deposit money. The resulting purchasing power does not enter every sector equally; it flows through the credit allocation decisions of banks and the institutional arrangements shaping those decisions. The issue is therefore not simply how much money and credit are created, but where the newly created purchasing power goes. 

Electricity, water supply, and transportation and storage continued to register strong credit growth, while household borrowing continues to weaken.(Figure 3, middle chart)  Credit expansion was therefore far from uniform. 

This sectoral concentration becomes more interesting when viewed against the institutional landscape. Electricity and transport are not simply market sectors operating independently of political decisions. Their economics are heavily shaped by regulatory decisions, concessions, pricing arrangements, public policy, and government intervention. 

From power-sector tax relief and corporate deals (e.g., SMC-AEV-MER, Prime Infra-FGEN) to renewable-energy payment arrangements (discussed last year) and transport fare adjustments, political decisions influence the distribution of costs, revenues, and financial risks. The resulting credit expansion deserves examination not just as lending growth, but in terms of the activities and institutional arrangements it finances. 

Consumer lending continues to reveal sustained softening. Growth peaked at 25.63% in May 2024, reached another peak of 23.91% in August 2025, and then decelerated for 13 consecutive months to 16.17% in September 2026. Consumer credit is still expanding, but its growth impulse is weakening. (Figure 3, lowest image) 

The contrast exposes the uneven transmission of liquidity: aggregate credit continues to grow, but household credit is losing momentum while selected politically favored sectors maintain stronger expansion. 

Credit creation is not capital formation. A growing financial system does not automatically mean a growing productive economy. 

V. Three Markets, One Signal 

Emergency policies did not abolish adjustment. They displaced it. EO 110's price suppression, BSP relief measures, and the managed foreign-exchange regime shifted costs among government, corporate, bank, and household balance sheets. 

Those costs are now surfacing in three markets.

Figure 4

The peso repeatedly set new lows, breaking Php 64 to the dollar at the end of October.

BVAL Treasury yields across the 1-to-25-year curve climbed to multi-year highs.

Meanwhile, the PSEi remained within a managed range even as market breadth narrowed. (Figure 4, topmost and middle diagrams) 

The signals differ, but point toward the same underlying pressure: the growing cost of sustaining an economy whose imbalances remain unresolved. 

The BSP raised its policy rate by 50 basis points to 5.5%, an increase described by the media as ‘jumbo’ or ‘aggressive’. Yet with headline inflation at 7.8%, the policy rate remained deeply negative in real terms, at approximately -2.3%. 

The 2022–2023 experience offers a revealing precedent. Despite 350 basis points of rate increases between July 2022 and February 2023, lending growth slowed to 6.65% by September 2023, while M3 growth remained around 6–8%. Lending subsequently resumed its upward trajectory. Higher rates slowed credit expansion but did not reverse the underlying monetary and credit dynamics. (Figure 4, lowest graph) 

Higher interest rates cannot manufacture electricity, fuel, food, or productive capacity. They raise financing costs precisely when manufacturing demand and household credit momentum are weakening. 

The BSP was already behind the inflation curve in 2023. The same question confronts it now: does monetary tightening lead price adjustment, or merely follow it? A central bank reacting to already-established price movements can raise the price of credit, but it cannot retroactively create the goods whose scarcity helped drive inflation. 

The price of credit moved. The supply constraints did not. 

VI. October: The Third Wave of the Inflation Cycle Affirmed 

The monetary expansion examined earlier provides the financial backdrop to this inflation wave. Deficit spending sustains nominal demand, while the twin deficits and peso depreciation raise the domestic cost of imported goods and production inputs. The 2026 oil shock compounds these existing pressures.

Figure 5

October headline inflation reached 7.8%, the highest since February 2023, against just 1.7% a year earlier. Core inflation climbed to 5.4%, its fastest since September 2023, while inflation for the bottom 30% of households reached 9.5%. (Figure 5, topmost chart) 

Transport inflation surged to 20.1%, and rice inflation reached 20.7%, despite the price cap. (Figure 5, middle and lowest graphs) 

The oil shock lit the fuse; accumulated monetary expansion and continued credit creation provided the conditions for broader price pressures to persist. This is no longer simply an energy-price disturbance. The rise in core inflation points to a wider deterioration in purchasing power, extending beyond the immediate effects of higher fuel and food prices. 

The third wave has already surpassed the first wave's 6.7% peak in 2018 and stands just 0.9 percentage points below the second wave's 8.7% peak in January 2023. 

And 7.8% is not the entirety of the household experience. CPI tracks the prices of a defined basket, but cannot fully capture every deterioration in product quantity, quality, or value and even stealth charges. 

Shrinkflation, skimpflation, and sneakflation can erode purchasing power beyond what headline inflation communicates. Nor does the official index necessarily capture unrecorded transactions in informal and black markets. As an aside, authorities deny shrinkflation on some of commodities. 

Here is the thing: the problem extends beyond measurement. 

Official statistics influence monetary policy, government financing costs, indexed liabilities, wage adjustments, and collateral valuations. Governments therefore have powerful incentives to influence not only inflation itself, but also how inflation is measured, represented, and communicated. 

Benchmarkism is not merely about the numbers published nor the market’s headline output, it concerns the institutional incentives surrounding numerical representation and the economic decisions anchored to those benchmarks. Lower reported inflation can ease pressure on interest rates, government financing costs, and collateral valuations. 

Governments therefore have incentives to influence or even ‘manage’ not only economic and market outcomes, but also how those outcomes are measured and communicated. Argentina's statistical manipulation under the Kirchners illustrates that these incentives are not merely theoretical. 

We have been warning about this trajectory for years. 

In 2023, we argued that the slowdown in the second inflation wave would be a transition toward a more potent third wave, anchored in deficit spending and the BSP's priority of maintaining ample liquidity. 

"And yes, we may be seeing peak inflation for this second wave.  The first wave was in 2015-2018.  The cracks in bank lending have emerged while Treasury markets exhibit a sharp tightening.   

Furthermore, both banks and the BSP have scaled down their liquidity interventions.  The BSP has reversed most of the December injections.   

But the coming CPI slowdown may be a transition to a more potent third wave—all of which will be anchored on the path dependency politics of deficit spending by the executive branch and the priority of maintaining and expanding liquidity by the BSP. (Prudent Investor, 2023)" 

In 2025, before the infrastructure scandal and the 2026 oil shock, we warned of a fiscal shock and its stagflationary consequences. 

"As fiscal risks mount, so too does the potential for cross-sectoral contagion and cascading effects. The banking system—already struggling with liquidity depletion—faces heightened exposure due to its expanding claims on sovereign securities (implicit quantitative easing). 

Again, though partially obscured, stagflationary pressures, deteriorating credit quality, and rising funding costs may converge, amplifying broader macro-financial instability. 

In short, the fiscal storm is no longer a distant threat—it is approaching fast, and its first casualties may already be visible in the cracks forming across the financial system. " 

The third wave is no longer a forecast. It is showing up in the price data. 

VII. Interventions Beget Interventions: From Minimum Wages to Struggling Labor Conditions 

Price suppression postpones price adjustment. Subsidies shift the burden. Cheap credit props up claims, while currency defense consumes reserves. Each intervention creates pressures that invite another intervention. The adjustment is displaced, not eliminated. 

Western Visayas is the latest example. A Php 40–45 daily minimum-wage increase takes effect on November 19, following increases in Central Visayas and NCR. It cannot explain October's inflation, which has already been recorded. But it adds another cost to firms already facing dearer inputs, weaker orders, and tighter financing. Wages can be raised by decree; productivity cannot. Businesses absorb the difference through thinner margins, higher prices, reduced investment, or fewer jobs. Consumers ultimately pay part of the bill.

Figure 6

September's labor data reveal the deterioration beneath the employment headlines. (Figure 6, upper image) 

The labor force expanded by 629,000 month on month (MoM) to 53.19 million, but employment increased by only 543,000, while unemployment rose by 96,000 to 2.86 million. The employment rate slipped from 94.7% to 94.6%, while unemployment increased from 5.3% to 5.4%. Year on year, unemployment surged from 1.96 million to 2.86 million, and the employment rate fell from 96.2% to 94.6%. 

Part-time employment, despite retreating in September, has also followed a rising trend since January. (Figure 6, lowest graph) 

Fishing presents another revealing contradiction. Employment expanded by 303,000 in the quarterly comparison, while fisheries production value contracted 8.5% to Php 50.86 billion in Q3. Labor is entering an activity whose economic output is declining. This raises a more important question than the employment headcount: are labor and financial resources being sustained in activities that cannot generate adequate returns? 

These developments expose the deeper problem of capital allocation. Government can sustain economic activity through subsidies, transfers, and credit accommodation, but sustaining activity is not the same as generating wealth. Real savings finance productive investment; productive investment expands the capital base and creates sustainable employment via productivity. 

Hiring depends on expected profitability, precisely what stagflation undermines. Inflation erodes household purchasing power and real savings, while higher financing and operating costs raise the hurdle every new project must clear. Firms facing weaker demand and rising costs postpone investment and hiring. Add minimum wages to this pressure. 

The labor market is not simply adding workers; it is revealing the economy's declining capacity to absorb them productively. 

Employment headcounts cannot substitute for capital formation, and government-supported activity cannot substitute for wealth creation. 

VIII. The Peso Rally is a Loan, Not a Fix 

In response to the peso's record Php 64.17 close on October 27, President Marcos urged Filipinos not to panic. The peso subsequently returned to the Php 63 range, closing the week at Php 63.055. But the exchange-rate rally does not change the underlying balance sheet.

Figure 7

The September balance-of-payments deficit (BoP) reached $3.144 billion, bringing the cumulative January–September deficit to a record $9.087 billion, almost the BSP's entire $9.2 billion full-year projection. (Figure 7, upper chart) 

Meanwhile, Gross international reserves (GIR) fell further from $99.494 billion in September to $97.350 billion in October, a decline of $2.143 billion and a three-year low. (Figure 7, lowest visual) 

The record external deficit echoes the domestic financing imbalance examined earlier: net claims on central government have reached historic highs, reflecting the growing absorption of financial resources by the sovereign. 

A currency rally does not erase a record external financing deficit or replenish depleted reserves. The peso may recover temporarily, but the demand for dollars generated by the underlying imbalance remains. 

Defending the peso has costs. The BSP can supply dollars from reserves, but that depletes its external buffer. It can rely on foreign borrowing, but that adds liabilities. Foreign-exchange swaps and derivatives can provide temporary liquidity, but creates future obligations. The latter two adds to the “dollar shorts.” 

Alternatively, genuine monetary tightening would attack the debt financed savings-investment imbalance by withdrawing the liquidity that sustains excessive domestic absorption and demand for foreign currency. 

But this is where the debt trap becomes apparent. In an economy dependent on deficit spending, cheap credit, and continued liquidity to sustain politically protected claims, genuine monetary tightening would expose the accumulated malinvestments and debt dependency. Higher financing costs and shrinking liquidity would undermine debt servicing, force spending and investment contractions, and trigger recession or financial crisis. 

This is precisely why free-lunch politics resists genuine monetary restraint: it would expose the savings-investment gap that continued intervention has concealed. Yet postponing adjustment through further borrowing and monetary accommodation only deepens the dependency and increases the eventual cost. 

The country cannot indefinitely defend its currency while ignoring the fiscal, monetary, and external forces generating the demand for dollars. 

A peso rally can buy time. It cannot buy an external adjustment. 

IX. Conclusion: The Bill Arrives 

The third inflation wave is not an isolated statistical event. It is the cumulative outcome of fiscal expansion, monetary accommodation, financial repression, and the suppression of economic price signals. 

The oil shock intensified the process. The corruption scandal exposed its political costs. Neither created the underlying vulnerability. 

We warned of the fiscal shock before either event. 

The bill has arrived. The question is no longer whether the economy must adjust, but how much more real savings, purchasing power, and productive capacity will be sacrificed in the attempt to postpone that adjustment. 

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References: 

Stagflation Part 17: Eight Months of Twin Deficits, Record Debt, and the Bill for Deferred Adjustment, October 4, 2026 

Predictions on 

Fiscal shock… 

Liquidity Under Pressure: Philippine Banks Struggle in Q1 2025 Amid a Looming Fiscal Storm, May 18, 2025 

Third wave of the inflation cycle…

Philippine Core CPI Forged a New 22-year High! Signs of Peak 2nd Wave Inflation: Pullback in Bank Lending and BSP Injections, March 12, 2023