And Now, the Counterargument

With mainstream and not-so-mainstream economists (including us) tripping over themselves talking about the need for a stimulus plan (and how the current one may actually be too small), and having just written an article saying the U.S. can probably absorb some more national debt before things go haywire (so did Simon), I thought it was only fair to point to the counterargument.

William Buiter at the FT argues that the U.S. cannot afford a major fiscal stimulus because the government (by which I think he means the entire political system, not just the Obama Administration) has no deficit-fighting credibility. If people do not believe that the government will raise taxes in the future to generate positive balances (I’m sorry to inform Congressional Republicans that cutting spending is not really an option, given the growth of entitlement commitments in the future and our increasing military needs, although cutting the growth rate of spending might be possible), they will conclude that the debt can only be paid off by inflating it away, which will drive interest rates up, the dollar down, and inflation up. Buiter spells this argument here and more recently here where he adds the U.S. is behaving like an emerging market economy in crisis (something with which we would agree).

The argument is plausible – yes, it is true that people could start dumping Treasuries and other dollar-denominated assets because of fear of the U.S. national debt – but not necessarily conclusive – on the other hand, they might not. Buiter recognizes the first objection to his argument: in fact, people’s behavior shows that they are not worried.

It is true that . . .  recent observations on government bond yields don’t indicate any major US Treasury debt aversion, either through an increase in nominal or real longer-term risk-free rates or through increases in default risk premia. . . .

In a world where all securities, private and public, are mistrusted, the US sovereign debt is, for the moment, mistrusted less than almost all other financial instruments (Bunds [German government debt] are a possible exception).

But . . .

But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expected inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia.

The US is helped by the absence of ‘original sin’ – its ability to borrow abroad in securities denominated in its own currency – and the closely related status of the US dollar as the world’s leading reserve currency.  But this elastic cannot be stretched indefinitely.

And as a result . . .

The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the ’sudden stop’ – the cessation of capital inflows to both the private and public sectors.  . . . But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world’s leading reserve currency.  A large fiscal stimulus from a government without fiscal credibility could be the trigger for a ’sudden stop’.

Buiter’s argument is essentially a tipping-point argument. Yes, the markets seem unconcerned about U.S. government debt, but pass that stimulus bill and all of a sudden – or shortly thereafter – they will panic. As I said, it’s possible. But the markets should already be anticipating that stimulus bill passing. (I find it hard to believe that with unemployment up to 7.6% the Republicans will block it; their better percentage is to go along reluctantly, say they are doing it to support President Obama, and turn on him when the economy does not respond immediately.) So all the information Buiter is basing his analysis on is already out in the market, and the market has shrugged it off.

More generally, though, we just don’t know. National debt of 60-70% of GDP in private hands (a rough post-crisis estimate) might be too much for Ecuador or Argentina, but what about for the world’s largest and most central economy? There just isn’t any data. Arguably debt incurred in World War II finished off the British Empire (I believe Niall Ferguson discusses this at the end of Empire), but the U.S. was already the world’s economic superpower by a wide margin. The U.S. was able to bring down debt from well over 100% of GDP after World War II. And we had debt (in private hands) of 49% of GDP as late as 1995, with the same tax-averse political culture we have now (this is after the Gingrich Revolution of 1994), yet the Clinton Administration was able to engineer low interest rates.

Maybe there is a tipping point somewhere. But no one knows where, and there isn’t much useful evidence. So do we forego the stimulus package because we’re afraid of the unproven tipping point? Maybe if, like Buiter, you think we are at the edge of the cliff and most people just don’t see it yet (although they have the same information you do), and you think the potential costs are huge.

In any case, I recommend reading at least one of Buiter’s posts.

9 responses to “And Now, the Counterargument

  1. The problem, I think, is that if we start to reach that tipping point, things could progress very quickly and be very hard to reverse.

    Do Keynesians believe there is any such thing as an inflationary depression?

  2. Do not overcrowd the safe-harbor.

    The Fed should charge the Treasury a “safe-haven” commission on all US public debt issued.

    That way the US Treasury, and the Congress, would know better that the benefits derived from safe-havens considerations is really not for them to keep; and also that it costs a bundle to keep ever more crowded safe-harbors safe.

    That the markets now trusts the Treasury has more to do with the lack of an alternative ports during a very difficult storm than with any intrinsic trust in the harbor chiefs. The US government and the US Congress need to humbly accept that before they, and we, are left with nothing.

    To finance a long term stimulus package with overnight funds anchored close to the exit of the safe-haven seems too dangerous.

    Also remember… do no harm! Do not forget that the credibility of the dollar is one of the remaining sources of financial stability in the world markets.

    If the US wants to risk it, then at least, after having recently observed the horrible consequences of adjustable mortgages, it should do its borrowings long term and at fixed rates? If it can’t get any acceptable rates, then the more it should know that perhaps it should not try it at all.

  3. Actually it was the debt rolled up in World War I that brought the British Empire to its knees. Britain was forced to renege on its debts in 1931.
    That aside, with all this discussion on the size of the stimulus, we are missing the point, and that is effectiveness. I never thought I would ever see Congress having such a difficult time spending money. They do not want to pull this trigger.
    There are two central problems.
    1. Congress is passing a stimulus bill that substitutes federal spending for what the states (or counties) were about to do. Take school construction, never before a federal issue, but indeed a central one in this stimulus plan. But these schools were already going to be built, and were just stacked up waiting either for votes on bond issues, or bond issues.
    2. The proposals are likely to be ineffective. The Senate attached one provision that provides a $15,000 federal tax credit for first time homebuyers (defined as those who haven’t had a house in the last three years) in order to clear the inventory of unsold new and second-hand homes. It would last only for one year. This looks wonderful, except we had a $7,500 tax credit last year, and we see what happened to the housing market. Sure the existing $7,500 was a loan that had to be repaid, and the $15,000 is a gift, but I do not see this moving the markets much because American consumers have woken to the realization that their credit card spending got us into this mess, and they are not in a spending mood.
    What I don’t see, which is alarming, is any clear and workable program to get the banks to take unsold houses off their inventories. Until the house price issue is resolve, this crisis will not be resolved.

  4. http://finance.yahoo.com/q/bc?s=%5ETNX&t=1y&l=on&z=m&q=l&c=

    Looks like the natives are getting restless. (OTOH, I’ve been crying “bond market bloodbath!” for a year now, and look where it’s gotten me.)

    Cheers,
    Carson

  5. Heard the story on “planet money” today so thought I’d surf over and ask the bigger question what about the debt in the future? By this I mean what do you expect the economy to do in a few years when the baby boomers start in earnest using US government social programs like social security, medicare and Medicaid? Won’t the federal debt just explode when the baby boomer generation starts taking from the well instead of putting funds in?

    The other big question I have that is not so well understood is what about the effect of credit default swaps on the economy? Since these financial instruments were unregulated and the size of the derivative market is up to 60 trillion according to some articles in the financial times, won’t this damocles hanging over the bond markets cause problems down the line?

    Basically I’m thinking if the unfunded social mandates which are on the order of 50+ trillion dollars and the credit default swaps which are also valued in the 50+ trillion dollar range, won’t these 100+ trillion dollar unresolved problems cause all kinds of grief in the markets?

    I don’t have an economics degree or a background in finance but I do read allot and from where I sit I don’t think the Bush TARP economic stimulus of 700 Billion, or the Obama economic stimulus now in the senate is looking a few years down the road at some really big problems…

  6. Old Poor Richard

    It looks like a great real estate buying opportunity is coming soon but not here yet. Banks have high inventory because there isn’t enough pressure to force them to unload at fire sale prices. When that happens, then time to stock up on real estate with as much leverage as possible. Buy temporarily undervalued assets with borrowed money that can be paid back with inflated dollars down the road.

  7. In a world economy that is not just de-leveraging but also de-investing what has the US got in the way of products and services that the ROW (or specifically China) wants or needs? The answer is not a lot, and with the dollar being kept artificially high what there is is too expensive.

    In effect there would appear to be no normal trade based market forces in sight that will cause the downward spiral in the US economy to correct itself. Meanwhile, to add to the downward spiral the US will suffer enormous budget stresses from a lack of revenues from domestic taxation.

    A wider understanding of this scenario may be the trigger for a tipping point if the world is relying on a US economic upturn to lead a general recovery.

    However, trillions of private and SWF money will continue to try to find short term advantages in one currency or another.

    Taxing these flows is the only opportunity that western governments have to offset hugely declining revenues from normal taxation sources.

    There are many reasons for taxing capital flows especially in turbulent times but failure to extract reveune via taxation of capital flows over the next decade or so would be yet another self inflicted wound, and evidence that governments, as is often the case, can’t see the wood for the trees.

  8. The stimulus may be “in the price” but I doubt the announcement of the $4 trillion bank recap program that Simon has been calling for would be.

    Might spook our creditors.

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