A Grumpy outlook on the debt

John Cochrane writes,

The danger the US faces the danger we should repeat and keep in mind, is a debt crisis. We print our own money, so the result may be a sharp inflation that wipes away the value of debt rather than an even more disruptive default, but the consequences will be almost as dire.

Read the whole essay. The counter-argument, which the market clearly accepts, is that the inflation-worriers have been with us for decades, and inflation has only trended down. Please do not repeat that argument in the comments. To me, it is the classic case of jumping out of a 10-story window, and as you pass the 2nd floor saying, “See, it’s all fine so far.”

In a subsequent post, Cochrane writes,

The main worry I have about US debt is the possibility of a debt crisis. I outlined that in my last post, and (thanks again to correspondents) I’ll try to draw out the scenario later. The event combines difficulty in rolling over debt, the lack of fiscal space to borrow massively in the next crisis. The bedrock and firehouse of the financial system evaporates when it’s needed most.

Basically agreeing with John, I recently wrote,

for the next several years the Fed will be focused on the task of enabling the government to continue to borrow. The conduct of what economists call monetary policy will be subordinated to that objective. The Fed will be expected to finance as much government borrowing as is necessary to keep interest costs under control. But regardless of how active the Fed is in purchasing government bonds, I believe that the United States will slide into a regime of high inflation.

My previous essays on the topic include How a Sovereign Debt Crisis Might Play Out and Guessing the Trigger Point for a U.S. Debt Crisis. As the latter paper points out, a debt crisis has to come as a surprise to the typical investor. That is why your confidence that there won’t be a debt crisis is not going to persuade me that it will never happen.

29 thoughts on “A Grumpy outlook on the debt

  1. High debt is only likely to cause a crisis if the burden of interest payments approaches the limit that politics allows.

    For countries with room to tax or sensible politicians (or voters?), Japan for example, this limit is much larger than for those countries where taxation is harder to raise due to widespread avoidance, like some of the Southern Eurozone countries. The stranglehold of the Germans raised this limit.

    Is the US likely to decide to stop repaying interest on the debt? I don’t think that risk free real rates will rise considerably soon, nor do I think that the interest burden will reach unacceptable limits, so I see no reason for “default risk inclusive” real rates to jump up and cause the debt crisis they were anticipating.

    People can’t seem to get enough US government debt if anything.

      • Anyone care to take a stab at the economics of the AR-15?

        Why so popular and why the wide price variance?

        A few conjectures:

        1) the “innovation renaissance” got started in the late 70s with the expiration of the remaining patents

        2) the platform is nearly identical to the M4/M16 used in the military.

        3) we decided to send hundreds of thousands of young men to Iraq and Afghanistan in the 00s and 10s where they were rigorously trained on the on the M4/M16 and became strong advocates of the platform (their lives depended on it).

        4) Those veterans returned home, insisted on using the similar AR-15 and convinced their friends and family that this was the right route. Think of it as a meme, but for firearms.

        5) due to 1) the platform is completely modular. Think of the parts as LEGOs for silly adult males like myself to BYO or to highly customize off-the-shelf offerings.

        6) those folks in 4) also provide high quality military-grade training at super reasonable prices.

        7) in terms of the price variance, most (but certainly not all) of it comes down to Veblen. I’ve got the Honda Accord of ARs, but there are so many fun options out there.

        8) what else am I missing?

      • 1) re-watch “the Big Short”

        In other words, by hedging against this risk, you are going to look like an idiot to pretty much everyone (including yourself) over a long period of time, but you have a <1% chance of coming out looking like a wealthy genius. Do you have the courage that it will take to withstand this?

        2) google 1970s inflation hedge. This is basically the last time that the U.S. had significant inflation. Real estate and gold were the answers back then and I’m pretty sure these still hold today. However, there are probably many more esoteric ETF investments available that attempt to mimic “hard” assets like these.

        3) don’t forget firearms. They don’t decrease in value during financial crises and are a boat load of fun to shoot. Added bonus: they make the left go totally crazy.

        3a) obligatory note to always follow the four rules of firearms safety.

  2. For interest rates to rise people need to sell USG bonds to buy something else.

    What else would they buy?

    If the USG can’t be counted on to pay its debts, who could?

    If the USG needed money to pay its debts, what asset could you possibly own that they wouldn’t confiscate by force?

    Are there any OECD countries that aren’t on the exact same fiscal path as the USG? If you sell USG, what exactly are you going to buy as an alternative?

    And what is “inflation” anyway? Doesn’t inflation these days go straight into assets rather then consumer goods.

    The only way you’re going to get a sovereign debt crisis is if there is some other “asset” that people believe will hold better value than USG. But ultimately, the value of USG is the entire suite of resources it can commandeer by force. Is there any greater force out there that can stop them?

    I’ll believe in a USG crises when I think it likely the USG is about to lose a war. Someone has to show there are things the USG can’t confiscate before there can be an alternative asset class.

  3. As long as the Fed stands ready to buy unlimited amounts of bonds, it is hard to see how a “debt crisis” emerges. An inflation crisis, yes; but inflation is already being seen in asset prices (stocks, real estate, etc.). Fortunately, it hasn’t really taken off yet in consumer prices (the important CPI component of occupancy costs is rigged to show little inflation). If inflation can be mostly confined to asset prices, it is relatively painless in the short run, though very unjust (for example, it prices home ownership out of reach for the young).

    In the bigger picture, developed nations everywhere have promised entitlements (primarily old-age) beyond their ability to pay for them, i.e, raising taxes in any politically acceptable way would tank the economy and fail to produce the revenues.
    So they have turned to monetization. If inflation can be kept to a tolerable level for consumers (like a frog being boiled), not much happens, as the aggregate debt is gradually inflated away.

    I don’t know whether and for how long this balancing act can be successfully managed, but for now, it seems to be working.

  4. In his book, “Private Truths, Public Lies” Kuran shows how a change in attitude/position by only 1% can cause a ripple effect. This will cause the existing status to be upended. Currently, the massive injections of high-powered money by the Fed have been counteracted by two things, in my opinion. First, the payment of interest on reserves has reduced the incentive to lend and, thereby, further expand the money supply. Second, the increase in the demand for money, primarily from precautionary motives, has reduced inflationary pressures. If something causes the public to change its view on the stability of the dollar, we will see Weimar levels of velocity of circulation. Needless to say, this has happened before in the world, there is no reason to believe it can’t/won’t happen here.

    • Interest payments on reserves have a fairly small on credit supply.

      Bank lending is determined almost entirely by capital levels and the demand for credit by creditworthy (as perceived by banks at any given time) borrowers.

  5. One thing you mention is the prospect of savings being wiped out by inflation. But in the past, that happened because bank deposits were an important form of savings. It’s not as important today. People either store their wealth in assets or investments which tend to track inflation, or will rely for future consumption on benefits programs which also tend to track inflation, often by law. Many wage contracts are also ties to inflation.

    Even minimum wages, which are supposed to get eroded in real terms by inflation over time, end up eventually being subject to political pressure to adjust upward, more or less with the level of inflation.

    It seems to me that the aggregate effect of all this is an “inflation-tracked society”. It’s hard to leverage “money illusion” and play Keynesian games with regard to sticky wages if the real value of everything is legally protected and many important prices automatically adjust in step with the general price level.

    Consider: local governments have the equivalent of equity in real property that pays dividends of about 1% annually of the value of assets which tend to rise with inflation. Sales taxes are also nominal. So, if their revenue is effectively inflation-protected, then a surprise with a big new inflation surcharge on their bond rates is ‘insured’ to the extent overall economic activity does not decline, and furthermore, any existing debt is reduced in its real burden.

    I admit I haven’t worked it through, but my hunch is that the way a crisis will manifest is in terms of a stubbornly high unemployment rate, and “services insolvency”, in which governments spend most of their tax revenue on various classes of beneficiary, at the expense of the quality and quantity of goods and services provided to most citizens and taxpayers.

  6. You write that “for the next several years the Fed will be focused on the task of enabling the government to continue to borrow.” I see no evidence that this is what the Fed is doing now, and I doubt that it will behave so in the near future.

  7. Isn’t inflation produced by “too much money chasing too few goods and services”? If so, wouldn’t the economy need to be near full utilization to see an uptick in inflation? And if there wasn’t much of an uptick in inflation in 2019, when US unemployment was very low, when would we see inflation? What level of the employment to population ratio would be so high that employers would need to raise wages to get new employees? Late 90’s levels?

    It seems that if inflation means full utilization of resources, including full employment and rising wages, it is preferable to a monetary regime which is characterized by a lack of inflation, stagnant wages, and chronic underutilization of resources.

    • The economy can have high rates of inflation even when output and employment are at fairly weak levels (e.g. the recession year of 1980 had 13.5% CPI inflation). Just because there is more money doesn’t mean that all sectors will be booming. You might just have a mix of depressed sectors and shortages in popular sectors.

      • Wouldn’t a change in relative prices by definition not be inflation? Also, wasn’t the recession of 1980 caused by a negative supply shock in the form of the Iranian revolution and a decrease in the supply of oil? I think that you would expect high unemployment and high inflation when energy becomes scarcer.

  8. Arnold, you end the post with these words: “As the latter paper points out, a debt crisis has to come as a surprise to the typical investor. That is why your confidence that there won’t be a debt crisis is not going to persuade me that it will never happen.”

    I agree with most of you say in your two papers but we don’t know who the typical investor is and I don’t need to be persuaded that it will happen, perhaps sooner than we’d like it. My take from decades of working on the restructuring of sovereign debt is that it happens when your lenders say enough is enough and the sovereign is not ready to accept the new conditionality to roll over the existing debt and to get the additional financing that needs desperately. So I pay a lot of attention to the lenders.

    Today I pay special attention to China as an important lender to the U.S. government. If I remember correctly in a comment to another of your posts on finance, I explained how the Chinese government still controls the domestic markets through the state banks and how part of these banks’ deposits are intermediated through PBC (the central bank) to invest abroad, including U.S. bonds. We are talking about huge amounts of stocks and flows going through China’s state banks and PBC. That started around 1995, and 10 years later some people started to speculate that the Chinese government could suddenly sell all the bonds to crush the U.S. economy. These speculations didn’t make much sense then because it was hard to find a historical example of two large economies involved in such nonsense (you can analyze crazy behavior but to be relevant you must explain why and how one party becomes crazy –the same point that one can argue about theoretical models of bank runs).

    The world has changed, however. Indeed, the Chinese government is not the typical investor that you had in mind when writing the final lines of your post. Defying my expectations and faster than anticipated by others, the Chinese government seems to have entered into a collision course with the U.S. (yes, you can argue that Trump’s “provocations” accelerated the entrance but thanks to him now we can say that the threat was not limited to reallocating production to China and it’s becoming much wider than anyone imagined). Since last March, observing the actions of several Western people, every day I’m more inclined to assume that the Chinese government has been able to co-opt too many Westerners. They remind me of the dormant spies we used to hear in real and fiction stories, but with a difference: they have power, at least in the weak sense of influence, because of their “free” access to the press and social media. The question then is when the Chinese government will rely on them to provoke a multiple-pronged crisis, one prong being the sale of China’s U.S. bonds. Stay tuned.

    • An ignorant question from a MAGA conservative: why does it make a difference whether the debt is held domestically vs. internationally?

      E.g. if the U.S. defaults or has to restructure its (uncollateralized) debt, does China send over guys with baseball bats to repossess their iPhones and other sundry goods? How does it work?

      • A common cause of crisis is

        1) I need X from someone abroad
        2) They won’t accept my currency $Y in return
        3) I don’t have anything to trade for which someone will give me a currency they will accept

        The crisis then gets triggered.

        So like if you need oil or grain from abroad to eat or heat your home, and you can’t pay for it, problems start to happen.

        For instance, when Germany needed certain raw materials from abroad to continue its military build up, and it wasn’t producing sufficient materials for trade, it caused a balance of payments problem that would have resulted in a currency crisis had they not started to confiscate the gold stores of whatever countries the Entente would let them swallow up.

        To the extent the US has what it needs domestically that kind of crisis is less likely to happen.

        As to China, it behooves them to try and diversify out of inflation risky assets as much as possible. As you note, its not like they can come over here are demand to be paid back in real terms. If they somehow could perhaps you get a situation like the French occupation of the Ruhr.

        Still, I have to imagine telling a bunch of Chinese peasants that their live savings are wiped out because we are proliferate bums might have some kind of ramifications besides their just grinning and bearing it.

      • Hans, to answer your question let us assume first that in the U.S. all government bonds are held by domestic investors and that a new Administration on January 21 suddenly announces that it will stop servicing the outstanding debt until it’s renegotiated. The bondholders will organize a committee to renegotiate the debt. The Administration will be pressed to reach an agreement quickly because it needs to finance the deficit and bondholders know that they need to limit the loss and therefore it’s better to make now some loss but conditional on the Administration doing something to ensure that there will be no additional loss. If the negotiation continues for several months without the prospect of a serious agreement, both parties will lose and the Administration may be inclined to impose its terms by force (there will always be some lawyers and judges that will find an interpretation of existing laws that may justify the resort to force).

        Second, let us assume that all the state banks’ deposits are invested in loans to state enterprises in compliance with instructions from the government, and on the eve of the 2021 Chinese New Year, PBC suddenly announces that the deposits will be lockdown until further notice (as the famous “corralito argentino” on December 2001). You can bet that there will be a short-lived run on the state banks but the military will be called to enforce a lockdown of all depositors as in Hubei province on January 23, 2020, to contain the epidemic (in Argentina, there was a bank run until Presidente de la Rua had to run away).

        If part of the U.S. government bonds were held by foreign “normal investors” (the ones that Arnold has in mind), they would join the domestic “normal investors”. Negotiations may be quite difficult because bondholders may disagree on the strategy to negotiate and then a few groups may be formed to follow separate negotiations with the Administration.

        If some deposits into China’s state banks had been made by foreigners, PBC may differentiate between domestic and foreign depositors. I suspect, however, that PBC would impose a larger loss on foreigners if and only if the relative importance of their deposits were high enough to placate domestic depositors.

    • I don’t think there would be a big issue.

      If China sold its Treasury debt suddenly, it would find itself taking a capital loss as bond markets plunge, but the crisis would be short as the Fed would probably buy those bonds back at depressed prices, buying until interest rates recover to whatever they were prior to the sale. The market would likely do much of the recovery work on its own, seeing elevated rates and knowing there was a Fed backstop in place.

      After that, China would be sitting on tons of dollar bills and (after that stunt) would probably be banned from making any direct investments in the US. I can see three options for what it could do next:

      1) Purchase American goods
      2) Purchase goods that trade in dollars (oil, maybe other commodities), but to do that in size would bid up the prices of those goods
      3) Exchange massive quantities of US currency for Euros or something else, likely taking more capital losses in the process

      None of those moves look very attractive.

      Aside from that, foreign relations with the US would likely prove be quite hostile in the wake of that action, perhaps even resulting in a web of US alliances to contain China.

      This is all speculative (maybe the Fed lets rates spike, maybe the US is too timid to try to build a new NATO in Southeast Asia), but I don’t see how China would really benefit from dumping treasuries.

      • Sorry, Justin. I have a very different view of what may happen in my hypothetical case in which PBC opts for suddenly selling its U.S. bonds. If the Fed buys them, the Fed will not issue money. It will borrow funds from the commercial banks, funds that the same Fed could have used to buy new bonds issued by the Treasury. The point is that the demand for bonds is shifting backwards and the supply is moving upwards implying that the price will decline. And the PBC will re-invest the dollars from any sale (to the Fed or John Smith) into other assets. These are portfolio shifts that have nothing to do with the money supply and more importantly what matters is how other holders of U.S. bonds respond and I assume that any sudden sale by PBC most likely would push other investors to sell (remember the context of my hypothetical). My point is that if it happens, it will disrupt the financing of future U.S. deficits which in turn will have other effects that depend mainly on the prospect of high political tensions in the U.S. for at least a few years (I can speculate about these effects but I’d have to make clear several assumptions to avoid being misunderstood).

        • It seems that PBC has been selling U.S. bonds at least for the past 6 months to buy commodities (the price of copper has increased enough to keep the Chilean peso per dollar stable despite expectations in early 2020 of a large depreciation). It seems that the ongoing portfolio shift is from bonds to the storage of commodities. Read (I don’t agree with the economic analysis but the shift may be a fact)
          https://www.goldmoney.com/research/goldmoney-insights/china-is-killing-the-dollar

          I don’t follow market news with enough detail to know what has been going on. In particular, I don’t know to what extent the depreciation of the U.S. dollar respect to the renminbi and some other currencies of the past 3 months may be the result of PBC action. Anyway, if the portfolio shift is confirmed, there are two interpretations. First, the Chinese economy is recovering and PBC is facilitating it. Second, the Chinese government may be trying to stock commodities as part of a new strategy to deal with the U.S. government after the election.

  9. I have no clue about the short- to medium-term. However, I highly doubt that any economist does either (notwithstanding their super sized egos and never ending penchant to engage in post-hoc analysis). Historically, their fancy economic models have not really amounted to much more than hand-waving and numerical masturbation.

    For the longer-term period, my bet is here…

    https://www.heartland.org/news-opinion/news/lenders-and-spenders-confronting-the-political-reality-of-debt?source=policybot

  10. I am of the mind that the debt doesnt matter. Until it does. And when that day comes people will be shocked.

    What happened to all the “audit the fed” folks? They have all disappeared for some reason. The balance sheet looks a little spooky.

  11. Why haven’t these conditions in Japan generated the adverse consequences we have been told to expect for years and years.

    • Japan’s 200%+ of debt to GDP ratio, over more than 20 years, is why I am no longer confident that the US 100% debt/ GDP (or GNP) ratio is so fearsome.

      The main reason given for “no prob” is that Japan’s creditors are mostly Japanese, with debt in JP Yen. Both in theory and practice, the Central Bank of Japan could print up the Yen and pay off the local creditors, likely causing its Yen to fall, and thus export costs, for oil for example, to increase.

      Deficit hawks need more reasonable theory to explain why the inflation has NOT happened in Japan. Arnold consistently fails to explain it, and John C. also fails.

      It doesn’t look like Japan will suffer anything worse than a third fourth “lost decade” of growth, while remaining one of the richest countries on earth.

  12. Inflation is not even half of the problem. Stagflation is the bigger problem. Unemployment is likely to remain stubbornly high. And GDP is unlikely to grow given current conditions and outlook.

    The Tax Foundation estimates that the Biden tax plan alone will cost 585,000 jobs and reduce GDP by 1.51 percent over the long term.

    That rosy outlook does not take into account other policy changes that will cost jobs and dampen consumer spending. The Tax Foundation’s dynamic analysis does not take into account the added pressure that reduced corporate earnings and profits will have on the Fed’s ability to continue propping up the corporate bond market. The Biden energy plan will shift jobs to China and increase retail electricity rates. Joining TPP 2.0 will further disadvantage workers in the USA economy. Allowing discharge of student loans in bankruptcy will encourage many to abandon jobs in favor of discharging debts. Although libertarians and free traders are indifferent to domestic employment, that indifference carries a stiff monetary penalty.

    A superior alternative to the Biden tax plan would be to expand the tax base by covering the barter between the surveillance tech giants like google and Facebook and ordinary citizens who trade their private information for access to free apps. Taxing this barter exchange, perhaps by a simple excise tax on each account, could offset the cost of Biden spending proposals with much less negative impact on employment and earnings. Similarly, the federal government could tax “virtual real estate” in the same way that local governments tax real estate. And of course the obvious solution to ongoing deficits would be a value-added tax which, by virtue of not discriminating against domestic employers, would not further disadvantage domestic employment the way an increase in corporate income tax rates would.

    Taken together, the market distortions associated with the Biden policy agenda have have the potential to snatch stagflation or a depression out of the jaws of mere inflation. Now would be a good time to consider the alternatives.

  13. The cute analogy of the falling man, whether at the second or fifth floor on the way down, fails a bit when it’s added … we don’t know how many stories high is the building.

    US debt, in US dollars, can be “paid in full”, whenever the Treasury wants.
    Print a few thousand bills of $1,000,000,000 (billion) dollars and pay of the debt with paper.

    What are the “rich” creditors going to do?
    (One thing, they will stop, or at least reduce, their lending… which will then cause the austerity that is now being avoided.)

    Arnold’s ‘Big Deficits Are Bad’ Theory (wide consensus! John C., etc): high deficits WILL result, sometime, in a debt crisis and Very Bad Things then. So, instead, US budget should have lower deficits now.

    Alt Theory: as long as investors keep buying US debt, it is not such a problem that political gov’t spending cuts nor higher taxes are needed.

    Fact: current US bonds are sold out very quickly, at very low interest. Investors are actually hungry for more “risk free” US gov’t bonds.

    Arnold on the effects of a debt crisis: the United States will slide into a regime of high inflation.
    Logically, we will have “a bit too much” inflation before we have “high” inflation.

    Fact: the US Fed has recently said that the US has been, for many years, UNDER their inflation target. This evidence is against Arnold’s Theory.

    I used to, but no longer, believe the current levels of deficit spending are “too high” and should be cut.

    A debt crisis immediately falsifies the Alt Theory – which is what is trying to be avoided by the consensus theory (against big deficits, now). Nothing this year can falsify the consensus theory. Without the possibility of falsification, the theory seems more a belief or dogma. Even if it’s “true”.

    I say it’s mostly NOT true if the deficits continue, and the ratio continues to worsen up to 200%, and there is no debt crisis nor hyper-inflation in 10 years. In 2010, Arnold wrote about the risks in 2015-2030.

    Econ theories, almost all of which are unrepeatable and thus never scientific, should have time limits when predicting some event. Options, puts and calls, are all time delimited.
    Bonds, too.

    The US moving towards 30 year bonds, or 50 years, or even 100 years, would be a good thing at this point to reduce the severity of any near future debt crisis.

  14. Forgot to add – most politicians who support deregulation and lower taxes also support lower gov’t deficits. And less gov’t in general.

    I’ve seen how, over and over, “deficit hawks” get elected, get a little less regulations, mostly avoid new taxes, and lose elections when trying to cut spending, despite having a bit more econ growth. The newly elected Dems will then increase gov’t spending, inefficiently rewarding those who didn’t earn it.

    The rate of economic growth that John C, like Piketty, talks about, needs to be high. Deregulation and low taxes help get more econ growth.

    “Lower taxes” of $500 billion will, historically quite consistently, result in higher growth than $500 billion of new gov’t spending. Higher deficit from a tax cut, with more growth, is better than a balanced budget with less growth.

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