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.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.