The fiscal meltdown scenario that Len Burman and others posit as a significant possibility, and that I affirmatively believe will happen in the U.S. within the next 15 years, requires that financial markets fail to operate smoothly or efficiently.
Suppose the U.S. has rising default risk, and that the hypothesis that we will deal with it in a rational rather than a needlessly destructive way is growing continually less credible. Meanwhile, suppose our debt to GDP ratio is rapidly growing, and that so much of the debt is short-term (as Burman’s paper shows) that we have to keep rolling over an enormous percentage of it each year. Then what is the playout with efficient and well-functioning financial markets?
The answer is pretty clear. The interest rate that the U.S. has to pay starts rising. This sends a signal to U.S. politicians and voters that they have to change their ways. As they lack a good alternative, even with the serious defects in the political system that I alluded to in my prior post, the ship gradually turns, and there is absolutely no reason for a calamitous budget crisis – a fundamentally discontinuous event, akin to going 100 MPH despite the brick wall at the end of the alley and then suddenly smashing into it – ever to happen.
Of course, discontinuous market events, seemingly without sufficiently new information to trigger them, do indeed happen. The sudden collapse of a bubble is the key example here, and indeed is what people like me are positing when we predict at least the possibility of a horrendous crisis, in lieu of the smoother scenario with gradually rising interest rates.
As an aside before I get to the question of why there might be a bubble in the U.S. bond market that is at risk of exploding suddenly some day, what should the U.S. government do about the fact that its borrowing rate is currently so low? Here the optimists at yesterday’s Columbia session made a point that I (to a degree) think is correct.
Again, the interest rate that the U.S. government has to pay for borrowing seemingly should be high, yet we observe that it’s very low. If the pessimists are right and financial markets are wrong, the unduly low rate implies a wealth transfer, in expected value terms, from lenders to the U.S. government. Shouldn’t we exploit to the hilt by borrowing as much as we can on these terms? (At least, isn’t that the right answer if we don’t conclude instead, as the optimists may have meant to imply, that the markets must actually be right after all, in which case the wealth transfer would be illusory.)
The answer is yes – we should take advantage of it, if we can do so properly. Hence it might make sense to run current budget deficits even without the ongoing recession or any claim about the need for Keynesian stimulus. But here are 3 reasons why this does not imply that the current U.S. fiscal path, with its huge deficits currently and as far as the eye can see, makes sense:
1) Even if low interest rates would make large deficits currently rational even without the recession and Keynesian story, there is no good reason not to put the U.S. budget on a sustainable path by currently deciding on and announcing how it will be achieved. At a minimum, this would make the low interest rate environment more robust.
2) The rational borrowing story calls for using the money to make productive investments, which are much easier to find (the hurdle rate becomes lower) if we are borrowing cheaply. The usual buzz word one hears, of course, is infrastructure. Or the government could simply buy assets that offer it a higher return than it is paying due to the low borrowing rate, and profit from the spread (if all the political choice problems this poses could be solved). But none of this is happening. Instead, we are using cheap borrowing to fund current consumption.
3) Borrowing for current consumption, just like investing profitably, becomes more appealing if the interest rate is low. But the path we are on, by reason of doing it this way, makes no sense in terms of long-term consumption smoothing. Even with cheap borrowing, it doesn’t make sense to frontload the consumption as much as we are doing, by holding off entirely on the very painful tax and spending adjustments that (mere arithmetic tells us) are highly likely to be necessary soon.
OK, on to the question of how financial markets could be getting it so wrong. Should we instead assume that they must be getting it right, such as by rightly predicting that the U.S. political system will make the needed adjustments before things get ugly? Who should we believe, the financial markets or our lying eyes?
And this is where saying “What about 2008 and mortgages?” becomes, not just a cheap retort, but to my mind a convincing one.
What did we learn from the events of 2008? Not just that financial markets can sometimes get it wrong. We also learned a lot, the hard way, about how they operate.
There were plenty of people who knew and said before 2008 that you can’t keep making loans to people who cannot repay and count on perpetually rising home prices to keep the whole thing operating. All the underlying problems that came home to roost were public knowledge – for example, concerning the loan originators’ incentives and the rating agencies’ fee structure – and yet the right conclusions mostly were not drawn.
A few people saw what was happening. As a result of getting it right, if they were able to carry their short positions for long enough, they got rich. But they didn’t move the overall market until it was too late. And no penalty was suffered by the individuals who got it wrong, and who thereby (while accumulating huge fortunes) imposed huge losses on everyone else. And don’t think for a moment that this lesson wasn’t noticed by the people who are making the calls on Wall Street to this day.
How could a bubble market in U.S. government bonds persist when the lenders are in effect making a gift (though without charitable intent) by buying and holding bonds at an interest rate that is too low given the true (actual or implicit) default risk? The main answers to this question include the following:
(1) Some big players in this market, such as the Chinese government, are willing to make the gift because from their perspective it isn’t one. Rather, it simply is part of the cost they have to pay to achieve purposes of their own. The Chinese government is subsidizing imports to stimulate its economy during a period of massive rural to urban transition that contributes to their preexisting post-Tianenman Square eagerness to avoid political unrest. Other big players, such as from the oil states, likewise have economic incentives other than as investors, and may be serving their own institutional interests whether or not those of their nations in the long run.
(2) The flight to quality creates a winner-take-all contest for the laurel of safest asset. And for now the dollar wins, because what else is there? The Euro looks even worse. But the winner of this beauty contest can suddenly and unpredictably change, potentially leading overnight to a panicked rush away from dollars and dollar-denominated assets.
(3) Even among conventional market actors, the massive inefficiencies in financial markets that we saw in 2008 are still there. These guys are not pricing U.S. government default risk in their models (or rather they are running short-term models in which it’s zero), just as they weren’t properly pricing scenarios of nationwide real estate price drops. It simply isn’t how either they or they models operate. Irrational? Socially yes, but at the individual actor level probably no. Keep in mind – these guys are betting other people’s money under poorly designed incentive compensation schemes under which they get rich too fast to care much if their careers end up being shortened when the crunch hits. In short, the Berle-Means problem of agency costs from the separation of ownership from control operates on the manager side, while collective action problems hamstring responses on the investor side. And just as in 2007, this encourages massive disregard of tail risk, or what would happen to one’s seemingly extra-normal returns when the bottom finally drops out.
In other words, we have a financial system in which, notwithstanding Adam Smith’s invisible hand, no one has the right incentives, and getting it right does not bring a sufficiently sure or proximate reward.
What is going to happen when the Chinese finally have to change course, and/or the dollar loses its first place rank in the safest-asset competition, and/or the other market actors finally start pricing the risk of U.S. government default in their investment models? This can rapidly lead to a self-reinforcing feedback loop, in which the need for a higher interest rate raises the likelihood of U.S. government default, which triggers the need for a still higher interest rate that triggers a still greater likelihood of default, until there’s no price at which anyone is willing to lend.
What happens then is anyone’s guess, but we just may get to find out some day. Lucky us.