Fiscal Follies
David Rosenberg takes on the sovereign debt issue in his latest commentary, highlighting the structural deficits in the U.S. and the U.K. They are actually higher than in Spain or Greece.
Greece here, Portugal there. Did you know that the structural deficit-to-GDP ratio is actually higher in the U.S. (7.8%) and the U.K. (7.6%) than it is in Greece (6.1%) and Spain (5.8%)? Of course, what makes the U.S. different is that it has a revenue-to-GDP ratio of only 30%, which is at the very low end of the OECD rates which hover close to 40% or above. So America certainly has much more taxing capacity than anyone else does (and undoubtedly will have to use it because cutting back on health care is going to be a tough task ahead looking at the future demographic trends). It is with this taxing power in mind perhaps that Congress is now busy preparing for another $100+ billion budget bill (Jim Bunning finally relented) that will revive popular tax goodies and extend jobless benefits through to year-end (when undoubtedly they will get extended again).
The real difference between the U.S. or the U.K. and Spain or Greece is the currency issue. Greece and Spain are constrained by the Euro in a way that the state of California or the cities of Manchester or Glasgow are constrained. That is not the case for the sovereign governments in the U.K. or the U.S. Even Rogoff and Reinhart know this. Bill Mitchell wrote just yesterday about their much-discussed book:
Most of the commentators do not spell out the definitions of a sovereign default used in the book. In this way they deliberately or through ignorance (or both) blur the terminology and start claiming or leaving the reader to assume that the analysis applies to all governments everywhere.
It does not. Reinhart and Rogoff say:
We begin by discussing sovereign default on external debt (i.e., a government default on its own external debt or private sector debts that were publicly guaranteed.)
How clear is that? They are talking about problems that national governments face when they borrow in a foreign currency. So when so-called experts claim that their analysis applies to the “entire developed world” you realise immediately that they are in deception mode or just don’t get it.
There is a world of difference between the U.K. and Greece. This bears remembering. That doesn’t mean the debt problems in the U.K. aren’t real. It just doesn’t have anything to do with national default. See my post On the sovereign debt crisis and the debt servicing cost mentality.
Back to Rosenberg, he goes on to show you which countries have the best fiscal situation – and given recent commentary from Bill Gross, you could expect these sovereign bonds to outperform on a relative basis.
Canada seems pristine with just a 2.5% structural budget deficit and a debt ratio that is also below the U.S. However, when you tack on Ontario’s dilapidated fiscal situation, we still look okay comparatively speaking but it’s still somewhat of a dire budgetary landscape.
If you are looking for countries with low primary deficits and low government debt ratios then what fits that bill are Australia, New Zealand, Switzerland, Korea, Norway, the Netherlands and Sweden.
For a peek at who the next fiscal problem child will be, have a look at the article on page B1 of the NYT — Traders Turn Attention to the Next Greece. It would seem that the answer is Spain, Portugal and Ireland. We also suggest that you read The Califonization of America by David Wessel on page A2 of the WSJ.
I guarantee you the sovereign debt crisis is not over. Greece’s problems appear to be abating for now, but this issue will re-surface.
Also see Bill Gross and the deficit ring of fire for another look at sovereigns that will outperform.
Source
Breakfast with Dave, 4 Mar 2010 – David Rosenberg, Gluskin Sheff
Ed,
The distinction you (or perhaps others) draw between default and inflation carries an assumption that inflation is the lesser of two evils. I think this is because most analysts assume that, with moderate inflation, one can get out of any debt problem given sufficient time and real growth. Of course, that implies that creditors will not try to hedge a 4% (say) p.a. principal loss over a dozen years, because if they did, then obviously the impact would be much higher term premiums, or perhaps a rapidly depreciating currency. Both of these, of course, would either dampen real growth and/or raise inflation above a “moderate” level. The former would just exacerbate the structural deficit, which would further boost term premiums. Anyone with experience in Latin American LOCAL CURRENCY debt markets is familiar with this dynamic.
Its possible that US$ debt holders are “greater (greatest?) fools”, but its also best to make that assumption explicit.
I have not made that assumption at all.
https://pro.creditwritedowns.com/2010/03/going-off-on-rogoff-there-is-no-hard-debt-constraint-for-fiat-currency.html#comment-37788871
No, Ed has not made that assumption at all.
By the way, I should point out that the piece I sent to Ed and New Deal
was sloppily edited by me. I cut out around 400 words in the in course of
doing so, pared back the link to Bill Mitchell’s analysis on this very topic
(_https://bilbo.economicoutlook.net/blog/?p=8322#more-8322_
(https://bilbo.economicoutlook.net/blog/?p=8322#more-8322) ) As is so often the case, Bill’s
inputs via his own blog was invaluable, because it goes into great detail
describing the situation in Argentina, Russia, etc. Very seldom do
economists make the kinds of excellent distinctions made by Bill, and his work in
this area is particularly illuminating.
I’m pretty fastidious about linking to my references but in this
particular instance the reference that specifically cited Bill’s work was cut out by
me, and I wanted to make that clear as I’m always delighted to give Bill
full credit for the insights he has provided to me (although he should never
be held responsible for anything I write!).
If you haven’t, read the entire analysis by Bill as he goes into great
lengths, discussing, not only the case of Argentina, but also Russia (which Ed
has also discussed a few times before).
In a message dated 3/4/2010 11:31:16 Mountain Standard Time,
writes:
======
Edward Harrison wrote, in response to
David Pearson (unregistered):
I have not made that assumption at all.
https://pro.creditwritedowns.com/2010/03/going-off-on-rogoff-there-is-no-hard
-debt-constraint-for-fiat-currency.html#comment-37788871
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Ed,
I should have known that you would not make such a claim (which is why I said “or perhaps others”, but I should have been clearer).
One of the reasons I feel strongly that default, while voluntary, may also be preferable is that too much faith is placed in the output gap as the guarantor of stable inflation expectations. This might be true if the eventual inflation issue is “too much growth”. But its far more likely that the cause of future inflation will be “too little growth”. Chronically low growth post-credit crisis drives further bank losses, which usually results in the government assuming large chunks of private debt, which adds to already-high structural fiscal deficits. The trajectory of structural deficits can cause a doom loop where higher deficits beget higher term premiums which beget higher deficit expectations, and the only way out is for either 1) default or 2) monetization. It is the expectation of the latter that drives velocity and inflation, and not “too much growth” beyond the output gap horizon.
David,
I saw you comment on a Pettis piece (https://mpettis.com/2010/03/stuck-in-neutral-%E2%80%93-what-japan%E2%80%99s-rebalancing-can-teach-us/) so I imagine we will agree about what I am about to write.
A problem in Japan in its dealing with its own bubble was that it propped up zombie companies and asset prices in a quest to prevent a Great Depression like deflationary bust. This kept debt levels in the private sector high, discouraged investment (low returns on investment because of zombie competitors), and trapped people in debt-laden assets.
I had been thinking about this in the U.S. context yesterday. What would happen to a neighborhood where house prices declined just enough that it created financial distress for the house debtors but not enough that they were foreclosed on or walked away?
The answer I came up with is low property maintenance. I intend to write about this at some point, but I liken it to what happened at RJR Nabisco post leveraged buyout. They were so indebted that they focused on debt reduction to the expense of capital investment and maintenance. This ended up hurting their brand and reducing profitability. The same is true for neighborhoods in distress where houses just aren’t maintained and fall into disrepair. (You see the same thing with elderly people living on fixed incomes, by the way.)
Then I asked myself what would happen with price discovery in that same neighborhood. The answer is default. The question then becomes whether those houses would remain empty and abandoned and fall into disrepair (because of excess capacity) or would eventually be bought because the price was now lower.
On the whole, I think we need price discovery – i.e. a more rapid fall in asset prices to their previous long-term trend level. This will stress the system and reveal banks to be bankrupt. However, if done with a countervailing fiscal stimulus, we could actually get through the period quicker and with less increase in public sector debt.
I’ll flesh this out better in a post hopefully.
That’s a good analogy. And Japan did a lot of “extend and pretend”.
We’re doing the same thing today in the US, which is why I foresee a long
period of Japanese style stagnation. But let’s not pretend that Japan actually
embraced a proactive fiscal policy. They didn’t until 2003, as Richard Koo
demonstrates repeatedly in his book.
In a message dated 3/5/2010 06:32:57 Mountain Standard Time,
writes:
======
Edward Harrison wrote, in response to
David Pearson (unregistered):
David,
I saw you comment on a Pettis piece
(https://mpettis.com/2010/03/stuck-in-neutral-%E2%80%93-what-japan%E2%80%99s-rebalancing-can-teach-us/) so I
imagine we will agree about what I am about to write.
A problem in Japan in its dealing with its own bubble was that it propped
up zombie companies and asset prices in a quest to prevent a Great
Depression like deflationary bust. This kept debt levels in the private sector
high, discouraged investment (low returns on investment because of zombie
competitors), and trapped people in debt-laden assets.
I had been thinking about this in the U.S. context yesterday. What would
happen to a neighborhood where house prices declined just enough that it
created financial distress for the house debtors but not enough that they were
foreclosed on or walked away?
The answer I came up with is low property maintenance. I intend to write
about this at some point, but I liken it to what happened at RJR Nabisco
post leveraged buyout. They were so indebted that they focused on debt
reduction to the expense of capital investment and maintenance. This ended up
hurting their brand and reducing profitability. The same is true for
neighborhoods in distress where houses just aren’t maintained and fall into
disrepair. (You see the same thing with elderly people living on fixed incomes, by
the way.)
Then I asked myself what would happen with price discovery in that same
neighborhood. The answer is default. The question then becomes whether those
houses would remain empty and abandoned and fall into disrepair (because
of excess capacity) or would eventually be bought because the price was now
lower.
On the whole, I think we need price discovery – i.e. a more rapid fall in
asset prices to their previous long-term trend level. This will stress the
system and reveal banks to be bankrupt. However, if done with a
countervailing fiscal stimulus, we could actually get through the period quicker and
with less increase in public sector debt.
I’ll flesh this out better in a post hopefully.
Site URL: https://pro.creditwritedowns.com/
IP address: 71.178.11.48
Link to comment:
https://pro.creditwritedowns.com/2010/03/fiscal-follies.html#comment-38140432
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No credit default swap has a triggering provision for inflation. If it did, then virtually every country in the world would be in “default”.
I agree that the distinction you raise is important, but it is not axiomatic that a sovereign government issuing debt in its own currency and spending to fill an output gap left by faltering private sector demand is going to create hyperinflation. I don’t think it follows. Of course, if you spend too much once we’re reaching full output and employment then you could get inflation. So we should make the distinction you suggest, but I would hope that you in turn would acknowledge that our advocacy of increased debt issuance per se will not automatically create the conditions which would lead to an “inflationary default” of the kind that you describe.
“our advocacy of increased debt issuance”
Marshall – for how long a period of time and to any sort of limit?
I know David Pearson is a lot more capable of responding succinctly than me, but surely “will not automatically….create an inflationary default” is irrelevant. It’s the likelihood of “could eventually” create that default that must be considered. Supposing there is still no “full output or employment” and so the effects of increasing debt issuance were not as you anticipate? Then what? It’d surely be a bit too late to say “whoops – sorry!”
So what happens if you’re wrong? You’re the economist – I’m just grasping for answers – so how about talking down to a pleb.
Marshall is focused on full employment. And I suspect he would tell you to wait until you reach full employment or you see the whites of inflation’s eyes, which ever comes first. The point of course is that there is no specific number at which point currency and/or debt revulsion and inflation kick in.
I have said that this necessitates an artificial constraint because the temptation to run up debt, as we saw in Japan, is too great. And the reality is no government will be allowed to do so in good times and bad. At the first sight of recovery, government will face pressure to raise taxes or cut spending. That is certainly what we saw in Japan and exactly what is occurring in the U.S.. The result is a relapse, of course.
Knowing that you cannot escape a balance sheet recession through fiscal measures except over a long period – for this reason alone, there needs to be a greater emphasis on debt destruction via bankruptcy.
You can do debt destruction via bankruptcy with PRIVATE debt.
How much and to what limit cannot be addressed in the absence of assessing the economic backdrop. The “how much” implies a number. There’s not a financing restraint per se, but a RES0URCE restraint. I would expect that to come as we get closer to full employment. On that fateful day where we’ve reached, say, 3% unemployment and 90% capacity utliisation, I would say that we could dial back gov’t spending (debt issuance) considerably. But that would imply that the gov’t spending had achieved its purpose. And at that stage, tax revenues would be substantially higher, social welfare payments significantly lower, and the automatic stabilisers would be working in reverse and restrain gov’t spending and debt issuance.
My critique of Rogoff/Reinhart is that they focus on a ratio of debt (without considering whether you can reduce that ratio by increasing the denominator – ie the GDP, or growth per se). And you really must distinguish between private and public debt, which they don’t do.
You can always reduce gov’t spending and increase taxes. What you can’t do is reduce deficits per se. Deficits reflect a given level of economic activity. Or, as someone very cleverly noted on Warren Mosler’s blog today: “Let’s do the same thing with the opposite argument ‘Maybe if we just cut govt spending to zero we can pay off the debt in 2 years, of course well stop paying EVERY govt employee Including the military a salary in the process’ Lets see how that works out for us.” –
Right private debt destruction via bankruptcy or a debt jubilee would speed the resolution of the PRIVATE debt problem.
I agree with you in theory — increasing public debt will not necessarily lead to hyperinflation. I think its the nature, and the strategy, for that spending that matters. The purpose of deficit spending following a credit crisis should be to cushion the affects of allowing asset prices to clear and creditors to absorb losses. This can be in the form of jobs programs and tax credits. What is important is for asset prices to provide attractive real returns, which then allows the government to remove support without tanking growth, which in turn means that investment is the source of the recovery.
Today, we are doing exactly the opposite: trying to reignite the old bubble and prop up creditors and asset prices, and to hope that the consumer will eventually produce a recovery despite his/her heavy debt load. What we will get from that is continued low real returns to pojects, chronically low investment, stimulus that can never be removed without causing another dip, structural deficits, and a long-term risk of hyperinflation.
Well said, David. We want a market clearing price and that means asset prices must fall. Stimulus will prevent this from spiraling out of control and hasten the recovery ONLY if we allow marginal companies to fail to provide the real returns that support capital investment.
I laid some of this out in 2008:
https://pro.creditwritedowns.com/2008/12/a-brief-philosophical-argument-about-the-role-of-government-stimulus-and-recession.html
What 2009 demonstrated is that politicians will generally try to use stimulus to reignite the old bubble and prop up creditors and asset prices. I am struggling to figure out how to get around this fact – because this is what leads to a decades-long malaise.
Agreed. We have a problem in the manner in which we are deploying fiscal
resources. This is a broader problem of what James Galbraith called “The
Predator State”. In the longer term, clearly, our politics and democracy
has to be reformed to prevent the kinds of abuses you recognise. But in the
short term, I think the expedient would be massive tax cuts. Yes, the
multiplier effect might not be as great as properly targeted government
spending, but it does reduce the risk of political cronyism, in the manner in
which you describe it here.
In a message dated 3/5/2010 07:28:20 Mountain Standard Time,
writes:
======
David Pearson (unregistered) wrote, in response to
Marshall Auerback:
I agree with you in theory — increasing public debt will not necessarily
lead to hyperinflation. I think its the nature, and the strategy, for that
spending that matters. The purpose of deficit spending following a credit
crisis should be to cushion the affects of allowing asset prices to clear
and creditors to absorb losses. This can be in the form of jobs programs
and tax credits. What is important is for asset prices to provide
attractive real returns, which then allows the government to remove support without
tanking growth, which in turn means that investment is the source of the
recovery.
Today, we are doing exactly the opposite: trying to reignite the old
bubble and prop up creditors and asset prices, and to hope that the consumer
will eventually produce a recovery despite his/her heavy debt load. What we
will get from that is continued low real returns to pojects, chronically low
investment, stimulus that can never be removed without causing another
dip, structural deficits, and a long-term risk of hyperinflation.
IP address: 174.68.90.242
Link to comment:
https://pro.creditwritedowns.com/2010/03/fiscal-follies.html#comment-38145888
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I wouldn’t be so confident about Australia’s position. Sure the public sector debt is low by comparison but the private sector debt is out of this world. Australia has just passed the 1 trillion $ household mortgage debt mark with a total of just over 2 trillion $’s in private sector debt – all this for a country of 22 million. Needless to say any further shocks will have serious repercussions on the Australian economy. China is now talking about restricting growth to 8% and reigning in the property bubble which will have an impact on Australia. Watching this one out with anticipation!
Glen, I think I have downplayed the private debt problems in Australia compared to Spain, Ireland the U.S. and the UK in the past because I am not as familiar with them. However, I do know that there is an enormous property bubble there that has left many indebted such that when it pops, you will end up facing many of the same problems we now have in the U.S. From what Steve Keen says, it is worse there. I too am watching this one.