Martin Wolf today gave Niall Ferguson a true smackdown on the U.S. budget deficit issue:
Niall Ferguson is not given to understatement. So I was not surprised by the claim last week that the US will face a Greek crisis. I promptly dismissed this as hysteria. Like many other high-income countries, the US is indeed walking a fiscal tightrope. But the dangers are excessive looseness in the long run and excessive tightness in the short run. It is a dilemma of which Prof Ferguson seems unaware.Ouch, that has to hurt. Martin Wolf, however, is making a fair point that currently the real U.S. government solvency issue is a long-run one given the projected runaway growth of entitlement programs such as Medicare. As is well known, soaring health care costs are behind these projections and thus, one of the motivations for health care reform is a desire to maintain long-term U.S. government solvency. James Kwak has been making this point recently and like Wolf has been on the warpath to scalp those poor souls who fail to see the long-term issues here. His victims include Robert Samuelson and Greg Mankiw. While I agree with what Martin Wolf, Jame Kwak, and other observers like them are saying on the long-term problems, I believe they underestimate the potential for a fat-tail event in the short-run. As we learned from the emerging market crisis of the late 1990s and early 2000s, market moods can unexpectedly swing and create havoc for sovereign debt. There may even be no fundamental reason for the market mood swing; it could be a random event or series of random events that triggers a reevaluation of a government's creditworthiness. Imagine for example, the other rating agencies follow Moody's recent warning about the U.S. AAA rating with their own warnings, news reports say China and other major holders are selling off a sizable portion of their U.S. securities, and bond investor suddenly began questioning the ability of the U.S. political system to address the unfunded liabilities of the U.S. government. In such a scenario,the Obama deficits suddenly become terrifying to the market and the U.S. government gets hammered with much higher financing costs. This in turn leads to fears of contractionary fiscal retrenchment or a monetizing of the debt. Welcome to the U.S. banana republic. Okay, this scenario is far fetched, but if there is anything we learned from this crisis it is that we should not ignore the potential for such fat tail events.
Update I: One thing Martin Wolf gets very wrong in his article is that monetary policy was tapped out and there was nothing more it could do. Hence, expansionary fiscal policy was needed. This is incorrect. There was and is much monetary policy can do even when its policy rate hits zero. Primarily, if the Fed would permanently change inflationary expectations (or the expectation of the future price level or better yet, the future path of nominal GDP) it could significantly affect current aggregate demand. See this Michael Woodford paper or Scott Sumner's blog for more.
Update II: On a related note, The Economist discusses sovereign debt domino theories. This is another reason we should be mindful of fat tail events.