Wednesday, February 17, 2010

Martin Wolf, Niall Ferguson, James Kwak, and Fat Tail Events

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.


  1. Wolf assets that the U.S. is in a liquidity trap. Monetary policy cannot deliver expansion, according to the authority, Blanchard. So, we must have short run fiscal expansion.

    The problem is that the claim is wrong. The U.S. might be in a modern macro influenced central bank trap, where they think of monetary policy in terms of overnight lending rates and promises about their future levels.

    The notion that quantitative easing has done all it can needs a tad of justification. The Fed is out of financial assets it can buy?

    Or is the problem that purchases of longer term bonds don't cause their yields to fall? Well, if they create expectations of higher nominal growth in the future, that will raise nominal growth now (the goal,) even at higher interest rates.

    It is just bad monetary theory.

    By the way, if investors decide that the U.S. government won't pay its debts and stop lending, then the U.S. government can and should limit spending to tax revenues. And the Fed can and should continue to target a growth path for nominal expenditures. Some parts of the economy would enjoy rapid increases in demand. The shifts in the composition of demand, would be wrenching, of course.

  2. Bill:

    I meant to say something about Wolf assertation that fiscal policy was necessary since monetary policy had been exhausted. Obviously I don't buy that. And to hear Wolf make that statement surprised me--he usually is spot on in his analysis.

  3. Hey what happened to the chartalists who were over here like flies around carrion at the weekend ? They have been iterating constantly on this issue. Their argument is that it is nonsense to compare Greece and the US. Greece faces a financing constraint that the US does not since it is a sovereign issuer of its own currency, the world's reserve to boot. While technically correct, they seem not to recognize the fact that currency traders may not be avid readers of Billy Blog. I dont think Bill Mitchell or Scott Fulwiler or any of those guys care much about expectations. A dose of GLS Shackle might do them a world of good....

  4. David,

    The relationship between bond yields and growth expectations is one I watch closely because of the concerns you bring up in your post. The warning sign of a sovereign debt crisis is that Treasury bond yields climb when growth expectations decline -- the opposite of the "normal" direct correlation. This is occurs because the market expects existing deficits to become "structural" in the absence of a robust recovery, and because the Central Bank is likely to intervene (on the short end) to monetize those deficits. Once this relationship takes hold, it becomes self-reinforcing: the more term rates rise, the more the deficit forecast rises, the more term rates rise. IMO, the importance of the Fed "exit" plan is that it may precipitate this dynamic by eliminating, abruptly, the subsidy to term rates.

    The emergence of an established pattern where bond and equity prices rise and fall together would be something to be very concerned about. Double that concern if gold is inversely correlated to the other two.

  5. ECB:

    I am guessing they have moved on to their next blog ambush, Nick Rowe. Some interesting points have been made there about them not having a theory for the price level.

  6. David Pearson:

    I hope we don't see this negative bond yield-growth expectation relationship you describe take off. Is there a preferred metric you like for observing growth expectations in this context?

  7. David,

    I look at equities (broad indexes) as a proxy for RGDP growth at this stage. The reason is long-term (5yr+) TIPS inflation expectations have returned to pre-crisis levels, so the improvement in equity prices from here must be driven primarily by a recovery in long-term RGDP expectations.

    I also look at the 5-yr real TIPS yield (currently 24bp) which is less sensitive than longer maturities to sovereign risk and therefore more reflective of RGDP expectations. A steep yield curve (we are at record 2y/10yr steepness) combined with a low real 5-yr TIPS rate tells me most of the term premium is due to structural deficit fears and not expectations of a sustained RGDP recovery. More steepness combined with a low 5-yr TIPS, combined with falling equity prices, would tell me sovereign risk is a reality for the markets.