Complacency Is The Right Attitude

Kevin Drum breaks ranks from the correct attitude of deficit complacency, citing Carmen Reinhart and Kenneth Rogoff’s argument that bond markets can turn on a dime:

Several studies of financial crises show that interest rates seldom indicate problems long in advance. In fact, we should probably be particularly concerned today because a growing share of advanced country debt is held by official creditors whose current willingness to forego short-term returns doesn’t guarantee there will be a captive audience for debt in perpetuity. Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today.

Like virtually everything I’ve heard Reinhart & Rogoff say since the publication of This Time Is Different, that strikes me as empirically accurate but irrelevant to the situation. I saw Sen. Rob Portman (R-OH) on TV earlier today darkly warning that absent sharp spending cuts, “interest rates will skyrocket, we’ll have inflation, we’ll have a decline in the value of the dollar.” In an ideal world, the TV host would have pressed him and noted that there’s no evidence for this in current financial markets. But he might have replied with the R&R point that this storm could come out of nowhere. But Portman’s model here is of something like the 1997 East Asian crisis, or what happened to Iceland or parts of Eastern Europe back in 2007-2008. These are, however, structurally different situations.

In one kind of case, you have an economy operating near full employment, but with high debt levels (in either the private or public sector or both). Then a sudden loss of confidence causes an outflow of foreign capital. That pushes borrowing costs up, which is a drag on the economy. But at the same time, the value of your currency falls, which puts pressure on inflation so your central bank can’t generate growth.

That’s bad news. But it has nothing to do with the actual situation facing the United States. Virtually nobody in the United States has debts denominated in foreign currency, and certainly the U.S. government doesn’t. What’s more, we’re not operating anywhere near full employment. If we experience capital flight and a declining dollar, what happens is that our debts get cheaper and easier to pay off, not tougher and more expensive. We’d face a very modest inflationary pressure (foreign-made stuff would cost more) but also a huge increase in real output since foreign demand for U.S.-made goods would skyrocket. The situation might be bad for rich creditors, especially foreign rich creditors, but from an overall national interest perspective, it would be more like the solution to our problems than the source of them.

None of that changes the reality that over the long-term the debt:GDP ratio needs to stabilize at some level. But there’s not any current problem that can be traced to debt woes nor any prospect of such a problem materializing in the near term. Thinking about the long-term is great, but we’re having severe present-day problems and it’s smart to tackle issues in order.