Monthly Archive for May, 2009

Stanford economist John Taylor is very worried

Standard and Poor’s decision to downgrade its outlook for British sovereign debt from “stable” to “negative” should be a wake-up call for the US Congress and administration. Let us hope they wake up.

Under President Barack Obama’s budget plan, the federal debt is exploding. To be precise, it is rising – and will continue to rise – much faster than gross domestic product, a measure of America’s ability to service it. The federal debt was equivalent to 41 per cent of GDP at the end of 2008; the Congressional Budget Office projects it will increase to 82 per cent of GDP in 10 years. With no change in policy, it could hit 100 per cent of GDP in just another five years.

“A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor’s view be incompatible with a triple A rating,” as the risk rating agency stated last week.

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor’s considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth – probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.

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The time for such excuses is over. They paint a picture of a government that is not working, one that creates risks rather than reduces them. Good government should be a nonpartisan issue. I have written that government actions and interventions in the past several years caused, prolonged and worsened the financial crisis. The problem is that policy is getting worse not better. Top government officials, including the heads of the US Treasury, the Fed, the Federal Deposit Insurance Corporation and the Securities and Exchange Commission are calling for the creation of a powerful systemic risk regulator to reign in systemic risk in the private sector. But their government is now the most serious source of systemic risk.

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Paul Kedrosky on the yield curve:

It’s admittedly an excruciatingly boring subject, one made worse by the ghoulish personalities of most people who talk about such things, but there is no denying that hugely important developments are underway in Treasury yield curves. Check the following two figures to see the rapid steepening under way — the tail in the first graph shows changes in last 30 days; the following graph is declining prices year-to-date of Treasuries at various durations. I

In short (no bond pun intended), rates are going up in spiffy fashion as investors decide that Treasuries aren’t really that much fun for holidaying any more. Next crisis they want to vacation elsewhere.

Felix Salmon:

David Riley, the head of sovereign ratings at Fitch, gave the first big presentation at the Fitch banking conference today — and quite rightly, too. The future of banking is inextricable from public finance and macroeconomics: looking at things on a bank-by-bank level ensures that you’ll miss the big picture. His presentation was a good one, and definitely worth blogging.

Riley’s message was simple, after a recap of what happened in the Great Depression and in Japan and in Sweden: the faster that governments move the better, and the stronger their initial response the better. Don’t worry, at least in the short term, about inflation, in an environment such as this one which is fundamentally disinflationary: instead, worry about a multi-year decline in the total quantity of bank credit, which will continue even after the recession has ended, and which will put a medium-term cap on future growth.

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“I think that there is a serious risk that we get a W-shaped recession”, he said, with the current fiscal stimulus running its course over the next year and the economy falling back into recession. “As we saw in Japan,” he said, “if you tighten policy too soon, if you leave it too late, then you start getting concerns about solvency and inflation risk.” Guess he’s happy he’s not a central banker these days.

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