How to avoid a fiscal panic
Edmund Andrews adjudicates dueling op-eds by Paul Krugman and Alan Greenspan on the subject of fiscal policy, and although he purports to come down somewhere in the middle, by the time he’s finished his prescriptions end up sounding very much like those of Krugman.
Andrews is right to dismiss Greenspan’s weird focus on the 10-year swap spread as the harbinger of doom: it’s no such thing. It’s stretching credulity for Greenspan to paint the swap spread as a sign that the market is worried about the US fiscal situation, even as the more obvious places for expressing such fears — like the interest rate on Treasury bonds — show no worries at all.
Andrews is also right that no one can have much certainty about anything right now, and that no one knows where any country’s fiscal breaking point might be. The markets have a tendency to veer wildly from complacency to panic for any or no particular reason, and as debt ratios rise, the probability of such a panic happening has to be rising as well. Andrews sounds sensible, then, when he says that it makes sense to insure against such an eventuality:
The markets can panic, without much warning in advance, just as they did about Greece and to some extent the euro-zone itself. No one knows where the tipping point between acceptance stops and panic kicks in. But there’s also no dispute that deficit and debt levels are in uncharted territory in the U.S. and in Europe. Nobody knows whether they will get back to sustainable levels or how long it will take them. Nobody knows what the bond markets’ tolerance will be like, or how all the moving parts will interact with each other…
We need insurance. We need to plan for the possibility of getting our next move wrong.
But the problem is that, as we discovered during the last financial crisis, you can’t buy insurance on the end of the world — or rather you can, but when the time comes to collect, you’re liable to discover that your insurer has gone bust.
What kind of insurance does Andrews have in mind?
At a minimum, it would include a credible plan for reducing long-term deficits. It would require targets for government spending and revenues. If I were king, the plan would allow for another round of stimulus spending but call for real belt-tightening around 2015. It would include agreements to limit future entitlements, limit our military ambition, rein in health care costs and increase tax revenues. And it would include back-up options, triggers to shift policy in case the economy performs better or worse than expected.
The problem here is twofold. Firstly, it’s fraught with risks of misfiring badly: a fractious political debate over entitlements could be precisely the trigger for the kind of panic that Andrews wants to avoid. And secondly, the triggers would be pro-cyclical, thereby defeating the purpose of delaying implementation until 2015. In any event, there’s no realistic way of putting together a plan which couldn’t and wouldn’t be overridden in the event of another economic crisis.
What’s more, Andrews actually goes further in his own scaremongering than even Greenspan does:
Look up Bruce Bartlett’s very smart recent warnings on two points. First, the U.S. is much vulnerable than most people think to a ratings downgrade on Treasuries, a move that would probably cause a long-term spike in interest rates Second, that right-wing Republicans and Tea Partiers could in their ignorance trigger an actual default by refusing to approve an increase in the government’s legal debt ceiling.
A ratings downgrade on the US simply isn’t going to happen: the ratings agencies need the US to be triple-A more than the US needs to be triple-A. And they have very good reason to keep the US where it is, for reasons explained by Greenspan:
The U.S. government can create dollars at will to meet any obligation, and it will doubtless continue to do so. U.S. Treasurys are thus free of credit risk.
The logic here is the foundation for everything the ratings agencies do: their business is based upon the idea that Treasuries are risk-free, and that all other debt instruments can be placed at some point on a one-dimensional spectrum, where they’re riskier the further they are from Treasuries. In reality, of course, debt dynamics in general, and Treasuries in particular, are much more complicated than that. But the ratings agencies will be the last to admit it: it’s their job to oversimplify and to breed complacency, which is the one part of their job that they’re very good at.
As for the possibility of a technical default caused by a 1994-style refusal to raise the debt ceiling, I’m skeptical: Treasury has all manner of rabbits in various hats that it can pull out to keep paying coupon payments through a legislative crisis, even (especially) if much of the federal government has been shut down. Besides, any technical default would be a bit like the technical default by Fannie and Freddie: no one really minded very much, because they knew that they would end up getting paid in full.
So yes, Andrews is right that it’s a great idea to start putting together a long-term plan for dealing with the deficit, which is very much in unsustainable territory. I’m quite sure that Krugman would agree with him on that front. But my feeling is that the best way to put together such a plan is to start coming up with new revenue sources, such as a carbon tax / cap-and-trade system, or a financial-transactions tax. The more income streams that Treasury has, the less likely we are to see any kind of market panic.
Update: See also DeLong.