Edmund Andrews has a long front-page story today on what he calls “the United States’ long-term budget crisis” — and has occasioned a strangulated “Urg” out of Paul Krugman in doing so. Krugman wrote a very smart blog entry on Friday (Tyler Cowen called it one of the best recent economics posts in some time) which talks about exactly the issue that Andrews is addressing — the question of whether and how the interest rates that the US pays on its borrowings might rise in future. But none of that nuance made it onto the NYT’s front page. Instead, we get this:

With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

Economic forecasting is hard enough a few months out; trying to guess what a certain number is going to be in a decade’s time is a fool’s errand, and it’s sad that Andrews didn’t give the other side of the story. What’s more, this scary chart doesn’t seem quite as scary when you look at the y-axis:

Most developed countries can cope quite happily with net interest payments around 3% of GDP. According to the OECD, Belgium is already at 3.8%, and Italy’s at 5.2%; the average for the euro area is 2.7%. So while there might be a big rise in this metric, it would be a big rise from a low level and to a number very much within the bounds of precedent.

None of which is to say that Andrews doesn’t raise an important question. But fiscal prudence is the kind of thing which get rich financiers like Pete Peterson and Bill Gross very excited; it doesn’t have nearly as much effect on the populace as a whole. Just ask the Japanese: if they’re having problems right now, it’s not because of their massive government debt. So it would have been nice to see a slightly less one-sided article.

Mohamed El-Erian, the CEO of Pimco, sent me a note this morning which sums up the dire straits of the economy, as revealed in today’s employment report, in one sentence:

The problem is that very few people in DC are thinking of this as a structural challenge. Until they do, there is little basis for the sketch of a potential solution.

Here’s the issue: unemployment is at 10.2%, and broader underemployment is at 17.5%. For the foreseeable future, both of them are going to be extremely high — it doesn’t really make much difference, at the margin, whether they’re going up or down. Financial markets are used to looking at first derivatives, but in this case it’s the absolute level which is important.

When you’re unemployed, you don’t spend. So long as unemployment remains high consumer demand will be depressed. That’s going to be true even if the savings rate starts dropping, thanks largely to the enormous debt burden that US consumers have already placed upon themselves. That’s important for the US economy, and it’s also a major sea-change for the global economy. As El-Erian says in today’s FT:

There is one public good that needs to be replaced: the key role that the US has played as the engine of global growth. This role is now constrained by the debt of US households.

The implications of this are huge. If the US no longer drives the global economy, then the rest of the world will be much less inclined to fund its twin deficits to the tune of trillions of dollars per year. Meanwhile, the high unemployment rate means that the Fed is going to keep the Fed funds rate at or near zero, which bodes ill for the dollar. These are huge forces, acting in an extremely complex global financial system, and you don’t need to be Nassim Taleb to know that the end result of such a state of affairs is likely to be large, unpredictable, and potentially catastrophic.

Which brings me back to Washington. Here’s El-Erian again:

The best defence against these outcomes is early recognition and coordinated action. Key economic powers must shape their expectations and policy strategies to the changed contours of the global economy. They must also actively manage policy changes at the national and multilateral level in a way that broadens the provision of global public goods.

They must, yes. But will they? I fear — and clearly Mohamed fears too — that the answer is no. So far I’ve heard nothing out of Washington which says to me that the White House has a plan for addressing long-term structural problems in terms of unemployment, capital flows, and interest rates. A lot of these problems have been around for many years, and most of them have been diagnosed sharply at one point or another by Larry Summers. So it’s not like Washington is oblivious to what’s going on. But we’re at the limits of what monetary policy is able to achieve, and the nation cannot afford to repeat the monster hit to the US fisc which we’ve seen over the past couple of years.

Maybe, then, there simply isn’t a solution: the problem is just too big, too complex, and too intractable. It’s a depressing conclusion, but also a pretty compelling one.

Wow:

In October, the number of unemployed persons increased by 558,000 to 15.7 million. The unemployment rate rose by 0.4 percentage point to 10.2 percent, the highest rate since April 1983. Since the start of the recession in December 2007, the number of unemployed persons has risen by 8.2 million, and the unemployment rate has grown by 5.3 percentage points.

Well, at least give the BLS credit for not trying to sugar-coat the data. This is truly awful, and makes it obvious why the Fed will keep rates at or near zero for the foreseeable future. You just can’t raise rates when unemployment is in double digits.

The length of time the average unemployed person has been without a job has been hitting new record highs for a while; it’s now managed to pass the 6-month mark. That’s much higher than any previous peak in this data series. And I fear that the only way it’s likely to come down any time soon is as these people become so demoralized that they take themselves out of the labor force altogether.

The overwhelming majority of the working population will never be able to prepare themselves for a period of unemployment lasting more than six months. As financial-market types worry about possible inflation in a few years’ time, tens of millions of Americans are finding themselves in a very real personal financial crisis to which there is no visible solution. Given the Fed’s dual mandate, it makes sense to keep interest rates low for the foreseeable future. Inflation is possible; unemployment is catastrophically real.

David Leonhardt interviewed Alan Greenspan at the Atlantic event in Washington this morning, and it was quite shocking how little Greenspan seems to have learned from the crisis. Yes, he has decided that banks need more capital: “You cannot function with a financial system with capital as low as it was,” he said, adding that “in retrospect, Basel II was clearly suboptimal. You can’t have capital at 10% or less, because human nature changes too quickly.”

But on other matters — especially when it came to systemically-important things which didn’t fail in this particular crisis, Greenspan was alarmingly sanguine.

When Leonhardt brought up the subject of derivatives, Greenspan was at pains to differentiate interest-rate and foreign-exchange derviatives, on the one hand, from credit default swaps, on the other. He explained, quite rightly, that the percentage of the notional amount which players stand to lose is much higher in the CDS market that it is in say the rates market, but he never mentioned that notional amounts outstanding in the rates market are orders of magnitude greater than the CDS market ever was.

The degree to which Greenspan claimed not to be worried about the vast bulk of the derivatives business was highly alarming:

Nobody hears about problems in interest-rate or fx derivatives. We’ve had the most extraordinary stress test, and they came up clean. I’m saddened by the fact that the problems in CDS have been generalized to all financial derivatives.

For one thing, we do hear about problems in interest-rate derivatives: a man appearing at the conference later this afternoon, Larry Summers, contrived to lose $1 billion of Harvard’s money in just that market. Given the extreme measures which have been taken by the world’s central banks, and given the fact that global capital imbalances remain enormous, there’s clearly a lot of tail risk in the interest-rate and fx markets. If volatility there spikes in some unprecedented way — which is entirely possible — then no one knows who could end up becoming spectacularly unstuck in those markets.

Greenspan defended the CDS market, too, in familiar terms:

We have to make adjustments in the way that market is working, but fundamentally the concept of CDS is a very desirable one. You are distributing risk to those who are more interested in holding it or more capable of holding it, and that’s desirable.

Haven’t we learned that this isn’t true? Haven’t we learned that the people who end up holding the risk, once the banks have done their derivatives-based, structured-product thing, are precisely people who are not interested in holding it but who don’t realize what risk they’re holding? After all, those buyers will always be much more attractive, to risk sellers, than the kind of risk-hungry hedge funds who demand high returns for taking on that risk. The derivatives market turns out to have been one the best mechanisms ever designed for hiding risk, and I don’t see that as desirable in the least.

Greenspan, in other words, seems to have learned almost nothing from the crisis. When Northern Rock failed, he said, “the UK authorities were the best set of regulators in the world” — er no, they weren’t, as a glance at the leverage ratios at UK banks would tell anybody. So when Greenspan talks about inflation not being a problem until 2012, as he did at the end of his session, it’s not obvious why anybody should listen to him. He simply isn’t reliable or useful any more.

Many congratulations to Agustín Carstens, who, according to Javier Blas, has managed to make Mexico $8 billion by putting on some smart oil hedges last summer:

Traders joked on Monday that Mr Carstens was probably 2009’s “most successful, but worst paid, oil manager”.

Of course, it helped that Carstens had $1.5 billion lying around last summer to pay for the hedges in the first place. But really all this financial cleverness only puts off the day of reckoning: Mexico is running out of oil revenues fast, and has no visible means of replacing the taxes currently paid by Pemex.

The tax burden on Mexican individuals and companies is low in theory and lower still in practice, and the kind of tax hikes which would be needed to even partially compensate for falling government oil revenues are politically impossible to pass. No one is more aware of Mexico’s coming fiscal crunch than Carstens, and if anybody can do something constructive, he can. I suspect, however, that no one can do anything constructive, and Mexico will be in serious fiscal pain sooner rather than later.

It’s a sign of the severity of the financial crisis that Barack Obama is re-nominating Ben Bernanke as Fed chief now, in August, despite the fact that his term doesn’t end for another five months. It’s one of the few sources of potential uncertainty which the White House can address and resolve unambiguously, and it’s good that it’s happening.

Obama is following Bill Clinton’s lead in reappointing a Republican Fed chairman who was appointed initially by a Republican president. In fact, by the time Bernanke’s second term expires, it will have been 28 years since a Democrat, Paul Volcker, held the post. But the good news is that Bernanke isn’t party-political: it’s pretty unthinkable that he would ever pull a stunt like Greenspan testifying before Congress in favor of tax cuts, on the grounds that things get a bit complicated when the government reaches zero debt. (Ha!)

It’s also good news, in its own way, that Bernanke has some opposition in Congress: it’s right and normal that the Fed chief should upset lawmakers. But now that he’s been renominated (and his confirmation is a slam-dunk), maybe those noises about the central bank losing its independence might die down a little.

I’ve been wondering for a while whether the real Treasury secretary — the person who actually makes the big decisions about US fiscal policy — is in fact not Tim Geithner but rather Rahm Emanuel. Today, we learn:

After Treasury Secretary Timothy F. Geithner stumbled in rolling out a new banking policy, Mr. Obama told Mr. Emanuel to step in, and he met for an hour each day with the economic team to develop a workable policy.

Geithner is a creature of Washington, and one would expect him to be very good at the political aspects of his job. But no one would expect Geithner to have more political nous than Rahm. And it’s hard to imagine, after Rahm is parachuted in to make US fiscal policy “workable”, that he adopted a posture of cringing obeisance towards Geithner’s policy ideas.

Speaking of which, whatever did happen to Geithner’s much-hyped bank bailout?

Greg Ip says that the Fed would have expanded its quantitative-easing program by now were it not for political considerations:

If the programmes are doing some good, why is the Fed not expanding them? The outlook has improved, for one thing: America’s economy is levelling out, it noted on August 12th. But the main reason is political, not economic. The Fed’s Treasury-purchase plan prompted charges that it was inviting hyperinflation and had subordinated itself to the government’s deficit needs. Alan Greenspan, a former Fed chairman, says inflation will exceed 10% if the Fed fails to shrink its balance-sheet and raise rates, and 3% for a time even if it does.

Needless to say, that is not the Fed’s view: it still foresees rising unemployment and falling inflation. But many officials have concluded that, for now, the benefits of buying more Treasuries do not outweigh the costs of a damaging rise in inflation expectations and a perceived loss of independence.

I can see why the Fed would decide against printing more money if doing so raised inflation expectations in a harmful manner. But that’s a basic consideration in making monetary policy decisions, and doesn’t really count as “political, not economic”.

So what’s the political consideration here? If second-guessing politicians means that the central bank fails to do something it would otherwise have done, then that central bank has lost independence. If the Fed’s doing what the politicians want, it has lost independence already. So what’s it worried about?

I think that what Ip is trying to say is that central banks have a lot of independence so long as inflation expectations are low, but if they’re perceived to have lost their grip on inflation, then that perceived independence can evaporate very quickly. (This is all about perceptions, interestingly enough: inflation expectations, rather than actual inflation and perceived independence, rather than actual independence.) And so in order to maintain a reputation for independence, they will be inclined to favor the arguments of political hawks. It’s a way of second-guessing themselves into having less independence in reality, just for the sake of keeping more independence in the public mind. Or something.

That said, at the margin, this phenomenon acts in favor of tighter monetary policy, even as politicians generally tend to agitate for looser monetary policy. So maybe these things largely cancel each other out.

Jonathan Ford thinks that GDP bonds are a good idea. What’s a GDP bond?

Imagine a country that normally grew its GDP at 5 percent a year. To the extent it grew at 6 percent, the coupon would be reset upwards by one percentage point. If it undershot by one percentage point, the interest rate would be similarly reduced.

Ford explains that this is good for both issuers and investors:

Most investors have three objectives: long-term growth; inflation protection and low price volatility… GDP bonds meet all three requirements…

For the issuer, GDP bonds also have appeal. As Willem Buiter has recently observed, they would give government debt some of the characteristics of an equity security. Their servicing costs would rise and fall in line with the state’s own ability to pay. This, Buiter observes, “would reduce the expansion of the public debt through the intrinsic debt dynamics that comes out of the product of the interest rate and the outstanding stock of debt.”

Ford and Buiter both worry about governments fiddling with macroeconomic statistics, but that’s actually the least of the problems here.

For one thing, although Ford and Buiter both point to Argentina as a precedent, there’s a big difference between what Argentina did and what they’re proposing. Argentina stapled detachable GDP warrants to its plain-vanilla bonds — they had upside, if GDP grew quickly, but no possible downside. Under this GDP bond scenario, by contrast, a bondholder could actually lose out by holding a GDP bond:

With $1 million worth of 10-year debt, for instance, there would be an amortisation of $100,000 each year, unless the growth rate of GDP that year were negative… With minus 2 percent GDP growth in year 1, interest payments would be minus 10,000, which could be paid as a reduction in principal repayments that year to $90,000.

Bond investors in general, and government bond investors in particular, are highly loss-averse — they’ll require much higher yields if there’s a real risk that they won’t be repaid their principal in full.

What’s more, bond investors valued those Argentine GDP warrants at zero when they were issued. If a detachable option with upside but no downside is valued at zero, then a built-in option with symmetrical upside and downside will clearly be valued at less than zero: the government is going to have to pay a big premium to complicate matters in this manner.

In general, it’s nearly always a bad idea to add optionality to bonds: it’s the kind of thing which seems very clever to investment bankers pitching deals, but which never really catches on among the buy-side.

With government bonds, the hurdles are even higher. Government bonds, after all, serve a dual purpose: they’re a mechanism allowing the government to borrow money, and they’re also the instrument by which the financial markets construct a benchmark yield curve. If GDP bond issuance were only a tiny proportion of the whole, like inflation-linked bonds are right now, then the upside for governments — lower interest expenses during recessions — would barely be noticeable. On the other hand, if they became the norm, then we would no longer be able to see at a glance what the risk-free rate of return was for any given maturity.

The fact is that while GDP bonds make a certain amount of sense in theory, they make no sense in practice. For the national treasury — a/k/a taxpayers — they will nearly always be more expensive than plain vanilla debt. At the same time, the fixed-income investors who tend to buy nearly all government debt want, well, a fixed income, not a variable dividend. If they wanted a variable dividend, they’d buy equities.