Stories to Watch: Unsustainable Fiscal Policy

The WSJ on the fragile bond market; Lyn Alden on the vicious cycle

For the WSJ, Eric Wallerstein writes,

Ever since the Federal Reserve broke the inflation scare of the 1980s, Wall Street and Washington have shrugged off multitrillion-dollar deficits, counting on America’s global standing to provide perpetual demand for its debt that could finance the spending. Now, the steep declines in prices of Treasurys—meant to be the world’s safest and easiest-to-trade investment—are forcing markets to confront the possibility that the rates required to place all this debt will be higher than anyone expected.

Higher rates could increase demand for bonds, thereby clearing the market. But higher rates make the debt less sustainable, because deficits rise along with interest costs.

Imagine that you are a consumer with a big credit card debt at 15 percent interest, and you ask the bank to raise your credit limit because you need to borrow more. The bank says that to compensate for risk of default, you now need to pay 20 percent interest. Does that help you? Probably not.

Now, imagine that you are a portfolio manager deciding how much money to allocate to U.S. government bonds. You start to charge a risk premium, because the government does not have a viable plan to meet all of its obligations in the long term. But at this higher risk premium, the cost to the government of refinancing its debt goes up. That makes the risk of default higher, so you have to charge a higher risk premium. You can see how the process can get out of hand.

The WSJ article says,

“This year the deficit is projected to be $1.5 trillion, or about 5.8% of GDP. We have never seen a deficit like this at a time of full employment,” said David Einhorn, co-founder and president of hedge fund Greenlight Capital, at Grant’s investment conference this past week. “I think everyone agrees that it’s unsustainable. But not everyone agrees when it becomes a problem.”

Many years ago, I wrote,

A debt crisis can be thought of as a sudden transition from the high-confidence regime to the low-confidence regime. In the former, investors have high confidence in the sovereign’s willingness and ability to repay its debt. In the latter, investors lack such confidence. The loss of confidence leads to higher interest rates, which in turn exacerbates the sovereign’s difficulties with repaying debt, and that in turn reduces confidence still further. Hence, the shift is discontinuous, not a gradual smooth shift. There is no “in-between” regime in which investors have medium confidence in the sovereign’s debt, because the strong self-reinforcing feedback loop that characterizes investor confidence, interest rates, and fiscal viability drives those variables in either one direction or the other.

This means that a debt crisis always comes as a surprise, and once it comes there is no easy way out. You can be certain that any signs of fragility in the government bond market will cause officials at the Fed and Treasury to lose sleep.

Lyn Alden writes,

I differ from Paul Tudor Jones in terms of how I see this playing out in the years ahead. In the interview, Jones frequently said the United States is going to have to raise taxes and cut spending to get the fiscal situation under control. I view that as being very unlikely to happen in today’s polarized political environment.

…So, in the long run I expect this to lead to persistent above-target inflation, or waves of inflation punctuated by temporary disinflationary slowdowns, driven by large monetized fiscal deficits.