The Coming Bond Bear Market: Will "Inflating our troubles away?" Work?
I think our most immediate danger is a rise in interest rates. If the real rates r charged to our government rise, say, to 5%, then the service on a 100% debt/GDP ratio rises to 5% of GDP, or $1 Trillion dollars. Now, debt service really does matter, and our outstanding stock of debt really does pose a surplus problem.
There are two mechanisms that might raise interest rates. "Not so bad" interest rate rises come as a natural consequence of growth. Higher per capita growth times the intertemporal substitution elasticity equals higher interest rate. If the elasticity is one, the interest rate rise "just" offsets the benefits of higher growth.
Conversely, low real interest rates can buffer the impact of lower growth. γ above one and r thus falling more than g may be a reason why our current slow growth comes with rising values of government debt.
"Really bad" interest rate rises come without growth, from a rising credit spread -- the Greek scenario. If markets decide that the entitlements are not going to be reformed, cannot be taxed away or grown out of, they will start to charge higher rates. Higher rates explode debt service, make market more nervous, and so forth until the inevitable inflation or default hits. In present value terms, higher r can quickly make the present values on the right implode. This sort of roll-over risk, interest rate risk, or run has been the subject of at least half the papers in this conference.
Here, I find the most important implication of this paper's calculations. The paper shows that the US has a very short maturity structure, so higher interest rates turn into higher debt service quickly. The paper shows that a large slow inflation results in a small change in the present value of surpluses. It follows, inexorably, that if a small change in the in the present value of surpluses has to be met by inflationary devaluation, that inflation must be large, and sharp. If x is small, 1/x is large.
We live on the edge of a run on sovereign debt. The US has a shorter maturity structure than most other countries, and a greater problem of unresolved entitlements. Despite our "reserve currency" status, we may actually be more vulnerable than the rest of the high-debt, large entitlement western world. That, I think, is the big takeaway from this paper -- and this conference.
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1 comment:
Perhaps by keeping its debt duration shorter than its trading (and lending) partners, the U.S. is signalling that it will not inflate because it has relatively little incentive to inflate. But when that posture changes and the U.S. begins to issue much more long term debt, the interest cost will high. The solution will be for the Fed. to support the U.S. debt by buying it and placing it on its balance sheet. As it is, Fed purchase of U.S. sovereign debt is a skimpy fig leaf of cover over naked money printing. Although the Fed could simply cancel the treasury debt on its balance sheet to make room for more, there is no reason to cancel because there is infinite room for more fig leaf.
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