Recently, I was asked some questions about America’s debt. The trouble is: I’ve been writing about America’s debt problem since this blog first began, so I often struggle to include all the context when I write something more about it. And when I started writing out that context, it turned into its own series of blog posts! So I’m going to give you a three part series on America’s debt ‘problem’. I’m splitting it as follows:
- In Part 1, I want to try and explain some of the events that might make you more skeptical about the collective concern with America’s debt;
- In Part 2, I’m going to try and lay out the two main arguments that go against the traditional “America has too much debt” narrative; and
- In Part 3, I want to talk about low interest rates, QE, and how that has changed the world we live in.
A Heterodox Debt Lapse Confession
Like any finance blogger on the internet, I began firmly on the old-school side of this debt story. That is: too much debt is bad, and it can cause feedback loops. As debt levels rise, the risk of default rises, which drives up interest rates, which in turn increases the likelihood of default.
This cycle can then escalate until you’re left with a Greece-type situation (austerity, tax increases, and a surrender of sovereignty to the countries that you owe). Or, worse, you destroy your currency in order to erode the real value of your debt (ie. you print money, and allow consequent inflation to destroy the value of your historic debt). Either way, there is an effective default.
But having taken that position, two things happened (and two things didn’t happen):
- Firstly, US government debt was actually downgraded (which wasn’t that serious a downgrade in practice, but was quite serious in implication – S&P downgraded the global currency of reserve!). But instead of interest rates rising to reflect the supposedly higher risk, US interest rates fell. Of course, Quantitative Easing was happening at the time, which was depressing bond yields. But you still would have expected some negative reaction in the yield curve in the week or so after the downgrade. Instead, the yield curve moved in the opposite direction. It suddenly looked as though the US yield curve had become Giffen-like. That is: when the risk of the US government rose, the market took on more US exposure in order to lower the risk of their global portfolios.
- Secondly, Quantatitve Easing didn’t result in the mass inflation that everyone was expecting. There was asset price inflation in the financial markets, yes – but consumer inflation (which would have undermined the value of the US dollar) never arrived. Perhaps it’s still to come, but the problem is: despite the liquidity creation of the Federal Reserve, the US dollar actually strengthened.
So here were these two supposedly-catastrophic events: the US downgraded, and its central bank engaging in a version of “money-printing”. But instead of rising interest rates and a dramatic weakening of the currency, you had the opposite (in both cases).
Whatever your theoretical-economic inclination, these two things happening in concert, and those two forecasted outcomes not happening in concert, are quite incredible. Literally not credible.
And in light of that, I became, shall we say, more open to the thinking of the Keynesian crowd.
As in: perhaps America having a lot of debt is not as bad as I’d thought it was?
It’s a problem, yes – but is it a catastrophe?
So that’s the personal context.
Now for some academic context.
There’s been a long debate (mostly between Paul Krugman and the more right-wing economists) about the nature of America’s debt (and whether we should worry about it). There’s also been a separate-but-related debate amongst the asset managers: where you have Warren Buffett and Cullen Roche on one side, arguing that the debt panic is distorted (and America is fine) – and on the other side, you have people like Bill Gross and John Paulson, who are all for buying gold in anticipation of some kind of economic crisis arising from the elevated levels of American debt (mostly, they feared hyperinflation).
In Part 2, I’m going to try and summarise those two points of view.
To be continued.
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.