Niall Ferguson Nails the Deficit Dilemma

“My prediction is that politicians will eventually be tempted to resolve the [fiscal] crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.” – Paul Krugman, 2003

Niall Ferguson in Newsweek: On average,” write Carmen Reinhart and Kenneth Rogoff in their new book, This Time Is Different, “government debt rises by 86 percent during the three years following a banking crisis.” In the wake of these debt explosions, one of two things can happen: either a default, usually when the debt is in a foreign currency, or a bout of high inflation that catches the creditors out.

Now, default is extremely unlikely and infationary forces are not visible. So what happens? Niall goes on to nail it:

Yet from where I am sitting, inflation is a pretty remote prospect. …

So here’s another scenario—which in many ways is worse than the inflation scenario. What happens is that we get a rise in the real interest rate, which is the actual interest rate minus inflation. … [S]ignificant increases in the debt-to-GDP ratio tend to increase the real interest rate.

Today’s Keynesians deny that this can happen. But the historical evidence is against them. There are a number of past cases (e.g., France in the 1930s) when nominal rates have risen even at a time of deflation. What’s more, it seems to be happening in Japan right now.

It’s not inconceivable that something similar could happen to the United States. Foreign investors might ask for a higher nominal return on U.S. Treasuries to compensate them for the weakening dollar. (emphasis added)

Unlike the last time we ran huge and persistent deficits (WWII), this time it is not being financed by US citizens. Instead, the Fed is buying, feeding on its own tail so to speak, and we still have foreign buyers. This can continue for a while, but he predicts a huge shortfall next year of around $600B with no clear buyer on the horizon.

Hmm, what does this mean for bonds? Right now we have seen no recent problems with Treasuries; if anything, after Dubai, we should expect Treasury rates to continue to drop. Yves’ scenario is intact. Niall’s scenario comes into play late next year, when the shortfall begins to emerge.

About Duncan Davidson 228 Articles

Affiliation: NetService Ventures

Duncan is an advisor to NetService Ventures, where he focuses on digital media and the mobile Internet.

Previously he was at four start-ups: Xumii, a mobile social service based on a Social Addressbook; SkyPilot Networks, the performance leader of wireless mesh systems for last-mile access, where he was the founding CEO; Covad Communications (Amex: DVW, $9B market cap at the peak), the leading independent DSL access provider, where he was the founding Chairman; InterTrust Technologies ($9B market cap at the peak), the pioneer in digital rights management technologies, now owned by Sony and Philips, where he was SVP Business Development and the pitchman for the IPO.

Before these ventures, Duncan was a partner at Cambridge Venture Partners, an early-stage venture firm, and managing partner of Gemini McKenna, a joint venture between Regis McKenna's marketing firm and Gemini Consulting, the global management consulting arm of Cap Gemini.

He serves on the board or is an adviser to Aggregate Knowledge (content discovery), Livescribe (digital pen), AllVoices (citizen journalism), Xumii (mobile social addressbook), Verismo (Internet settop box), and Widevine (DRM for IPTV).

Visit: Duncan Davidson's Blogs

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