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.