Arnold Kling  

An Economic Disaster?

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In a meandering interview, Russ Roberts and Robert Barro talk about disasters. Barro wonders why, given history, we would presume that the probability of an economic disaster is low. I guess short-term history for the United States, meaning the last 50 years or so, would suggest no disaster. But looking at longer time periods, and particularly including other countries, would suggest something different.

Barro points out that the demand for risk-free assets is high, as indicated by the low yields on treasury-indexed securities. See William J. Bernstein. That, along with the boom in commodity prices, may indicate that investors have an unusually high probability of a disaster.

Will the disaster come from housing? The New York Times sees potential for another wave of mortgage defaults. On the other hand, Charles W. Calomiris, Stanley D. Longhofer and William Miles write,

Our models predict that as foreclosures continue to climb in many states, house prices will remain flat or decline in those states -- but will not collapse.

They point out that the Case-Shiller home price index is likely to over-weight homes that shot up in price during the boom, and hence is likely to overstate the magnitude of the decline.

I would not be so confident in the models of Calomiris, et al. I would worry about the fact that there is a large stock of unoccupied homes, built during the boom. With employment falling, household formation is going to slow down, and that is not going to help absorb the excess inventory.

As far as disaster scenarios are concerned, one to ponder is a sudden drop in confidence in U.S. government liabilities. Suppose that the government could only borrow very short term at very high interest rates. Would it start printing money? That would undermine confidence altogether.

Years ago, some people warned that Freddie Mac and Fannie Mae were insolvent, in the sense that without the confidence of investors willing to lend to them at low rates, they would collapse. Is the U.S. government in such a position?

One could argue that under current policy, the U.S. fiscal path leads toward bankruptcy. You would expect policy to change in order to put us onto a better course. But will they be the right ones, and will they be enacted in time? It is easy to imagine that the next round of economic policy will combine wider short-term deficits (aka "stimulus") with higher marginal tax rates. That hardly improves the long-term outlook.

If you were worried about this scenario, where would you run? If you think that the U.S. will inflate its way out of debt, the Treasury-indexed bonds are still safe. You might try foreign government securities, but the debt/GDP ratios are scarier in most other countries than in the U.S. U.S. state and local governments are certainly not safe in a scenario where the Federal government loses confidence.

The traditional safe haven is commodities. Barro points out that plenty of commodities have shot up in value in recent years, and he is puzzled as to what demand factor could account for it. Hmmm...

I personally tend to be optimistic. I think that technological change is accelerating, and this will boost the denominator in the ratio of government debt/GDP, which will bail us out. But the ability of government to raise the numerator, and to lower the denominator, cannot be completely discounted.

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CATEGORIES: Macroeconomics

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The author at Jim's Blog in a related article titled Explanations of the oil price rise writes:
    My explanation for high oil prices is the collapse of oil states. Arnold Kling argues that instead the problem is that investors fear the collapse of advanced states, so are reluctant to take their money. ... [Tracked on August 6, 2008 3:31 PM]
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Ironman writes:

The national debt-to-GDP ratio is the wrong measure (although it's close). Try this one instead (here's a related discussion with an especially relevant chart.)

Flip writes:

I think that gold bullion is the last resort for a portfolio, preferably held in a foreign jurisdiction. If the stock market and bonds collapse, the gold will at least hold some value and may go up a lot. I wouldn't have a lot, but I would (and do) have some.

Mark writes:

In the Raleigh, NC area, where housing prices actually increased slightly from June '07 to June '08, things don't look good.
There are presently about 300 homes on the market in Wake County alone priced at $1 million or more. There are 700+ in the $350k to $400k price range; 900+ in the $400k to $500k price range; and over 1,400 in the $500k to $1 million price range.
Housing inventory has increased by 50% over the past two years.
I'm waiting for the bottom to fall out even in this seemingly bright spot of the U.S. housing market.

Arnold Kling writes:

I think that what is misleading about debt/income is that it does not take into account the future obligations under Social Security and Medicare. If we ignore those, then we're fine. But if we include those, we're in huge trouble.

Ironman writes:

Arnold: You're obviously correct with respect to the various debt-to-income ratios. They are, at best, a snapshot in time, one whose picture quality could be improved by factoring in the present value of the nation's long term financial obligations. From an accounting perspective, it's disappointing that the government doesn't do this already.

While I can't speak for how Medicare will go about meeting its future obligations, I can for Social Security. Under current law, Social Security will revert back to a pay-as-you-go system once the OASDI trust fund surplus is exhausted (around 2041-2, according to the program's actuaries' intermediate assumptions), with all money collected from Social Security taxes in any given year afterward being fully distributed to program recipients.

The actuaries also forecast that people receiving Social Security benefits can expect to see their checks reduced by 20-25% when the trust fund is depleted at that time.

This isn't a problem from our current crop of politicians' perspective, as this is the only obligation that's been promised to be paid. There's no gap to be made up in a technical sense, even though each and every recipient of Social Security benefits will notice it.

Perhaps someone could clarify if Medicare will operate differently, or will simply be effectively capped and rationed as Social Security benefits will be.

aaron writes:

The debt to gdp ratio isn't as important as the interest to gdp ratio and what the volitility of that may be. What do we expect to have to pay on that debt?

dWj writes:

I had thought dependence on short-term funding was exactly the distinction between solvency and liquidity.

I think dividing DTI by population is the stupidest thing I've read this morning, but the day is still young.

As a holder of inflation-indexed US debt, I'd rather we inflate than default in a crisis, but as a citizen, I'd far rather we default. The premium we would presumably have to pay afterward to borrow money should be the same in either case, and the economy will do better with a stable currency than without one.

Supposing nominal GDP grows 5% a year over the next decade or so, we can currently borrow 1% of GDP and pay back less than 1% of GDP (because nominal interest rates are lower than 5%). The short-term deficit worries me more because it suggests continuing deficits than anything else; if I thought we could stop on a dime, I'd be perfectly willing to run deficits until it became less lucrative. Well, that and that international investors are starting to show some signs of worrying about our credit; the liquidity thing does worry me a little bit.

Ironman writes:

dWj: The "stupidest thing you've read this morning," and yet, you can't say why?... Please elaborate if you have a point.

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