Arnold Kling  

Why I am Paranoid

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Sovereign debt crises happen suddenly. One day, a country is paying normal interest rates and has full control over its fiscal and monetary policy. Then, investors lose confidence. Within days, the country has collapsed, and within weeks the savings of the majority of its people are wiped out, as the government either defaults or radically devalues its currency.

The election is not the source of my paranoia. I think that Obama is more likely to have advisers who understand the concept of currency crises.

What has me paranoid is the enormous surge of debt issuance that is coming. If enough international investors decide that they need a large risk premium to compensate them for funding this debt, we could find ourselves with a lot of Treasury bills to roll over in an environment where interest rates are 10 percent or more. The government will not be able to afford to pay those rates, and so something drastic will have to be done.

At that point, what are the government's options? Sharp spending cuts? My guess is that will be unthinkable (we might still be in a recession, after all). Print money to pay the debt? My guess is that option will not look attractive politically.

That leaves the option of declaring a national emergency and enacting what is known as a wealth tax or a capital levy. The idea is you undertake a one-time confiscation of assets and promise never to do it again. You hope that this has zero adverse incentive effects but brings in a boatload of money.

Only a relatively small portion of the population will be affected--and even they can be persuaded that the alternative is riot or revolution. So it can be the least bad alternative from the standpoint of political survival.


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CATEGORIES: Fiscal Policy



COMMENTS (30 to date)
Gary Rogers writes:

I know of examples where governments printed money in an attempt to get out of similar situations, but they were never successful. What are the historical examples of capital levies? I would say that Argentina's confiscation of private pension plans would fall into this category, but I know nothing about how successful this has been as a debt strategy. The best solution may be simply to default on the debt and let everything collapse. Some sort of international bankruptcy could then be negotiated. What is certain is that the current level of spending is unsustainable.

Les writes:

Thanks for this perceptive analysis. I certainly agree with your logic, but I wish I was as optimistic about Obama as you are - I see a President-elect who has an unerring knack for pushing destructive and highly toxic economic policies.

I also seem to have less generous feelings towards our politicians, who contributed so much and so handsomely to create our financial woes.

burger flipper writes:

Was the last line left in by mistake?

Isn't perpetual debt rollover bound to run into this situation eventually?

winterspeak writes:

Hi Arnold:

The US runs on a fiat currency, and has its debt obligations denominated in dollars.

It is simply not susceptible to currency crises the way emerging market economies are, or Iceland.

The US can always issue Treasuries to rollover debt. They will reduce the value of the dollar (through inflation) to reduce the real debt burden.

Ruy Diaz writes:

I think the line "You HOPE that this has zero adverse incentive effects" is right on. Because when people are hit with a punch like that, I think, they'll tend to have long memories.

Has a capital levy been tried before? It doesn't ring a bell; can't think of an example, thought that likely reflects the quality of my education...

thrill writes:

The incoming administration has already made it clear that the defense budget is going to be a source for significant "redistribution". The long term downsides of such policies will ignored in the "spirit of bipartisanship".

MattYoung writes:

The consumer runs out of reserves, and stops the consumer trade.

Trade partners devote their reserves to their domestic economy.

The USA has to support its own government debt with much less help from abroad.

Interest payments at the Federal level rise by 30% as interest rates rise on 10 and 20 year terms.

State and county government begin to bankrupt without short term financing.

MattYoung writes:

Inflationary debt management forces up long term interest rates, which always has an inflation premium.

As one drives up the rate with printed money, then the private sector is right back in the muddle and trade completely stops.

The only way out is to re-negotiate with lenders (partial bankruptcy) or compete against the emerging economies.

What will happen if the IMF demands we lower the minimum wage?

Don the libertarian Democrat writes:

Doesn't the government have assets it could sell? For example, land.

Matt C writes:

I think a run on the U.S. dollar is inevitable. If not during the current crisis--fairly likely, I am afraid--then down the road when the entitlements surge starts coming in.

I'm curious why you think a capital levy would be more attractive to politicians than printing money. Seems the opposite to me, even if printing money is worse in the long run.

You can call me paranoid, but I am worried that we may see a new world war as trade breaks down and financial stability falls apart. I hope my retirement savings aren't stolen (or forced into T-Bills), but there are worse things yet.

Huxley writes:

I believe that Brazil seized a portion of people's savings accounts in 1989.

Gold bullion is looking pretty good, I think, particularly if kept outside the US.

Arnold Kling writes:

Burger flipper--yes the last fragment was left in by mistake. I deleted it. Thanks (for others, it said "That leaves an emergency tax" it was an earlier start on what became the last paragraph

Methinks writes:

Gold bullion is looking pretty good, I think, particularly if kept outside the US.

The U.S. taxes everything and everything, regardless of where it's held.

It may be time to just spend your savings on riotous living so you have less to lose when the crisis hits.

What do you all figure the probability of a currency crisis is?

ryan yin writes:

Ruy Diaz,

I believe a tax on capital and a tax on capital income are more or less identical (or at least they would be if there's no uncertainty about the return to capital), so in a sense, sure, it's tried all the time (it's just that we normally keep the capital tax below r).

Is there a huge difference between a massive tax on wealth and a massive jump in inflation? It just seems to me like they're both large taxes on savings. If that's wrong, someone help me out.

Lord writes:

If they sell or stop acquiring the dollar, the dollar falls boosting exports making it easier to reduce and pay the debt. It isn't much of a problem for us, but it is a problem for them. They either have to maintain the value of the dollar or compete against a stronger competitor, but that is the problem when you try to fight the market.

Adam writes:

I've been thinking lately of the similarities between democracy and Ponzi Schemes. Ponzi schemes collapse quickly and spectacularly, so it seems will democracy.

Adam writes:

B. Franklin said we got a republic, if we can keep it. Turns out, we couldn't keep it. The republic degenerated into democracy. As the founders feared, democracy leads to tyranny in the old, greek sense.

The fundamental economic idea that drives the demos and their pols is not Ponzi, but generalized piracy economics (GPE). GPE asserts that each citizen can prosper by stealing, through government, from every other citizens. GPE assumes no deadweight loss from government action. Indeed, government provides the needed net gain from theft.

Over the years, economists who long to be "policy-relevant" have worked out the theorems and implications of GPE, such as the equilibrium ideas about hedging and insurance. One key theorem is that of generalized theft (GT). The GT theorem shows that if you can't steal from the present generation of citizens, equivalent or greater wealth can be stolen from future generations and nations. Lemmas appending the GT show the variety of fanancial schemes that may be used to effect such cross-generation and cross-nation theft.

When the GPE system of theorems, propositions, and lemmas fails, policy economists, and the MBAs they've trained, stand at the ready to innovate with ad hoc emergency methods. The latter keep the patient alive while the pols and CEOs figure out longer term approaches for life support.

As with all scientific theories, GPE cannot be proven correct. It can only be falsified. Obviously, we're now in a severe test of the theory. We have a President-elect committed to GPE and an economy gone sour on policies emanating from the Great Depression. We'll see if GPE can struggle on for another epoch, or if it will meet its falsification.

Of course, we do have some concerns: Once falsified, what theory and practice might replace GPE?

Adam

Rasmus Karlsson writes:

As winterspeak says, the debt is denominated in dollar. Though I personally think a wealth tax would be reasonable after the Bush years I think it would be very difficult to administrate and just think of what a surge it would mean to off-shore financing (who wants to keep their money in a country that suddenly steals it?).

Instad I think the "nuclear" option is a lot more likely, the latest issue of The Economist even suggests it:

"It could work like this: the government announces a tax rebate and issues bonds to finace it. But instead of selling them to private investors, it lodges them with the central bank in exchange for a deposit. It draws on this account to clear the cheques mailed to taxpayers"

This would of course lead to inflation, but given the present fear for deflation that could be sort of a blessing. One can only hope that the money is not spent on a general tax rebate but to finance a greening of the economy and massive investments in scientific research, infrastructure and so forth.

Jeremy writes:

If there was the slightest forewarning, the wealth of the truly rich would leave the country, and the burden of the confiscation would fall on the middle class as these things always do.

Meanwhile, the capital flight would be damaging, and it would be a long time before a government that has demonstrated the ability to seize what it likes could encourage its return. We would have become Argentina.

Methinks writes:

One can only hope that the money is not spent on a general tax rebate but to finance a greening of the economy and massive investments in scientific research, infrastructure and so forth.

Right. Because that would obviously be the most efficient use for scarce resources - that's why private money is just pouring into these pursuits now. Oh wait. But I'm sure the government, replete with economists, is far better at determining which investments are better. That's why command economies have been so successful. Right?

The government making the economy more inefficient will not aid in paying down its debt. Sadly, the most efficient system we have is the bumbling market and all of its feedback loops.

Without government central planning, we would not have a massive debt burden and we would not be worried about a currency crisis.

Alex J. writes:

Ruy Diaz,

Yes, in the United States, seizure of capital has happened before.

ws1835 writes:

Jeremy -

The last four years of reckless spending have been more than enough warning. Any number of prominent financial advisors have been suggesting relocation of your dollars overseas for a couple of years now. Jim Rodgers (a well known commodities guy) actually relocated his family lock, stock and barrel to Singapore last year.

The idea must be catching on and the resulting outflow must be significant because Congress has enacted an "exit" tax that imposes instant tax liability on all capital gains/profit (realized or UNrealized) if an individual tries to expatriate. That tells me plenty of people with money have been hitting the exits during the last two years.

For my part, my existing investments are all in commodities and asian markets. There will be no new money in my portfolio until Obama clearly establishes his policies. If his administration turns out to be as tax-and-spend as he sounds, it will be years before I add anything to the market. Instead, I will pay down my fairly moderate debt and cut back on work.

In an atmosphere of 'soak the guy with a bank account' why work and save any more than you need to live? With the Bush administration and Congress bailing out irresponsible home owners/speculators at the cost of responsible savers, and Obama's stated intention of taking even more from the productive folks in the country, why build and invest? Why not just cover your immediate needs and tell the government to pound salt?

I think we are at, or near, a John Galt moment when a good chunk of productive people realize it just ain't worth it to produce. My immediate family is educated and affluent. They are the low end rich Obama is targetting (200-300K/yr). And if Obama delivers on his campaign promises, we are all taking 'vacations'. My semi-retired folks will do it by investing in tax free bonds. My brother and I will do it by working less. I just can not believe the American public has completely forgotten the 70's already.

Lucky for me, I got tax accountants in the family. Business is looking good........

mjh writes:
That leaves the option of declaring a national emergency and enacting what is known as a wealth tax or a capital levy. The idea is you undertake a one-time confiscation of assets and promise never to do it again. You hope that this has zero adverse incentive effects but brings in a boatload of money

The fear, of course, is that congress will see this income and not use it for it's intended purpose, but rather use it as an open shopping spree. Similar to what's been reported to be happening with the bailout.

Methinks writes:

I just can not believe the American public has completely forgotten the 70's already.

They haven't forgotten. People who were children under the age of ten (too young to really understand what was going on in the 70's) are just now approaching 40. The youths who voted for Obama in this election were not even a gleam in their parents' eye in the 70's. The baby boomers who are now retiring don't care about the national debt because they won't be around to pay for it.

I'm considering shutting down my business, spending a lot of the wealth I've accumulated by working 90 hour weeks, living frugally and staying debt-free. Maybe it's time to take a mortgage I can't afford and a very long vacation. I couldn't imagine thinking this way just 12 months ago.

Congress has enacted an "exit" tax that imposes instant tax liability on all capital gains/profit (realized or UNrealized) if an individual tries to expatriate.

I thought that was only for those who are renouncing citizenship.

Methinks writes:

I just can not believe the American public has completely forgotten the 70's already.

They haven't forgotten. People who were children under the age of ten (too young to really understand what was going on in the 70's) are just now approaching 40. The youths who voted for Obama in this election were not even a gleam in their parents' eye in the 70's. The baby boomers who are now retiring don't care about the national debt because they won't be around to pay for it.

I'm considering shutting down my business, spending a lot of the wealth I've accumulated by working 90 hour weeks, living frugally and staying debt-free. Maybe it's time to take a mortgage I can't afford and a very long vacation. I couldn't imagine thinking this way just 12 months ago.

Congress has enacted an "exit" tax that imposes instant tax liability on all capital gains/profit (realized or UNrealized) if an individual tries to expatriate.

I thought that was only for those who are renouncing citizenship.

Dan Weber writes:

I think a run on the U.S. dollar is inevitable. If not during the current crisis--fairly likely, I am afraid--then down the road when the entitlements surge starts coming in.

Don't several European countries have much bigger entitlement waves coming much sooner than the US does?

I think we can use them as an early warning system; hopefully we would have enough time to change course when we see what happens to them.

Matt C writes:

Arnold, I understand better what you meant by capital levies being easier for politicians than printing money. I don't agree, b/c you are talking about hitting the most influential and powerful people hardest, the kind of people that most politicians are viscerally averse to upsetting. Also, it is easier to kid yourself about the long run consequences of money printing. But I understand your reasoning at least.

Dan, I have heard this also but don't really know. If we're lucky, yes. My gut feeling is our fiscal problems will be denied or kicked down the road until major consequences start rolling in, regardless of hints from other countries. (oh, come on, we have to cut Medicare because ITALY is screwed up?)

Jaap Weel writes:

As for the suggestion made here of selling government land: a quick google search, no real research or anything, pulled up this: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=328688 "New data, and attention to the detailed decomposition of federal land holdings by type, lead to substantially larger estimates of the value of federal land than have been presented in previous research. Our estimate is that by 1981, the total value of federal land was $175 billion." If those are 1981 dollars, that makes about $394b today. It is of course possible that the estimate is off or things have changed a lot. But barring such confounding factors, government land is not worth a whole lot compared to the federal debt.

Shane writes:

1. Just as the government can declare paper to have monetary value, it can declare land to have monetary value. Just pay the interest and principle in land at a value where the value of the land is equal to the debt.
2. Right now, the total market cap of U.S. stocks is about 14 billion. MZM is about 9 billion. To completely back our money, for every 5 shares of stock, companies would need to print 9 shares to turn over to the FED. Massive dilution would result - each share would be worth about 1/3 of what it is now, assuming the market cap would stabilize because of the re-backing of the dollar.
Who thinks that possible?

Bill Woolsey writes:

The U.S. doesn't have fixed exchange rates to defend or devalue. More importantly, there is no need to earn foreign exchange to pay off foreign denominated debts.

But I don't think that means that the U.S. isn't subject to a unique sort of financial crisis.

If people begin to expect inflationary default, nominal interest would rise rapidly, unless the inflationary default actually occurs. That is, the Fed purchases debt with newly created money at low nominal interest rates. As old bonds come due, new ones are sold to the Fed. The old bond holders are paid off with newly issued money.

If, on the other hand, the government behaves responsibly and fights these expectations, this is an increase in real interest rates, best understood as a high risk premium.

Tax increases or spending cuts are required to pay the higher nominal and real interest rates--now.

So, if potential lenders are convinced that future fiscal problems will not be solved except through inflationary default, these fiscal problems can move rapidly from tne future to today.

And that makes the potential of inflationary default immediate.

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