Arnold Kling  

Questions About Financial Crises

Basic Economics Is Intuitive... Krugman on Federal Debt...

Neither a borrower nor a lender be.

That's the way I feel after reading This Time is Different, by Carmen M. Reinhart and Kenneth S. Rogoff. This is certainly one of the must-read books of the year. Some thoughts after reading it.

1. Considering the propensity for governments to default and for financial institutions to fail, it is amazing that lending markets persist. I wonder if one of the reasons that people like to hold short-term debt is that it fosters the illusion that they will be able to avoid losing money. I make a short-term loan and think, "If the borrower gets in trouble, I'll be one of the first people to notice, so I won't renew my loan and I'll be ok." Everyone thinks they will be faster than average at pulling money out before the borrower goes under. Obviously not a rational equilibrium. The rational equilibrium would have more equity finance and more long-term debt relative to short-term debt.

2. I would expect defaults to come in clumps. When lenders observe a rise in defaults in some sector, they will cut back on lending to that sector, leading to more defaults. By the same token, when borrowers in one sector observe similar folks defaulting, they will think, "I can default now, because everyone else is defaulting, so it won't hurt my reputation so much."

3. Default, particularly government default, is not just an economic choice. There are all sorts of subtle political economy issues and signalling issues. The politicians have to decide who to hurt when.

Overall, reading the book made me raise my estimate of the probability of widespread defaults by Western governments. My guess is if the U.S. defaults (through high inflation, for example), that will open the floodgates so that European countries will believe that it is ok to default. So if you want to maintain wealth, you need to put your money somewhere where the government will be trying to establish its reputation for reliability while everyone else is defaulting.

An excerpt, from p. 66:

Financial repression can also be used as a tool to expand domestic debt markets. In China and India today, most citizens are extremely limited as to the range of financial assets they are allowed to hold...and very few options for accumulating wealth to pay for retirement, healthcare, and children's education, citizens still put large sums in banks despite artificially suppressed returns. In India, banks end up lending large amounts of their assets directly to the government, which thereby enjoys a far lower interest rate than it probably would in a liberalized capital market. In China, the money goes via directed lending to state-owned enterprises and infrastructure projects, again at far lower interest rates than would otherwise obtain. This kind of financial repression is far from new and was particularly prevalent in both advanced and emerging market economies during the height of international capital controls from World War II through the 1980s.

I don't know if I would use the term "financial repression," but it is interesting the way the U.S. banking sector is rigged to funnel money into government debt. Deposit insurance encourages people to put their money in banks. Capital regulations encourage banks to invest in government and agency debt. Of course, when they re-rigged it to encourage banks to invest in mortgage securities, the results were not exactly pretty....

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COMMENTS (8 to date)
winterspeak writes:

ARNOLD: In the book is there a single country that defaulted which had a non-convertible, floating fx rate fiat currency or liabilities denominated in that currency? A single one?

Hummel has a list but each one violated one of the three criteria above, (and none of which apply to USG.) Help me out.

Doc Merlin writes:

He is including using high inflation to reduce debt in his definition of defaulting.
If you do that, that would include the united states during the 70's, which used inflation to help finance the vietnam war and the War on Poverty/Great Society.

E. Barandiaran writes:

From your feeling after reading the book, I must conclude that it's the typical book written by people paid by international organizations to justify their survival (the IMF in this case). Your comments amount to say that given the pervasive corruption of the construction industry, it's surprising that so many buildings have been built. From going around the world for a long time and from studying the history of private and public finances, I have drawn a very different conclusion: too many buildings and loans are indicative of little corruption and incompetence.

winterspeak writes:

Doc Merlin: Thanks!

So tell me, is a "credit default swap" triggered by inflation?

If it is not (and it is not) then what sense does it make to use a word that means one thing ("default") to mean a completely different thing ("inflation")?

Or, would you say that most people, when asked "Has the US Govt ever defaulted on its debt" would say "sure, did it 40 years ago!"?

Would Hummell agree that the US defaulted in the 70s? He did not include it on his list.

Dan Weber writes:

Is USG really more likely to default than other countries? I thought the standard line was that the major welfare states would collapse under their own burdens.

Now this raises a question of signaling: would the US become less likely to default because a) people flee to it because it hasn't, propping it up, and b) in order to keep people and capital flowing in, the US works hard to maintain that signal. Or would the US become more likely to default because they wouldn't default "as bad"?

winterspeak writes:

DAN: That US need NEVER default. Jeffrey Rogers Hummel thinks it is inevitable, but he does not understand what default is and/or how that the US runs on a fiat currency now, and not any flavor of gold standard.

All US obligations are in $. US can produce any quantity of $s it wants, at any moment, without any constraint. Therefore it cannot default any more than a bowling alley can run out of points to award to its punters.

There may be inflation. There may be redistribution that some consider unfair. There may be lower growth rates through ineffective Govt allocation of resources. etc. etc. The list of bad economic things that might happen in the US is a long won, but so long as it maintains dollar obligations, and the dollar is a fiat currency (non-convertible, floating fx) default need never be on that list.

Jim Glass writes:

In the book is there a single country that defaulted which had a non-convertible, floating fx rate fiat currency or liabilities denominated in that currency? A single one?

Russia had a fiat currency and obligations denominated in it upon which it defaulted.

It could have readily floated the currency to inflate and avoid default if it wanted to -- but it chose not to.

This is Rogoff's point mentioned above: Default isn't just economic, it is political. The Russian politicians had to choose between angering their external creditors or the populace at home with pitchforks (via inflation) and made their choice.

It's an example of why it's so naive to say "governments with fiat currencies can never default, they'll just drop their exchange rate, print more money, whatever, inflate debt away."

(This apart from the fact that nations that continue to run deficits don't and can't inflate their debt away).

winterspeak writes:

JIM: Russia in 1998 was operating on fixed-fx regime.

I will repeat my question: "is there a single country that defaulted which had a non-convertible, floating fx rate fiat currency or liabilities denominated in that currency?" Not a single person has been able to come up with one. Does that tell you anything?

There is nothing naive about my statement. It reflects reality and accounting. The "US will default!" story is the naive fairy tale based on some distant gold standard past.

The McArdle link is typical -- people don't bother to understand double entry bookkeeping but they run regressions all day long. It's as if spotting a correlation beats thinking. Or learning what a t-table is.

The Government deficit equals net private sector savings, by accounting. This is because the Government deficit funds net private savings, by the operations of the Fed, Treasury, and monetary system.

If the Government injects too much money into the private sector, and not all of it is absorbed as savings, the rest causes inflation. If the Government injects too little money, or extracts too much via taxes, then you get deflation driven by lack of aggregate demand (as we see now).

A commentary on the chart showing that declining debt-to-GDP does not tie to inflation is completely ignorant of how these two interact. If there is deflation, it means the private sector is trying to save, so debt-to-GDP must grow to fund this, or you'll get continued economic weakness.

Reducing debt-to-GDP is how you COMBAT inflation, not create it! Government surpluses drain the private sector of net savings, a very contractionary policy!

To clear all this up the US should 1) stop issuing Treasuries, 2) set the interest rate to zero across the entire yield curve, 3) rename the deficit "paid out equity". Everything would continue to operate just fine, and it would be awesome to see these "US will default" people explain how the sun continues to rise and set.

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