Arnold Kling  

Bond Bubble Watch

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A Nice Sentence... Balan's Test...

Morgan Stanley's Arnaud Mares writes,


The sovereign debt crisis is not European: it is global. And it is not over.

Pointer from WSJ Real Time Economics.

Mares points out that the current debt/GDP ratios are not the problem. It is when you add in the unfunded liabilities of governments, primarily pension and health care promises, that things get ugly. He also points out that the relevant ratio is the ratio of debt to revenues, and it may not be so easy to raise tax revenues as a share of GDP.

Mares' main point is concerns the ways in which bondholders are vulnerable.


Outright default is not the only way to impose losses on creditors. Financial oppression - the fact of imposing on creditors real rates of return that are negative or artificially low - can take other forms: repaying debt in devalued money (e.g., through unanticipated inflation), taxation or regulatory incentives on institutions to purchase government debt at uneconomic prices, for instance

He concludes,

current yields and break-even inflation rates provide very little protection against the credible threat of financial oppression in any form it might take. Note that a double-dip recession would not invalidate this conclusion: it would cause yet further damage to the governments' power to tax, pushing them further in negative equity and therefore increasing the risks that debt holders suffer a larger loss eventually.

Some day, "The United States could never default on its debt" may go down in history as another bubble mantra, next to "There could never be a nationwide decline in house prices." So, you may be spared a default in which you are only paid 50 percent of principal. But you could wind up with principal payments that are worth only 50 percent in terms of real purchasing power. The thing is, with so much of our debt in short-term securities and inflation-indexed bonds, inflating our way out of the debt could take a fair amount of work.

Anyway, the Morgan Stanley piece seems to be a nice companion to my paper on guessing the trigger point for a U.S. debt crisis.


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CATEGORIES: Fiscal Policy



COMMENTS (3 to date)
Steve writes:

Arnold,

Your concern about the government inflating the debt runs counter to Mares' point that unfunded liabilities are a major contributor to sovereign debt risk. To the extent that unfunded pension and medical liabilities are on a government's economic (if not accounting) balance sheet, inflation will not be a viable government strategy.

wintercow20 writes:

Oh Arnold, I'd have to disagree that it is not easy to raise additional tax revenues as a share of GDP ... didn't you know it was as simply as going after sliced bagels? See here: http://www.democratandchronicle.com/article/20100826/NEWS01/8260341/Tax-on-bagels-has-local-Bruegger-s-owner-fuming

[tinyurl replaced with full url.--Econlib Ed.]

Rebecca Burlingame writes:

Doctors have been aware of the precarious state of government finances for years. Back when the economy seemed rosy compared to now - a few years after 9/11, one doctor said, "another terrorist attack (or something equivalent) and Medicare and Medicaid as you know it could just go away."

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