Vex me! Last week Megan McArdle opined on the possibility of rising credit default spreads on US Treasury debt, prompting a derisive response from Paul Krugman and inspiring a marvelous (yet unpublished!) post by Yours Truly. A week later, Krugman has rebutted himself, which ought to spare me the trouble, but allow me to reflect on what might have been.
The subject was the question of whether rising yields on long term Treasury Notes foreshadowed a rising risk of default. Here is Krugman from March 31 identifying high inflation as the likely pre-cursor to default:
More broadly, on the risks-of-default thing: surely if investors were growing worried about US ability to honor its debts, they would be worrying about a breakout of inflation as well as or instead of default per se.
I now wish I had posted several points, rather than simply reviewing them with my cats.
First, the notion of hyper-inflation followed by default probably takes its inspiration from Weimar Germany and Latin America. However, neither example is useful since they (like Greece, but unlike the US) were dealing with debt denominated in something other than their own currency. In fact, as Krugman notes in the passage above, inflation is probably a substitute for formal repudiation of our debt.
However, Japan's Lost Decade provides a more relevant example - a long, grinding deflation could push the US into an untenable financial position. And that might happen despite a sustained Fed policy of low interest rates and easy money. Imagine that China maintains its link of the yuan to the dollar, so that easy dollars simply result in easy yuan, thereby stimulating employment and production in China (actually, that is pretty easy to imagine, since it has been the story of the last several years, although China's policy may change.) The Fed will never achieve either inflation or robust growth here, since China swallows it up by buying dollars and selling yuan, and the US might be pushed to the brink.
But to the brink of what? What might a US default look like? Since we control our own printing presses, it is not that easy to picture logical scenarios in which we default on our debt rather than spinning the presses and printing the legal tender needed to pay off our bills, notes and bonds. But we are talking about Washington, so why rely on logic?
An obvious irrational default scenario is simply that a Just Say No Congress plays chicken with the Treasury and the Administration, refuses to raise the debt ceiling, and delivers a train wreck on some maturing debt. That may not tell us much about the US long-term ability to pay, but it will surely spook markets. Even if the debt ceiling problem is quickly resolved, there will be repercussions throughout the global payments system as people who were relying on maturing Treasury debt to make other payments find themselves caught short. Even though people would get their interest and principal in a near-timely fashion, US borrowing rates would be higher for years. And as to whether inflation would be high or low when Congress acted out, who can guess?
And can we conjure a semi-rational default scenario? Yes, but it depends on the meaning of "default".
Suppose the US becomes fed up with China maintaining a link to the dollar, thereby boosting their economy instead of ours. Congress and the Treasury might dream up some arcane withholding tax that has the effect of keeping some of the interest and principal owed to China right here in the US (just for example, it could be dressed up as a concern that terrorists or drug cartels are investing in Treasuries through Chinese banks).
Since Chinese investors won't be receiving full and timely payment they might consider the US to have defaulted; other investors not subject to the targeted withholding may or may not not agree. Chaos! But one result would be a strong disinclination on the part of the Chinese to continue the cycle of supporting the dollar by buying US Treasuries. That might free the Fed and boost the US economy.
My gist (had I posted this) would have been that deflation is probably more of a worry than inflation as far as a US default goes. As a sidebar, I would have noted that the probability of default might be modeled separately from the probability of high inflation, since inflation is neither necessary nor sufficient to trigger a default.
But I let a week go by and now Krugman has beaten me to it! Here he is, taking a lesson from Greece:
But what are the lessons for America? Of course, we should be fiscally responsible. What that means, however, is taking on the big long-term issues, above all health costs — not grandstanding and penny-pinching over short-term spending to help a distressed economy.
Equally important, however, we need to steer clear of deflation, or even excessively low inflation. Unlike Greece, we’re not stuck with someone else’s currency. But as Japan has demonstrated, even countries with their own currencies can get stuck in a deflationary trap.
What worries me most about the U.S. situation right now is the rising clamor from inflation hawks, who want the Fed to raise rates (and the federal government to pull back from stimulus) even though employment has barely started to recover. If they get their way, they’ll perpetuate mass unemployment. But that’s not all. America’s public debt will be manageable if we eventually return to vigorous growth and moderate inflation. But if the tight-money people prevail, that won’t happen — and all bets will be off.
It's two columnists in one! A week ago a rising risk of default should have been accompanied by a rising concern about inflation. Now, a rising risk of default should be coupled with a rising fear of deflation.
Whatever. For our friends on the left, Krugman was a genius each time. For my money, he was right the second time.
REPEAT FOR EMPHASIS: Here is a longer excerpt from Krugman I:
More broadly, on the risks-of-default thing: surely if investors were growing worried about US ability to honor its debts, they would be worrying about a breakout of inflation as well as or instead of default per se. But we can track that by comparing interest rates on ordinary bonds and inflation-protected bonds. What we see is that from 3/17 to 3/30 — the period that inspired all those recent scare stories — the nominal interest rate on 10-year bonds rose by 26 basis points; the real rate rose by 28 basis points. So expected inflation actually declined, marginally.
This is not at all what you’d expect to see if markets were pricing in fears about the US ability to repay. It is, on the other hand, exactly what you’d expect to see if markets slightly upgraded their hopes of recovery.
A week later, per Krugman II, a reduced perception of future inflation (assuming the 2 bp move is not just noise) is now consistent with an increased risk of deflation and default. So "This is not at all what you’d expect to see if markets were pricing in fears about the US ability to repay" can be revised to read "This is exactly what you’d expect to see if markets were pricing in fears about the US ability to repay".
And since default can occur in either deflationary or inflationary scenarios, his basic notion that we can track it by comparing conventional and inflation-indexed bonds is now out the window.
It would be interesting to see Krugman's email inbox; if the flaws in Krugman I were obvious even to a primitive caveman righty such as myself, I'll bet he got pushback from others as well.
TO BE MORE SPECIFIC: My original intended title had been "The Over-Excited (But Under-Specified) Paul Krugman". Eventually I would have made the point that we have too few variables for the explanatory factors in play. For example, rising optimism in a strong recovery could push up expected future real interest rates, or rising fiscal gloom could push up expected default premiums. In either case, all we mere mortals would observe is that nominal interest rates are higher. And that would apply to both fixed and inflation-indexed bonds.