The Road to Fiscal Crisis
by Simon Johnson, Peterson Institute for International Economics
Op-ed in Project Syndicate
March 23, 2011
© Project Syndicate
It has become fashionable among Washington insiders—Democrats and Republicans alike—to throw up their hands and say: We ultimately face a major budget crisis in the United States, particularly as rising healthcare costs increase the fiscal burden of entitlements like Medicare and Medicaid. But then the same people typically smile and point out that investors from other parts of the world still want to lend the United States vast amounts of money, keeping long-term interest rates low and allowing the country to run big deficits for the foreseeable future.
This view is seriously flawed. It implies that the United States can kick the can down the road as long as the dollar remains the world's preeminent reserve currency, and America offers the best safe haven for skittish capital owners. By 2015, according to this logic, politicians will have done nothing to raise taxes and very little to cut expenditure, so the United States will still have a budget deficit of around $1 trillion and will finance a substantial portion of it by selling government bonds to foreigners. By 2050, there will undoubtedly be a fiscal problem—but, again, there is plenty of time to ignore it.
This logic, supported by the clear intention of the Federal Reserve to keep all interest rates low, suggests that benchmark US interest rates—for example, on the 10-year Treasury—will remain below 4 percent (and perhaps under 3.5 percent) in the near term. This week, such government debt paid around 3.2 percent, which is very low by historical standards. If the "Washington Fiscal Consensus" proves correct, when benchmark rates eventually edge upwards, they will move slowly.
But this consensus misses an important point: The financial sector in the United States and globally has become much more unstable in recent decades, and there is nothing in any of the reform efforts undertaken since the near-meltdown in 2008 that will make it safer.
People sometimes talk about "systemic risk" as if it were intrinsic to the financial system. But modern financial history, including in emerging markets, strongly indicates otherwise. When banks and other financial institutions get into trouble, private losses are transferred—explicitly or implicitly—to the government's balance sheet. Dangerous financial systems pose big fiscal risks.
The three people who have articulated this problem most clearly include two of the world's leading central bankers. Before Ben Bernanke became Chairman of the Federal Reserve Board, he was rightly renowned for his academic work on the Great Depression, which showed how, under the right (or wrong) conditions, the financial sector could act as a form of accelerant for developments in the real (nonfinancial) economy. The Fed's efforts in the past three years to stabilize banks and other parts of finance have no doubt been motivated in large part by this insight.
Anat Admati, a professor at Stanford's Graduate School of Business, focuses on bank capital—specifically, the incentives that banks have to fund their activities with very high leverage—little equity and a great deal of debt. In my view, she has the single most important page on the Web today, containing both original research by her, Peter deMarzo, Martin Hellwig, and Paul Pfleiderer and their many interventions in the policy debate.
The insight of Admati and her collaborators is simple and very powerful. Higher leverage allows bankers to earn more money, but it can easily become excessive for shareholders—because it makes the banks more vulnerable to collapse—and it is terrible for taxpayers and all citizens, as they face massive downside costs. In the United States, the costs include more than eight million jobs lost since 2007, an increase in government debt relative to GDP of around 40 percent (mostly due to lost tax revenue), and much more.
Mervyn King, a former academic who is currently Governor of the Bank of England, and his colleagues have a vivid name for the toxic cocktail that results: "doom loop." The idea is that every time the financial system is in trouble, it receives a great deal of support from central banks and government budgets. This limits losses to stockholders and completely protects almost all creditors.
As a result, banks have even stronger incentives to resume heavy borrowing (as Admati argues), and, as rising asset prices lift the economy in the recovery phase, it becomes possible for them to borrow even more (as Bernanke knows). But what this really amounts to is taking on more risk, typically in an unregulated, unsupervised way—and with very little effective governance within the banks themselves (again, Admati explains why bank executives like it this way).
The Bernanke-Admati-King view suggests that the Washington Fiscal Consensus is seriously deficient. The US and global economy will recover, to be sure. But that recovery will be just another phase in the boom-bust-bailout cycle.
America's too-big-to-fail banks are well on their way to becoming too big to save. That point will be reached when saving the big banks, protecting their creditors, and stabilizing the economy plunges the US government so deeply into debt that its solvency is called into question, interest rates rise sharply, and a fiscal crisis erupts.
In other words, the "doom loop" isn't really a loop at all. It does end eventually, as it has—just for starters—in Iceland, Ireland, and Greece.
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.