I promised an individual at Atrios a quick brief in layman's language what Steven Roach of Morgan Stanley is worried about when he said that there was a
10% chance that the US could avoid a major fiscal crisis in the next couple of years. Paul Volcker, Greenspan's predeccor, is also worried that there is a
75% chance of a fiscal crisis in the United States. Two highly qualified experts who forget every morning more about macro economics than most policy makers ever learn are extraordinarily worried about the future fiscal health of the United States. Roach is more extreme in his probability adjusted outcome matrix, as is his nature. He has
long term concerns on the bubblization of the American economy as the US jumped from a high technology bubble, to a real estate bubble and now to an oil bubble. He was not able to correctly time the popping of the housing bubble as interest rates have been able to stay low and American consumers have been able to successfully flee to
adjustable rate mortages. with even lower interest rates. But this is the last gasp of a
bubble.
So what is Steven Roach worried about? He is worried that the worlds' creditors will soon start thinking that the "full faith and credit" of the US government is not worth quite what it used to be, and that the worlds' lendors will refuse to lend to the US the 2+ billion dollars a day that the US is currently consuming in excess of what we are producing. Or at least to refuse to make these loans at the currently low real and nominal interest rates.
Why is this bad? The US economy is based upon easy access to capital in order to finance debt. Debt in and of itself is not a bad thing for a nation, a corporation or an individual. The things that matters is what the debt is used to finance. If it is used to finance a long lasting productive asset, then the lender should feel pretty comfortable in receiving their money back, so therefore the interest rate is low. My decision to go into debt for a college education and then grad school is partially based on the high probability that my lifetime earnings profile will be dramatically higher than if I had stopped my education at high school. California's recent decision to go into debt to finance stem cell research has a decent to high probability of creating a higher earnings profile for the state than the counterfactual of no stem cell research funding.
However, there is also bad debt, and that is debt for short term consumption. For instance if I grab my fiancee's credit card and went on a ten day bar crawl that starts in Pittsburgh and ends in some shady bar in Bangkok, that is not a constructive or productive use of debt. My long term earnings profile has not changed in a positive direction and I still have to pay off X thousands of dollars of new debt. My standard of living and my ability to pay will have been negatively affected. Right now, the US government is in the middle of a great bar crawl as the deficits are not being used to significantly finance new investment or infrastructure. Instead it is being used for current consumption (military and domestic) while the costs are being pushed off as long as possible.
There are a couple of ways for individuals and countries with high levels of debt to deal with their bad debt problems. The first is to dramatically cut back on current consumption and devote a larger portion of their income to debt service. This is relatively easy for an individual (move from a 3bedroom apartment for a single person back into Mom and Dad's basement) but hard collectively. Secondly, both individuals and nations can attempt to earn more income. You can do this buy getting a new job working 3rd shift at the gas station down the street, or a country can do this buy encouraging new export manufacturing. Both these steps don't put any pain of your debt problem on the lenders, so they are happy and will keep interest rates low.
But there are a few steps that can get the problem under control, but spread the burden and pain around. First, both an individual and a government can try to renegoatiate their higher interest rate debts into lower interest rate debts. This is real common, and not too hard to do; it is the basis of the refinancing industry for home mortages, and muncipal governments do it all the time. The US federal government did a little bit of this in the 90s as it called in bonds issued in the high interest rate 70s and replaced them with much lower interest rate bonds. Lenders lose some of their profits on these transactions but will engage in them for their competitors will do so also. Refinancing reduces a borrowers outgoing cash flow for debt service. The next step if there is a significant debt problem is bankruptcy, or at least the threat of bankruptcy/default. At this point a borrower says "I have too much debt and no reasonable way to pay it off, so I'll only pay a portion of it." The lendor takes a hit, and then significantly raises that individuals' future interest rates if they ever try to borrow again. Governments have one other device that they can use to get out of a painful debt situation and that is inflation. The vast majority of loans are written to say that I owe the bank X amounts of dollars and not K% of the US GDP. If the money supply chasing the same number of goods doubles, the nominal prices of everything doubles, (including my income stream) while the percentage of my income that is needed to pay off my fixed rate debt is cut in half. Variable rate debt will quickly consume the same percentage of my income for debt service as it did before the general inflation. Higher interest rates on fixed term debt will compensate lenders for this risk.
These are the basic ways to avoid a debt crisis. The lendors of the world like to create incentives for countries not to get into debt crisis, so interest rates are seen as the guidelines for borrowing. As interest rates go up, the riskiest borrowing that previously was done under the lower interest rates, no longer occurs. High interest rates encourage borrowers to only engage in safe and sure activities that will definately allow for repayment of the loans. However this pure system is not pure in practice as capital does not always seek the highest rates of risk adjusted return. Sometimes, capital will be allocated for short term political reasons which creates more systemic risk. Foreign private capital is losing interest in US debt at the current interest rates. The buyer of last resort right now is the Chinese and Japanese central banks. The Chinese are trying to defend their hard peg of 8.28 yuan/$ in order to encourage a strong soft landing for their urban economies and to buy time to work out their urban/rural divide. The Japanese have a strong interest in not letting the dollar get too weak as they are trying to defend their manufacturing base against the locked into the dollar Chinese. If the Japanese were to let their currency float without a credible promise of intervention, Japanese goods and services would get more expensive compared to Chinese goods and services, provided that the Chinese maintain their hard peg.
Steven Roach is worried that the Japanese or the Chinese are going to say that the current benefits of supporting a stronger than the fundamentals suggest US dollar will soon outweight the very signifcant costs of maintaining either a hard peg (China) or a soft currency band (Japan). Once this decision is either made, or collectively occurs without conscious thought, than the US will quickly see the ability to borrow 2+billion dollars a day at cheap interest rates disappear.
If that happens, then the entire US economic system which is based on easy access to cheap debt comes under some very serious threat. Housing has been the major store of value for most American families in the past ten years, and especially in the past five as we are experiencing localized bubbles (thankfully not in Pittsburgh). Higher interest rates means that the individuals and families with fixed rate mortages will have a harder time selling their houses, while homeowners with variable rate mortages will see their payments increase and a harder time to sell their house at current prices. This means that prices will fall and therefore previous evaluations of creditworthiness that take into account an individuals' ability to pay by measuring their equity and asset net worths will take a hit, thus neccessitating higher interest rates. This is Steven Roach's concern, that the circle of debt may be broken in the relatively short term by the refusal of either or both the Japanese and Chinese central banks to fund US debt at the currently low levels of interest/return.