An Economic Disaster?
By Arnold Kling
In a meandering interview, Russ Roberts and Robert Barro talk about disasters. Barro wonders why, given history, we would presume that the probability of an economic disaster is low. I guess short-term history for the United States, meaning the last 50 years or so, would suggest no disaster. But looking at longer time periods, and particularly including other countries, would suggest something different.
Barro points out that the demand for risk-free assets is high, as indicated by the low yields on treasury-indexed securities. See William J. Bernstein. That, along with the boom in commodity prices, may indicate that investors have an unusually high probability of a disaster.
Will the disaster come from housing? The New York Times sees potential for another wave of mortgage defaults. On the other hand, Charles W. Calomiris, Stanley D. Longhofer and William Miles write,
Our models predict that as foreclosures continue to climb in many states, house prices will remain flat or decline in those states — but will not collapse.
They point out that the Case-Shiller home price index is likely to over-weight homes that shot up in price during the boom, and hence is likely to overstate the magnitude of the decline.
I would not be so confident in the models of Calomiris, et al. I would worry about the fact that there is a large stock of unoccupied homes, built during the boom. With employment falling, household formation is going to slow down, and that is not going to help absorb the excess inventory.
As far as disaster scenarios are concerned, one to ponder is a sudden drop in confidence in U.S. government liabilities. Suppose that the government could only borrow very short term at very high interest rates. Would it start printing money? That would undermine confidence altogether.
Years ago, some people warned that Freddie Mac and Fannie Mae were insolvent, in the sense that without the confidence of investors willing to lend to them at low rates, they would collapse. Is the U.S. government in such a position?
One could argue that under current policy, the U.S. fiscal path leads toward bankruptcy. You would expect policy to change in order to put us onto a better course. But will they be the right ones, and will they be enacted in time? It is easy to imagine that the next round of economic policy will combine wider short-term deficits (aka “stimulus”) with higher marginal tax rates. That hardly improves the long-term outlook.
If you were worried about this scenario, where would you run? If you think that the U.S. will inflate its way out of debt, the Treasury-indexed bonds are still safe. You might try foreign government securities, but the debt/GDP ratios are scarier in most other countries than in the U.S. U.S. state and local governments are certainly not safe in a scenario where the Federal government loses confidence.
The traditional safe haven is commodities. Barro points out that plenty of commodities have shot up in value in recent years, and he is puzzled as to what demand factor could account for it. Hmmm…
I personally tend to be optimistic. I think that technological change is accelerating, and this will boost the denominator in the ratio of government debt/GDP, which will bail us out. But the ability of government to raise the numerator, and to lower the denominator, cannot be completely discounted.