Editors Note: This is an interview conducted by Business Insider Editor in Chief Henry Blodget In Davos. Read the full transcription below.
BI: So, Professor Ferguson is the United States still screwed?
NF: Well this is not a technical term in economics that I recognise so let me maybe rephrase the question. Does the United States still have an economic problem? Yes. What is that problem? The problem is that having thrown massive fiscal and monetary stimulus at the economy it is still growing too slowly to bring down the unemployment rate. um what is the answer to that problem? some people say more fiscal stimulus and that indeed is what is being done and more monetary stimulus, and that indeed is what is being done in the form of QE 2. That may well have some short term impact but there is a risk that the fiscal position of the United States tips over from being stimulative to being unsustainable. And the big worry is that at some point this year, could be next year, the level of borrowing the United States engages in pushes inflation expectations or even default expectations to the point that nominal yields really start to spike and then The Fed is in a jam b/c it would then have to do QE3 on a massive scale and quite quickly we could be facing a really major dislocation either in the bond market or currency markets that is the problem. Is the U.S. screwed? No not the way Japan is screwed or even the way the Euro zone is screwed but the U.S. is certainly not out of trouble.
BI: So isn’t that what people were saying about Japan, in 1993, that they were done and here we are 18 yrs later and interest rates are still zero, they’re still spending, still borrowing and borrowing and they haven’t collapsed yet?
NF: Well if that’s the fate of the United States it is screwed right? So if the United States were to have two lost decades of growth then you’d have a mountain of debt and you would have an extremely disgruntled populace. There are two big differences between Japan and United States one is, Japan is a homogeneous society, it is ethnically almost completely homogeneous and it can cope with low growth, socially, culturally, the United States is not. Second difference is Japan finances its vast debt domestically. half the federal debt is in foreign hands and of that a very substantial proportion of that is held by the People’s Republic of China. So its a completely different situation and I doubt very much if the United States is going to repeat the Japanese experience. Even if it did, it would hardly be a good outcome.
BI: You’ve written a long presentation on what happens to countries that get into a situation that the United States is in basically that there’s no easy way out. What do you think will happen to the United States?
NF: Well never make predictions especially about the future but there are a couple of obvious scenarios, one is based on historical evidence. One is inflation which is the kind of obvious way out if you have large debt in excess of 100% of GDP that is denominated in your own currency and your own currency you can print for free. Then you would expect the fed to let the printing press run, as happened in the period after WWII particularly in the ’70s. Second scenario which is not quite so likely is default, where the United States defaults on some of its liabilities, perhaps its external liabilities. It certainly will default on its liabilities in social security and medicare that is very likely. But on the bond market i doubt a U.S. default is likely. Defaults by states however, Illinois, California, seem very likely so there will be elements of default at the state level. The third scenario which gets much less air time is one in which the US can not escape from the debt mountain b/c every time it tries to inflate the markets price and the inflation risks with higher yields and in that sense it begins to look more like your Japanese scenario, except that as i said there is much less social stability to cope with that low growth, high debt scenario and you’ve got foreign creditors getting very uneasy. So, I think at the moment its scenario three that I think is most likely, and that is a scenario in which the debt mountain wont go away, the dollar refuses to depreciate fast enough to reduce the debt burden, the economy doesn’t grow very fast, and significant social and political problems ensue because I don’t think Americans will take it lying down. And then it gets a little cloudier in my crystal ball to see where we’ll be even a year from now is difficult if there is a shift in bond market sentiment, if there is a big move in currency markets, who knows? Right Now the US is indeterminately pursuing fiscal and monetary stimulus while the rest of the world is putting their foot on the break. At some point I think that has to end b/c frankly foreign governments will refuse to finance US borrowing at these kinds of rates, in the low threes. It’s just not likely to continue and when we get to that point, I think the Congress and President are going to face an incredibly difficult decision and I have the sense by the way that those risks are being underestimated at Davos this year.
BI: Certainly the stock market will tell you that everybody thinks everything is off to the races again. US GDP is growing strongly again and a lot, perhaps 90% of wall street economists will say its 4 – 5% growth from here, we’re in great shape. Is there any scenario that you see that would lead to a happy outcome as opposed to the three horrible scenarios that you described?
NF: Well I certainly think 4.5% growth would be a very important part of that. I’d love to know where this growth is supposed to come from with highly leveraged households and a dollar that refuses to get weak, as weak at least as would be necessary for a really major export drive. I heard Larry Sommers go through the determinates of growth and when I did the arithmetic in my head I didn’t get to 4.5% or anything close. The stock market is not a great measure of the health of the US economy anymore because the corporations on the S&P 500 on the DOW are multinational and international corporations their business is booming in Asia, their stocks are going to look good, but does that help you in Michigan if you’re unemployed? So the high growth scenario is what everyone wants to see but I must say that I do have difficulty imagining such a high number b/c the debt has not gone away, the deleveraging process has achieved remarkably little so far in household balance sheets, so consumers are still constrained in a very major way and they are or were 70% of GDP. Maybe corporations will suddenly go out on an investment splurge and of course we know there’s great piles of money on the sidelines but I’m wondering what would impel them to do that unless they were really focused on emerging market exports. Final thought if people are into stocks, or if they are into investing in real assets, they are out of the treasury market right, that seems to be where that money is currently parked. So if that money is moving in to higher risk assets that seems to me to imply higher yields b/c they’ll be out of the treasury market so I don’t know how that really helps. QE2 was sold to me only yesterday as a policy that would reduce yields but they’ve gone up since that policy was announced, and they’ll go higher.
BI: You’re very clear that we’re on a road to hell in a hand basket as you think. Some people would say but if we were to change course right now we will kill the economy, the same way the UK just killed the economy by becoming austere as it worried about the debt. What do you recommend that we actually do to to make the best possible of the worst scenarios that you talked about?
NF: Well first now, I don’t accept that the UK killed the economy, I mean it was clear it was going to some pain b/c you don’t move out of a bloated public sector into a dynamic private sector w/o some major pains of transition and the kinds of cuts that George Osborne is implementing will have an impact on consumption b/c the people in those bloated public sector jobs will lose their jobs and they aren’t going to go shopping to celebrate, there’s nothing surprising about what the UK is doing (HB – and its still the right thing to do) It was clearly the right thing to do b/c the alternative given the horrible numbers that George Osborne inherited from Gordon Brown and Alistair Darling implied a Greek or Irish style crisis and I think it was very prudent to preemptively avoid that by embarking on a course of fiscal stabilisation and I think politically, as well as economically, it was the right thing to do. In the US the situation is different, the governments obviously been in office now for longer, and therefore the political benefits of acting decisively are smaller. But there’s a critical point that I think Obama and his people consistently have dodged. It is not impossible to have a 10 year plan to return to fiscal stability without a short run austerity package. In other words you don’t need to front load this but you do need to have a plan that will get the US back into equilibrium in a 10 year time frame. If you don’t have that, you lack credibility. And if you lack credibility you’re going to have a risk premium at some point, whether its an inflation risk or default risk. So my hope is that we will see, and it remains to be seen, is that the White House will work with the more intelligent elements of the Republican party personified by Paul Ryan to come up with that kind of road map that Ryan has been talking about now for some years. A road map that will get the US back to fiscal equilibrium over as I said a 10 year time frame. I think that would do a wonder, do a marvellous amount for business confidence in the US. Small businesses look at the numbers and the say ‘hey I don’t know what’s happening this year but this has to imply either my input’s going to be costing me more because of inflation or I will be hit by a tax bill like I never saw before’ because this just can’t be sustained. Uncertainty is the thing that keeps people back from investing and from hiring new people, and a clear and credible plan for fiscal stabilisation over the decade would do a lot for confidence.
BI: Last question because I now you’re besieged and congratulations for that by the way (NF: It’s probably a curse in disguise). Given what you know about the US political system do you think its possible that we could enact such a plan and stick to it?
NF: I wish i could say yes. I mean the moment that there is a quality to politics in Washington that is deeply worrying. The worry is that a polarization in terms of partisanship is making it very hard indeed to construct the kind of consensual reforms that will be needed and entitlements that will be tackled if the tax code is really to be reformed. I see the personalities that could do that but they’re not a large number of people. I can remember going to dinner last year in Washington to discuss radical fiscal reform, I thought it would be held in one of the big hotels in one of the ballrooms to accommodate all the interested congressmen. Three showed up and one of them was Paul Ryan. The worry I have, and it was increased by the State of the Union address, is that American politicians will talk about tackling the deficit and do completely the opposite until finally they run out of road. And that is a very very risky scenario for two reasons, one, even if interest rates stay low the way Paul Krugman says they will, the percentage of revenues going on debt service goes up every year because you’re borrowing at 10% of GDP every year. And as that rises from 10% to 20% to 30% you are running out of money to pay for anything else. I mean discretionary expenditure gets squeezed whether you like it or not and you really don’t want to see the US budget devoted to entitlements – medicare, social security, and interest payments and oh that’s it. And that would be the future without change and change now. Remember the CBO just before Christmas said you need to stabilise the GDP ratio to increase taxes by 12% or cut entitlements by 12%, there isn’t a single living American politician that would let those words pass his or her lips. But if you leave the problem the CBO said it gets worse. In the immediate aftermath of that reports publication the agreement was reached to borrow another $900 billion. So they say one thing, and they know what has to be done, but their political incentives lead them to do the exact, diametric opposite. So yeah I must be the you know the voice of doom in otherwise cheerful Davos but I don’t know the more cheerful people are I think back to 2006 and people were cheerful then but look this is going to be liquidity crisis, now I’m saying this is going to be a bond market.
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