NIALL FERGUSON: OK, I Admit It—Paul Krugman Was Right

Niall Ferguson
Professor Niall Ferguson, Harvard University.

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On Friday in Davos, I interviewed Harvard professor Niall Ferguson, who has been very vocal in recent years about how the world is careening down an unsustainable path. Unless countries get control of their ballooning debts, Ferguson has argued, we will be headed for crisis after crisis. And Ferguson remains convinced that Europe is on the edge of disaster.

But Professor Ferguson’s take on the United States has changed notably over the past year. He still thinks the U.S. budget deficit is unsustainable and that our entitlement programs will ultimately have to be cut. But he has changed his mind about the U.S.’s ability to sustain its huge debt load.

In one key way, Professor Ferguson now concedes, his adversary Paul Krugman has been right: The U.S. can carry a much-higher debt-to-GDP ratio than he thought. In fact, Ferguson now says, even his Harvard colleague Ken Rogoff, who wrote a seminal book about debt crisis called This Time It’s Different, may be too pessimistic about the United States.

But Europe, Professor Ferguson says, is still screwed.

BLODGET: Welcome, Professor Ferguson! Great to see you again. So, where are we? You have been very concerned about the huge debt load the world’s building up, but so far we seem to be tolerating it.

FERGUSON: Well, I think that’s true of the United States. I don’t think it’s true of Europe. I think the debt crisis in Europe is unresolved and may be very close to going critical. The Greek default may be a matter of days away. And we heard from Angela Merkel, a speech at the beginning of the conference that really filled me with foreboding, because it suggests that she doesn’t get—or doesn’t want to admit—that the only way out of this short of disbanding the single currency is for substantial commitment of resources to the peripheral economies. All she’s offering is austerity, austerity, and more austerity. And that just isn’t going to work. So I think the debt crisis in Europe is an even bigger problem than it was 12 months ago.

BLODGET: And the U.S.?

FERGUSON: I think the U.S. is illustrating a curious paradox—or maybe it’s just the reverse side of the Euro—the worse in Europe, the better in the U.S. The money that has fled the European debt markets has largely gone into Treasuries, and that has given the U.S. a stay of execution. The debt problem in the U.S. is just as bad as ever, but the pressure on the politicians to do something about it has in fact been eased by the Eurozone crisis.

BLODGET: We’ll come back to the U.S. In Europe, what people are saying here [in Davos] is that they are surprised at how much of an impact the latest kicking-the-can-down-the-road has had. All the interest rates are coming down. People seem optimistic that maybe Greece defaults but no big deal, they’re not going to leave the Euro.  Why are you still so concerned?

FERGUSON: Well, I am not surprised that finally an act of policy by the ECB has had a good effect. What [new ECB head] Mario Draghi has done is what [old ECB head] Trichet should have done some considerable time ago—and that is more aggressive expansion of the ECB balance sheet. That has solved the liquidity problem for the European banks. And that, in turn, has eased the pressure on some of the sovereigns. Not Portugal, though. And Portugal is a flashing red light telling you that you can’t just confine this to Greece. Whatever happens to Greece by logical extension will happen to Portugal. And believe me, what happens to Portugal by logical extension will happen to someone else. And if it’s Spain or Italy, that’s a heck of a problem. So I think the monetary side of the story is a definite improvement. I think we’ll see more of that. I think we can expect very aggressive policy by Draghi, though the rhetoric won’t be aggressive. The ECB cannot signal how aggressive it’s being because it has to talk, as somebody put it, in German, even while it’s behaving Italian. And that means that the impact is slightly muted. It’s not like Ben Bernanke, who can tell you exactly what he’s going to do for the next four years—guaranteed easy money as far as the eye can see. Draghi has to talk in a slightly more muted way. But if you turn your attention to the solvency issues, both on bank balance sheets and in sovereign budgets it’s horrible. So, I’m pretty sure that the Davos mood of “Oh, it’s all going to be fine” is, as usual, totally wrong. And we’ll probably find that just a few days after this conference, it will be panic stations again in the European debt crisis.

Niall Ferguson

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BLODGET: You say you found Merkel’s speech concerning because of a commitment to austerity?FERGUSON: Well, you see the problem is that the logic of what she said was that she sees Europe becoming like the Federal Republic of Europe over the next 20 years. The European Commission will be the government, Parliament will be more powerful, the Council of Ministers will be like the second chamber. Fine. But the Federal Republic of Germany isn’t based on an austerity pact that requires countries never to run a budget deficit. It’s based on a transfer union. The money goes from the richer Bavarians to the poorer north Germans and, of course, to the East Germans. And it’s based on a central treasury with things called Bunds. Now, if you apply the analogy to the European level, it means there has to be a proper European treasury and European bonds. And that’s just what the Germans have been opposing. So the German position is inconsistent. They want a Federal Europe, that’s now clear. But they’re not prepared to will the means. And you cannot base fiscal federalism exclusively on a pact—a kind of pact of death that nobody ever runs a budget deficit.

BLODGET: So, stepping back from all this… You’ve done a huge amount of research on previous societies that have built up huge debt loads like the ones we have. Historically, is there any way out of this other than total collapse and crisis?

FERGUSON: There are, in fact, three ways out of an excessively large public debt. One is that you default on it a la the Greek scenario. You give the bondholders a haircut. The second is that you inflate it away, which is a scenario we’ve seen more often than not, actually. The big debts of the world wars, in fact, were to a very large measure inflated away, including the substantial part of the U.S. and U.K. debts. There’s a third way, which is that you grow your way out of it. That’s rare. I mean not many countries with a debt in excess of 100 per cent of GDP have paid it off without either inflation or default, but it is in theory possible. I think when we look at the European situation the default scenario is the more likely, or the most likely, of the three, simply because to inflate the debt away is something that the ECB is prohibited from doing. And as for growth, well, if austerity is the only solution in German minds, you can forget that. I think we are going to get some defaults one way or the other. The U.S. is a different story. First of all I think the debt to GDP ratio can go quite a lot higher before there’s any upward pressure on interest rates. I think the more I’ve thought about it the more I’ve realised that there are good analogies for super powers having super debts. You’re in a special position as a super power. You get, especially, you know, as the issuer of the international reserve currency, you get a lot of leeway. The U.S. could conceivably grow its way out of the debt. It could do a mixture of growth and inflation. It’s not going to default. It may default on liabilities in Social Security and Medicare, in fact it almost certainly will. But I think holders of Treasuries can feel a lot more comfortable than anyone who’s holding European bonds right now.

BLODGET: That is a shockingly optimistic view of the United States from you. Are you conceding to Paul Krugman that over the near-term we shouldn’t worry so much?

FERGUSON: I think the issue here got a little confused, because Krugman wanted to portray me as a proponent of instant austerity, which I never was. My argument was that over 10 years you have to have some credible plan to get back to fiscal balance because at some point you lose your credibility because on the present path, Congressional Budget Office figures make it clear, with every year the share of Federal tax revenues going to interest payments rises, there is a point after which it’s no longer credible. But I didn’t think that point was going to be this year or next year. I think the trend of nominal rates in the crisis has been the trend that he forecasted. And you know, I have to concede that. I think the reason that I was off on that was that I hadn’t actually thought hard enough about my own work. In the “Cash Nexus,” which I published in 2001, I actually made the argument that very large debts are sustainable, if your borrowing costs are low. And super powers—Britain was in this position in the 19th century—can carry a heck of a lot of debt before investors get nervous. So there really isn’t that risk premium issue. There isn’t that powerful inflation risk to worry about. My considered and changed view is that the U.S. can carry a higher debt to GDP ratio than I think I had in mind 2 or 3 years ago. And higher indeed that my colleague and good friend, Ken Rogoff implies, or indeed states, in the “This Time Is Different” book. I think what we therefore see is that the U.S. has leeway to carry on running deficits and allowing the debt to pile up for quite a few years before we get into the kind of scenario we’ve seen in Europe, where suddenly the markets lose faith. It’s in that sense a safe haven more than I maybe thought before.  

BLODGET: You mentioned the three ways that countries can work their way out. Japan has been trying to create inflation for two decades and can’t do it. The United States would love some inflation, even though they will say the opposite. Can countries do something to create that inflation? And will they?

FERGUSON:  Well, certainly Japan is a terrible warning to the United States, that you can get into an awful equilibrium of very, very low growth and an inexorably growing debt mountain. And that is not where the U.S. wants to go. There are various forces in [the United States’] favour. It’s socially not Japan. It’s demographically not Japan. And I sense also that the Fed is very determined not to be the Bank of Japan. Ben Bernanke’s most recent comments and actions tell you that they are going to do whatever they can to avoid the deflation or zero inflation story. The U.K. is actually ahead here. If the game is to quietly give bondholders negative returns without awakening public fears of inflation, the U.K. is doing pretty well. We clearly are more likely in the U.S. to go down the U.K. route than the Japan route. In other words, the model whereby you eventually do tighten fiscal policy, that for sure is going to happen in the U.S. By the way, it should be said, going back to the Krugman/Ferguson argument, that if Krugman has been right about rates, I’m right about fiscal policy, because the U.S. is doing pretty much what Britain did, but later. In other words, it is on the path to reduce its deficit and it doesn’t really matter who’s President, that’s going to happen. And the U.K. is doing a combination fiscal stabilisation and monetary stimulus. I think that will be the U.S. recipe too. It’s not a recipe for rapid growth, mind you. But it’s certainly preferable to the European option or the Japanese option. 

BLODGET: Looking forward to the next 12 to 24 months, what do you think happens?

FERGUSON: I think that the drama in Europe takes a new and alarming turn and we see the European Lehman event, which is probably a disorderly Greek default. At which point, as in the United States, everybody blinks and the Germans blink in particular. I think that’s probably the next scene in the drama and quite soon. I think in the U.S., people begin to start pricing in a bit more carefully an Obama re-election and what that means for fiscal policy. You know I think the fiscal tightening will come next year even with Obama as President or Romney, so we probably need to assume that this is the last year of any meaningful fiscal help. Even that’s not true, even now we’re kind of in a fiscal headwind. But the headwind is going to be stronger next year. People will start, I think, perhaps to come off their optimism on the U.S. I felt that the last quarter of last year was a bit of a false dawn because it was a sharp drop in the savings rate that was really driving the story and that’s not sustainable. We’ll probably get back to deleveraging. So when the Fed revised down its forecasts, it was pretty much in step with my thinking. If there’s optimism still here about the U.S., it probably won’t last long. Third scene for 2012 is brinkmanship, brinkmanship, brinkmanship over Iran, but probably not a war. But the Strait of Hormuz … you can’t rule out the possibility that this could escalate into conflict. A lot of people in this game have an interest in conflict. And then the fourth scene that I’m thinking more and more about is China and what exactly unfolds there in this year when they have to manage political transition efficiently. That means steady as she goes, take no chances. But in reality they have a problem.  It’s still not over, the real estate crisis and its financial ramifications. And I think that we need to be quite cautious about how that plays out. I don’t think we should take Chinese growth for granted, while the shadow banks of Wen Jiabo are imploding. I’ve talked to a lot of Chinese journalists here and clearly that’s one of their big concerns. 

BLODGET: Thank you very much, professor.

FERGUSON: My pleasure.

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