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A fiscal train wreck

Gregory Mankiw ponders whether the US economy will default on its national debt, inflate to decrease the real value of its debt or (most responsibly) raise taxes massively to what he calls European levels.  He favours the latter view.  Grim reading. A default seems improbable but the second solution – to devalue the debt by further devaluing the US dollar or forcing an appreciation of, in particular, the RMB – is something I have long-believed is highly likely.  If the inflationary solution is adopted I assume the rest of the world will be better insulated from inflationary pressures and stagflationary pressures than it was when the US last reneged on its debts (after the Vietnam War) because of exchange rate flexibility.  Still I hope Mankiw’s forecasts are more accurate than mine.

2 comments to A fiscal train wreck

  • Jim

    It may, of course, be some combination of the three. Fiscal Theory of the Price level, I reckon, is the one worth look at here, though.

    Essentially, when bond-holders no longer believe in the sovereign’s future primary surplus (that is, they don’t believe the state can repay debt), they will rationally sell their bonds. For any central bank using the interest rate as its instrument, this means increasing the purchase of bonds, and an increase of the money supply. One doesn’t need to ask Gideon Gono what the usual outcomes of that strategy are.

    However, much of this is based on bond-holders’ beliefs in the capacity of the US to meet its interest payments. Given the giant sums of money going into the military there, I wouldn’t be surprised if bond-holders reckon the US would prefer to decrease military spending than default, or print money.

    If the Tea Partiers, though, get their way, those beliefs may change…

  • Uncle Milton

    The US can only inflate if the Fed agrees to it, which they won’t. There is simply no way the US will outright default on its bonds.

    But they can default by the back door, which is by depreciation. As soon as the markets realise this is likely to happen, it will happen.

    That’s no good if you have US T bonds in your portfolio, but excellent if you are going on a holiday to the US or buying books from Amazon.

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