Greg Ip is generally a very good reporter, but he gets the story of the U.S. debt badly wrong. (He is now the U.S. economics editor at the Economist, but was formerly a reporter for the WSJ.) First, he uses the price of credit default swaps (CDS) as a measure of investors' expectations of the likelihood of a default on U.S. government debt. It is not clear that investors' expectations mean much (remember, these are people dumb enough to have been willing to pay $50 for a share of Citigroup stock little more than a year ago), but the price of CDS on U.S. debt is a very bad measure of the expectation of default. The bet on a CDS is not just that the bond will have a default event, but also that the issuer will be around to make good on the CDS. In other words, if J.P. Morgan sold a CDS on U.S. debt, the buyer is not only placing a bet that U.S. government debt will be subject to a default event, but also that J.P. Morgan will be around to pay off the CDS. Since it is very likely that J.P. Morgan (or any other issuer) will also be defunct if the government goes bankrupt, the value of these CDSs is not really giving a measure of the expected risk of default. In fact, CDSs can provide payments to holders in the case of a default event, which could include the government temporarily exceeding its debt limit. This is a far more likely event than a default on U.S. government bonds, and it is almost certainly the main factor underlying the value of CDS on U.S. government bonds. The other more important point that Ip gets wrong is his assertion at the beginning of the article that the United States had pursued "responsible macroeconomic policies." This is blatantly wrong. It was astoundingly irresponsible to allow the growth of a $10 trillion stock bubble followed by an $8 trillion housing bubble. These policies directly led to the extraordinarily steep downturn the country is currently experiencing. It would be difficult to envision macroeconomic policies that could be more irresponsible than the one we pursued over the last dozen years. The irresponsibility of U.S. macro policy also has direct relevance to the issue that Ip raises about the sustainability of the debt burden. The high dollar policy initiated by Robert Rubin caused the government to run large current account deficits. These deficits are unsustainable over the long-run and will put downward pressure on the price of the dollar since the United States is putting more dollars into world markets than is needed to buy our goods and services. This will eventually lead the dollar to fall to a level that is consistent with more balanced trade. This decline in the dollar would occur even if the government were running a budget surplus, it is the result of our trade position, not our budget situation. However, a declining dollar could make foreign and domestic investors less willing to hold dollar denominated debt, since they can get better returns holding debt denominated in other currencies. This reluctance to hold dollar denominated debt will cause interest rates in the United States to rise. The Fed can seek to counteract this rise in interest rates, but the cost will be allowing somewhat higher inflation (most likely in the 3-6 percent range, not hyper-inflation). This scenario is not hugely different than the scenario described by Ip, except that the culprit in the story is the over-valued dollar (really bad macroeconomic policy) which never makes an appearance in Ip's column. It is important that economists and reporters acknowledge the origins of our problems so that we can learn enough to avoid repeating the same mistakes.
--Dean Baker
