Adair Turner's account of financial markets is insightful but misunderstands the role of the state in creating financial crises.
Given the high levels of public debt that have arisen since the 2008 financial crisis, there is a common belief that the United States is on the edge of a debt catastrophe and that it simply cannot afford to continue borrowing at high levels. These analyses often miss the important fact that borrowing can and should be an investment that creates future taxable assets. With this in mind, the current global climate provides a favorable opportunity for the United States to manage its long-term debt.
Following the 2008 crisis, China and many other countries supported domestic employment growth by exporting, leading to large surpluses. But they failed to deepen their domestic financial market which would have offered their people options to pursue domestic investment opportunities. These countries built up trillions of dollars in assets, even as (for political and ideological reasons) their peoples’ savings found no domestic outlets. There is nothing that disperses power more than a decentralized, deepening, accountable financial sector—and that’s not what those in power in these countries wanted.
On the other side of this global balance sheet, the United States has been the main recipient of the inflow of dollars, sustaining both consumer spending and budget deficits. The Eurozone experienced a similar kind of imbalance, with some countries spending and importing beyond their collateral, while others saved and invested—only in this case, the imbalance was also the consequence of attempts to forge greater global negotiating power and sustain European solidarity in light of the continent’s history of bloody tribal conflicts.
Economists define the resulting situation with the neutral-sounding “saving glut.” (This is a misnomer: after all, in a world with billions of people looking to significantly improve their lives, the savings are not channeled toward investing in them.) This savings imbalance resulted in increased budget deficits and current account deficits in the US—the former now severely aggravated by the current coronavirus crisis.
The public debt of the US government has risen to $23 trillion from $10 trillion just before the world financial crisis of 2008. These numbers do not include either unfunded liabilities of Social Security and Medicare, estimated in the $100 trillion range, or the promises just made in the coronavirus stimulus packages.
As of now, large as these numbers are, the United States continues to be the preferred destination for the world’s savings, and the dollar continues to be the world’s reserve currency—meaning that there is still confidence that the United States will create sufficient taxable assets in the future to avoid defaulting on its debt.
Felix Rohatyn’s New York City Lessons
What can be done to sustain this confidence? Experience is the best guide. Two features of the late Felix Rohatyn’s actions that prevented New York City’s default are worth bringing up.
From the 1950s on, New York spent beyond its means. By the mid-60s, the city was borrowing to bridge gaps between day-to-day tax-revenues and spending. In 1975, New York projected a billion-dollar gap against $5 billion in annual tax revenues, and it also needed to refinance a $3 billion short-term debt. The banks were not willing to lend anymore, and the city was on the brink of default, risking the biggest bankruptcy in the world of municipal finance.
In mid-1975, New York Governor Hugh Carey appointed Rohatyn as head of the Municipal Assistance Corporation (MAC)—a shell corporation intended to raise debt. MAC did, following negotiations to back the bonds by the city’s sales taxes to the state, thus preventing politicians from continuing to misspend money. MAC used the sales-tax revenue to pay the interest on the debt. If there was something left, it gave it back to the city. This financial solution, combined with an eventual federal guarantee, allowed the city to prevent defaulting on its general-obligation bonds.
Rohatyn also brought banks, pension funds, and unions to the negotiating table, and quickly corrected the earlier mistake of indiscriminate firing of public employees, finding that it had resulted in rapidly declining services that mattered to taxpayers.
By the early 1980s, the city recovered. New York continued to borrow through similar special-purpose entities, paying lower rates than “general obligation” bonds would have carried, the expectation being that politicians could waste less money because of the financial discipline imposed by these entities. With confidence restored, by 2004 a new shell non-profit, Sales Tax Asset Receivable Corporation, borrowed $2.5 billion to refinance the 1970 bailout debt. The greater discipline Rohatyn’s solution brought to the municipal sphere bought time—but its lessons, a variation on the idea of leveraged buyouts, did not quite register on the federal level, as the present virus bill shows.
Hopefully, Washington can initiate Rohatyn-style bipartisan solutions in the near future while investors’ confidence—or rather, their lack of options around the world—persists. This would mean a reduction of certain services and entitlements, as well as the creation of shell corporations to back the financing of new spending intended to produce specific tax revenues that would be out of politicians’ reach.
The United States is still in an exceptional position to pursue these policies. Whereas the federal debt has more than doubled in the last 10 years, the interest on the debt as of March 2020 is still roughly 1 percent on the 30-year Treasury, and 0.3 percent on the 10-year Treasury. The Federal government can use this lucky circumstance to borrow and lower taxes. (Once the US gets out of this house arrest, there would be opportunities that would bring returns greater than 0.3 to 1 percent, allowing for a comfortable spread.)
Alternatively, the federal government could continue to spend without applying Rohatyn’s disciplining solutions, though the lesson of New York’s experience must be kept in mind: it implies that if the federal government is not held more accountable for its spending, bringing less than a 1% return on it, the day of reckoning can come abruptly.
The reason the United States finds itself in such a favorable situation, which allows it to borrow at such low rates, is the fact that there are no other places for savers to park their money. Although the US has been committing its share of policy mistakes, the rest of the world has committed more and is expected to correct them more slowly. In the world of the blind, the one-eyed man is king. As a result, the US borrows cheaply, buys time and can avoid abrupt, tough decisions.
The United States’ Debt Management Options
The option of lowering taxes, restructuring, borrowing at the present rates, and using shell corporations would be preferable to the option of borrowing backed by general obligation bonds.
When government borrows money and spends it on a “white elephant” project that brings no return, the transaction is a simple redistribution of income. Suppose that government borrows $10 billion to subsidize “education,” but the spending ended up raising a new class of unproductive grasshoppers, as in Aesop’s fable. The $10 billion spent may not only fail to create any future taxable income, but may dig society into deeper holes, not just financially but morally, destabilizing society by raising the ire of the hard-working, tax-paying ants. That spending, no matter how it is officially categorized, was a simple redistribution of wealth—it not only failed to create future taxable assets, but destroyed some of them.
On the other hand, if one assumes that people stay idle as a consequence of mistaken government policies, as in the 1930s, paying them just to get out and clean streets could sustain discipline and morale, create networks and goodwill, and prevent “assets” from depreciating. This could be a case of government correcting its own earlier mistakes—such as monetary policy blunders—that brought about the initial idleness. But to achieve such an outcome, governments must be well-organized, and bureaucracies held accountable, which usually is not the case: it certainly was not in New York of the 1970s.
This example also shows the mistake with much of the current debt analysis, which calculates interest payments relative to debts or national incomes and suggests that the sky is falling. These measures are backward, not forward-looking. No matter what these numbers are, society is better off if it can borrow at, say, one percent and pursue policies to get a return of an average of three percent. This spread is the relevant variable for the government’s budgetary consideration and its fiscal and regulatory plans.
The favorable borrowing opportunity for the United States will last as long as the rest of the world is making more mistakes and correcting them more slowly. This was the case in New York relative to other US cities during the 1970s. Of course, today’s lucky global circumstances may change abruptly, raising interest rates, a possibility that must be kept in mind, so as not to get over-leveraged. But as of now, the federal government could use the present rates and buy as much time as possible.
Numbers from the present crisis, however, show that politicians did not learn the lessons. As an example, although municipal bonds rallied in response to Washington’s and the Fed’s plans, yields on Illinois’ 2027 bond jumped from 5 to 6 percent. Illinois’ pension commitments are among the highest of all the states, and their pension funds are now in trouble, given the decline in the value of their stock holdings and prospects of refinancing bonds at higher rates.
Are there any modern-day Rohatyns to come to the rescue?