Fiscal Deficits and the Bond Market Vigilantes

Tim Duy is channeling Hamlet, torn between his concern over mass unemployment in a stagnant economy and his fear that an attack on the dollar could be just around the corner. I think he is right that we came close to a disorderly decline in the dollar during the period leading up to the financial crisis, but it’s a big mistake to think that slashing fiscal deficits is any sort of insurance against a return of this threat. On the contrary, big government deficits are exactly the result of credit contraction in the private sector.

Duy gives us a FRED visual on capital inflows to the US economy; I’m reproducing it here.


Inflows ballooned from the mid 90s until the onset of the financial crisis. This was not a period of outsized fiscal deficits, however; it was the private economy (housing but not only) that ran up the tab. When the bubble popped, it was left to the Fed/Treasury combo to transfer debt from those who couldn’t finance it (households and financial institutions) to those who could (taxpayers). Unless you have a plan to turn a chronic current account deficit into a surplus within the next year or two, this is exactly what financial recovery in the private sector means: fiscal deficits. It’s the macro identity.

(Remember, this is not a functional relationship. It has nothing to do with what people want, choices they make, or probable consequences of their actions. It is an identity. If the private sector overall is to pay down its net debt, in the absence of a change in the balance of payments it is equivalent to saying that the government is taking it on.)

What the Eurozone crisis teaches us, in case we didn’t know it from centuries of prior experience, is that it is a country’s external position, whether it borrows from or lends to the rest of the world, that determines how much confidence there will be in its financial assets. Greece ran up fiscal deficits and got hammered. Ireland and Spain maintained orthodox fiscal policies but had private sector debt binges and got hammered. What they all have in common is that they ran up unsustainable external deficits year after year.

And the US? As Fred’s chart shows, the financial crisis brought about a sudden but transitory collapse in our external borrowing, and now it’s back on the increase. In fact, it appears that only the anemic condition of our economy compared to some of the emerging high-flyers, has kept our borrowing below crisis levels.

Yes, we need expenditure-switching—more exports, fewer imports—but we’re not getting nearly enough of it. A softening of the dollar would help, but we would need consent from our main trading partners to accept a drastic reduction in their trade surpluses, and, in any case, it will take years to undo the structuring of the US economy around imported resources and consumer goods. (Adaptation to credit-driven consumption has gone on for so long it may have become a cultural issue. Political economic considerations also apply, as I’ve argued earlier.)

What will do absolutely no good at all is fiscal retrenchment. It will cause hardship for millions and provide no protection against the risk of a future collapse of US asset values. On the contrary, if households respond to a shortfall in income by ramping up their borrowing again, dollar-denominated assets will once again enter the danger zone. Slashing fiscal deficits is like fighting a war by firing on our own troops.