Niall Ferguson: America Needs to Cancel Its Debt
by Michael Hogan January 20, 2009, 8:25 AM
As dedicated V.F. readers already know, Niall Ferguson “gets” the economic collapse. Now, the historian and bestselling author is sharing his insights with a new book, The Ascent of Money, and an accompanying TV special (which means regular people might actually absorb some of what he has to say).
And what he has to say is rather terrifying, with profound implications for an Obama presidency and, beyond that, the future of the United States as a superpower. I tried putting my most basic questions about the economy to Ferguson, and here’s how it went:
Michael Hogan:First of all, this whole financial collapse is great timing for your book. Are you psyched?
Niall Ferguson: Well, I can say with a degree of self-satisfaction that it wasn’t luck. Two and a half years ago I decided to write this book, because I was sure that this financial crisis was going to happen, and the reason I was sure was because people kept coming up to me—whether it was investment bankers or hedge fund managers—telling me that volatility was dead that there would never be another recession. I just thought, “These people have completely disconnected from reality, and financial history is going to come back and bite them in the ass.”
In the book, you identify the five stages of a bubble. What stage are we at now?
We’re pretty much at the last stage, which is the Panic stage.
If you remember roughly how it goes, you begin with some kind of Displacement or shift that changes the economic environment. I would say in this case, the displacement was really caused by the wall of Asian savings coming into the U.S. and keeping interest rates lower than would have normally been in the cycle.
Then you get the Euphoria, which is when people say, “God, now prices can only go up, we should buy more. We should borrow more, because this is a one-way bet.” And then more and more people enter the market, first-time buyers, and that’s the classic run-up phase of the bubble. Then there’s this sort of irrational-exuberance Mania—which came at the end of ’06, when we still had property prices rising at an annualized rate of 20 percent. But then you get Distress. That’s when the insiders, the smart people, start to look at one another and say, “This is nuts, we should get out.” That’s when the John Paulsons start to short the market.
And then you get the shift into downward movement of prices, which ultimately culminates in Panic, when everybody heads for the exit together. In this bubble, it happened in a strange kind of slow motion, because the game was really up in August 2007, but it wasn’t really a full-fledged panic—at least across the board—until Lehman Brothers, September 15, 2008, more than a year later.Wile E. Coyote ran off the cliff in August of ’07, but he didn’t really look down until over a year later.
What do you think happens next to the stock market, to the real estate market, and to the banks?
Well, they have further to fall, without doubt, because we’re going to get almost a third phase of the crisis. The third phase of the crisis is when rising unemployment starts to impact the real estate market and consumer spending generally. So, we go another leg down. Unemployment is rising at a very rapid rate. It could go as high as 10 percent, and it’s just going to keep going up in the next two quarters, maybe throughout the year, because this is bad. This is worse than the early 80s. This is as bad as it’s been since the 30s.
And in those conditions, there’s going to be further negative movement of real estate prices, and further negative movement of stock prices. People are going to get horrible earnings reports, and when the earnings reports turn out to be worse than anybody expected, the prices of most corporations are going to head south. So, it’s certainly not over. Best case, the rate of decline begins to slow, so we’re not falling vertiginously. We start to fall more gradually.
Is a $700 billion stimulus, like the one Obama is talking about, better than nothing?
Well, it is better than nothing.
Why?
Well, I think we have to realize that nothing would be the Great Depression. So it will be a “success” if output only contracts by five or seven percent. It will be a “success” if unemployment only reaches 11 percent, because in the Great Depression output contracted 30 percent, and unemployment went to 25 percent.
These measures that we’re taking at the moment are preventative measures. They’re really designed to prevent a complete implosion of the economy. That’s why I call this, the “Great Repression,” with an “R,” because we are repressing this problem. But, that’s not the same as a cure. And what we’re going to see will look very disappointing, because we’ll be comparing it to the recovery of the sort that we used to see. In a traditional post-war recession, there would be a shock; the Fed would cut rates; there would be some kind of fiscal stimulus; and the economy would quite quickly recover.
The reason that won’t work this time, and this is the key point, is that the whole U.S. economy became excessively leveraged in the last ten years. The debt burden, as a proportion of G.D.P., is in the region of 355 percent. So, debt is three and a half times the output of the economy. That’s some kind of historic maximum, and those debts aren’t going away.
So we’ve all been bingeing on money that we didn’t have.
That we borrowed. And we borrowed it from abroad, ultimately. This has been financed by borrowing from petrol exporters, and borrowing from Asian central banks, and sovereign wealth funds. But yeah, whether it was the people who refinanced their mortgages and spent the money that they pocketed, or banks that juiced their returns by piling on the leverage, the whole system became excessively indebted. And notice: what is the policy response? You guessed it, more debt. And, now it’s federal debt.
So you end up in a situation where you’re curing a debt problem with more debt. Is that going to bring about a sustained recovery? I find that hard to believe.
So I guess the unanswerable question is, what could you do to solve this problem?
Well I’ll tell you what you have to do—you actually have to cancel the debt. There are historical precedents for this.
Excessive debt burdens in the past tended to be public sector debts. What we’ve got now is an exceptional level of private debt. There’s never been an economy in history that’s had so much private debt. Britain and America today lead the world in the indebtedness of the household sector and the banking sector and the corporate sector. But debt is debt; it doesn’t even matter if it’s household debt or government. Once it gets to a certain level, there is a problem.
In the past, when excessive debt burdens were accumulated by government, they tended to do one of two things: either they defaulted—this is the Argentine solution—where you say, “Ah, I’m sorry, I’m afraid we’re not going to be able to meet the interest payments this month, and never again will we make the interest payments.”
The other scenario is inflation, where the real debt burden is eroded because the money that it’s denominated in loses value.
I don’t think we’re really going to be out of the woods here until something of that sort happens to the huge debt burdens of the U.S. economy. Either these debts will have to be fundamentally written off in some way, or inflation will have to reduce the real burden.
Don’t either of those scenarios spell the end of America as the world’s unrivalled superpower?
Well, it certainly will be extremely painful. And that is why we have to look very closely at the attitude of the foreign creditors, because the U.S. owes the rest of the world a lot of money. Half the federal debt is held by foreigners. And if the U.S. either defaults on debt or allows the dollar to depreciate, the rest of the world is going to say, “Wait a second, you just screwed us.” And that’s, I think, the moment at which the United States experiences the British experience—when, in the dark days of the 60s and 70s, Britain fundamentally lost its credibility and ceased to be a financial great power. The I.M.F. had to come in, and the pound plunged to unheard-of depths.
And George Soros became a billionaire, right?
George Soros and others made some serious money off the back of it, certainly. I mean, somebody can make an awful lot of money off a massive dollar sell-off this year.
How badly could the Chinese screw us if they wanted to?
Well, they would have a difficulty in that they would kind of be screwing themselves. This is their dilemma. There’s a sort of “death embrace” quality to this, I think that someone’s talked about mutually assured financial destruction. The Chinese have got, we know, reserves in the region of $1.9 trillion, and 70 percent [of it is] dollar denominated, probably. That’s a huge pile of treasury bonds, not to mention Fannie and Freddie debt that they’ve accumulated over the last decade, when they’ve been intervening to keep their currency weak, and earning these vast amounts of foreign currency by running these trade surpluses. Now, politically, it might be quite tempting for the Chinese to phone up and say, “We really disagree with you about, let’s say, Taiwan and Japan and North Korea. You’d better listen to us, because otherwise, People’s Bank of China starts selling ten-year treasuries, and then you guys are dead.”
But then their investments become worthless.
Then you lose about five percent of China’s GDP, and that’s a hard sell—even for an authoritarian regime. So, they have a dilemma, and they are discovering the ancient truth that, when the debt is big enough, it’s the debtor who has the power, not the creditor.
But, then again, these things aren’t always the result of calculated policy, decisions. There’s a sense in which a catalyst elsewhere could force the hand of People’s Bank of China. It doesn’t need to be the Chinese who start the run of the dollar. It could be Middle Eastern investors.
In which case the Chinese might just follow and cut their losses.
Well, they might have no alternative. They might be facing the decision that, “If we hold on, you know, we’re left really holding the hot potato.” So, that is a big worry of theirs. I know it’s a big worry of theirs. They’re thinking, “Can we somehow sneak out of some of these decisions without anybody noticing?” That’s why they’re so secretive.
One of the great problems for anybody trying to make a decision about currency is, where else do you go? Short-term, it seems to me that everybody is kind of stuck trying to avoid this dollar crisis because it would be so expensive for those people who are invested in the U.S. But you shouldn’t assume—you can’t assume—that this is a stable state of affairs. It’s anything but that. It’s very, very precarious.
Your book is about moments in history where there were innovations—the creation of money, the creation of credit, the creation of bonds, the stock market, and so on. And the people who were at the wheel during the run up to the bubble seemed convinced that they had overseen an innovation on this level. Now we’re seeing that maybe they didn’t. Fifty or 500 years from now, when someone writes a book like this one, do you think they’ll look back and see something valuable that came out of this?
I’m sure they will. They’ll look back and they’ll say, “What an extraordinary proliferation of new financial instruments and business models there was between 1980 and 2006. And then the crisis came along, and it was like one of those events in natural history: asteroid hits the Earth, environment becomes a lot colder, only the strong survive.
Some species will be extinct: investment banks are already extinct, and hedge funds will go extinct in six months. But they won’t all disappear, and the strong and well managed—and lucky!—will survive. The derivatives market will contract, but it won’t disappear, because those are useful things. They are simply insurance policies. Too many of them were sold at bad prices. It was clear that the models which were being used to price, say, credit default swaps were fundamentally unrealistic about the probability of defaults. That doesn’t mean that the underlying idea of being able to buy protection against default is a bad one.
And that’s characteristic of financial history. If you go back to, say, the banking innovations of the 17th and 18th century, when newbanks proliferated all over the English-speaking world, from Scotland to Massachusetts and beyond, banks were invented, and then along would come a financial crisis, and large numbers of them would go bust. But yeah, the ones that survived generally ended up being better banks, and I think that’s the cheerful news. This is an evolutionary system, there is an element of Darwinian, of the survival of the fittest, and although crises seem to be an integral part of the system, no crisis has been completely fatal to it.
READ MORE
• Niall Ferguson, “Wall Street Lays Another Egg” (December 2008)
• Charting the Road to Ruin: VF.com’s Recession Archive