The Debt Crisis: Niall Ferguson Said It Would Come To This

Harvard historian Niall Ferguson, back in November of 2009, wrote the following for Newsweek:

History strongly supports the proposition that major financial crises are followed by major fiscal crises. . . .

This is how empires decline. It begins with a debt explosion. It ends with an inexorable reduction in the resources available for the Army, Navy, and Air Force. Which is why voters are right to worry about America’s debt crisis. . . . If the United States doesn’t come up soon with a credible plan to restore the federal budget to balance over the next five to 10 years, the danger is very real that a debt crisis could lead to a major weakening of American power.

When Niall Ferguson wrote this, he surmised that President Obama’s historic failure was probably going to prove to be his focus on health care (as opposed to getting the debt down). And he offered historic parallels for contemplating the consequences of Obama’s blunder:

The precedents are certainly there. Habsburg Spain defaulted on all or part of its debt 14 times between 1557 and 1696 and also succumbed to inflation due to a surfeit of New World silver. Prerevolutionary France was spending 62 percent of royal revenue on debt service by 1788. The Ottoman Empire went the same way: interest payments and amortization rose from 15 percent of the budget in 1860 to 50 percent in 1875. And don’t forget the last great English-speaking empire. By the interwar years, interest payments were consuming 44 percent of the British budget, making it intensely difficult to rearm in the face of a new German threat.

Call it the fatal arithmetic of imperial decline. Without radical fiscal reform, it could apply to America next.

Unfortunately, Naill Ferguson proved to be a prophet.

And he offered a number to watch out for. Beware spending 20% of federal revenues on debt service:

[H]istory suggests that once you are spending as much as a fifth of your revenues on debt service, you have a problem. It’s all too easy to find yourself in a vicious circle of diminishing credibility. The investors don’t believe you can afford your debts, so they charge higher interest, which makes your position even worse.

I don’t think we’re approaching this number (or are even close). But it’s something to keep an eye on.

Also, Niall Ferguson pointed to the real possibility that America might try to inflate its way out of debt:

As the U.S. is unlikely to default on its debt, since it’s all in dollars, the key question, therefore, is whether we are going to see the Fed “printing money”—buying newly minted Treasuries in exchange for even more newly minted greenbacks—followed by the familiar story of rising prices and declining real-debt burdens. It’s a scenario many investors around the world fear. That is why they are selling dollars. That is why they are buying gold.

Stocks might also make for a good investment in inflationary times, but Niall Ferguson pointed to a worst-case scenario: interest rates go up ahead of inflation (or in a deflationary environment). In other words, borrowing might become more expensive in real terms even as the United States shows an inability to inflate its debt away. Of this scenario, Niall Ferguson wrote that

 . . . in many ways [it] is worse than the inflation scenario. What happens is that we get a rise in the real interest rate, which is the actual interest rate minus inflation.

I think that President Obama would have been better served if he had brought people like Niall Ferguson around him as advisors a few years back (as opposed to the Keynesians he actually did surround himself with).

But that’s water under the bridge.

And I think he’s adjusting. 

Barack Obama wants another four years as president, and he’s very smart and on a learning curve about these debt matters.

Conservatives, in my view, should not underestimate his ability to ride a libertarian wave, positioning himself as a born-again debt fighter who can nevertheless be trusted to offer at least some pushback to the Tea Party (even as he caves to the bulk of their demands).

The main reason I think the economy and stock market will be roaring back next year is because the nation’s focus is on the right problem: deficit spending and what to do about it. In this scenario, even the credit-worthiness downgrade is going to help the country. It provides focus, and I genuinely think the country is more than capable of righting itself (if not by President Obama, then by a fiscally hard-nosed Republican like Romney or Perry).

America’s crisis is also an opportunity for the country to come roaring back over then next decade or two. We have freedom, and lots of mind wells (Silicon Valley, MIT, etc), and a political culture that won’t let the federal government get too much bigger from this point forward. We might even start closing the gap between revenues collected and what we actually spend. (What a concept!)

So, I still think that stocks are a better buy than gold. Don’t sell America short.

Here’s a bit of Niall Ferguson at YouTube: