Leverage and the Business Cycle

 Theories of leverage cycles have been around for awhile: to name a few examples, in the work of Irving Fisher back in the 1930s, Hyman Minsky in the 1970s, and John Geanakoplos in the last decade or so. Here, I\’ll offer a quick description of the theory of leverage cycles, and why it makes a plausible explanation for financial crises and at least some recessions. There has been some question about how well the data supported such a story. I\’ll offer some basic graphs suggest that the Great Recession in the U.S. economy can be interpreted (at least in part) as a leverage cycle. In addition, in a recent working paper called \”When Credit Bites Back: Leverage, Business Cycles, and Crises,\”  Oscar Jorda, Moritz Schularick, and Alan M. Taylor (no relation) present evidence on the importance of leverage cycles based on data from almost 200 recessions in 14 advanced economies between 1870 and 2008. If sharply rising leverage poses systematic macroeconomic hazards, it suggests that central banks and other policy-makers should be paying attention to this variable as the economy evolves.

 \”Leverage\” is the term that economics and finance people use for the extent of borrowing. To illustrate the theory of the \”leverage cycle,\” I\’ll first use an example from housing markets. Say that the housing market is using a general rule (with a few exceptions) that people need to have a 20% down-payment. But over time, housing prices seem to be stable or rising, so that 20% begins to seem overly stringent. More loans get made with a 10% downpayment, or no down-payment, or subprime mortgages to those who wouldn\’t have qualified to borrow earlier, and all the way to the infamous NINJA loans, made when the borrower didn\’t provide any financial information: that is, \”No Income, No Job or Assets.\” The greater ease of borrowing means more purchasing power to buy houses, and the rising price of houses that results makes it seem like even lower down payments make sense. The same logic leads people to increase their leverage by taking out bigger loans over longer terms, or  of the loan, or mortgages that reset with much higher payments.

But of course, as the down payments fall and leverage increases in these other ways, borrowers become much more vulnerable to a downturn in prices.  And a leverage cycle pops, not only borrowers but those holding the debt, like banks and financial institutions, are vulnerable as well.

Now extend the example of increase borrowing (\”leverage\”) for housing across all sectors of the economy. When the economy is going well, the risk of default looks low, and borrowing expands: that is, more borrowing for housing, for cars, for credit cards, for student loans. More borrowing by businesses and by financial firms. The greater borrowing pushes up the economy for a time, but borrowing can\’t stay on a rising trend forever. When the bubble bursts, those who have overborrowed still need to make their interest payments. Some will be unable to do so, and many will make the payments but retrench for a time, trying to minimize their borrowing and reduce their debt levels. Just as the climbing leverage in the upward part of the cycle supported an expanding economy, the falling leverage in the downward part of the cycle magnifies the downward effects.

The claim isn\’t that leverage cycles explain all recessions, but rather that they can help explain why some recessions–often those that also include a financial crash–can turn out to be so severe. The U.S. data on borrowing certainly suggests that leverage went through a leverage cycle. Here are two graphs from FRED, the ever-useful website run by the St. Louis Fed. The first shows total bank credit in proportion to GDP. Total bank credit was about 45% of GDP, give or take a bit, from 1975 through the mid-1990s. But then it starts rising, hitting 50% of GDP by about 2002, and then shooting up to about 67% of GDP by 2009. It has dropped since then, but is still above 60% of GDP.  But when leverage rises this fast, it has \”bubble\” written all over it.

A second table tells a similar story, but this time using total credit market debt owed–that is, including bank debt along with bonds and commercial paper and other forms of borrowing–divided by GDP. One might expect an economy\’s ratio of bank credit/GDP or total credit/GDP to rise gradually over time, as financial institutions in a country become more developed and sophisticated. But notice that it takes 28 years for total credit market debt to rise from 150% of GDP in 1975 to 300% of GDP in about 2003–and then just six years for it to rise from 300% of GDP to 400% of GDP. Also, notice that in earlier recessions, these measures of leverage flatten out, but don\’t drop off noticeably. The Great Recession looks like a time when, unlike other recessions in this time period, borrowers and lenders as a group felt a need to pull back dramatically. Indeed, that\’s one way to illustrate what a \”financial crisis\” means on a graph.

Jorda, Schularick and Taylor sift through data on nearly 200 recessions in advanced economies from 1870 to 2008. Some involved financial crises; many did not. They write:

\”We document a new and, in our view, important stylized fact about the modern business cycle: the
credit-intensity of the expansion phase is closely associated with the severity of the recession phase. In other words, we show that a stronger increase in nancial leverage, measured by the rate of growth of bank credit over GDP in the boom, tends to lead to a deeper subsequent downturn. Or, as the title of the paper suggests–credit bites back. This relationship between leverage and the severity of the recession is particularly strong when the recession coincides with a systemic financial crisis, but can also be detected in \”normal\” business cycles.\”

In particular, they find that when an expansion has been driven by a credit boom, the recessions that follow are more likely to involve a severe drop in lending, which in turn is felt most greatly in a decline in investment:

\”In a normal recession the drop in private loans mirrors the drop in real GDP per capita and the amount of leverage appears to have almost no eff ect. Thus at the six year mark, the cumulated drop is also about 5%. Contrast that with the severe contraction in lending during a nancial crisis recession. With average levels of excess leverage, lending activity drops by three times more than in normal times, about 15%. Measured against the decline in output during the same circumstances, the ratio is about 2-to-3. … [W]here is the drop in lending most acutely felt? … In normal recessions, the cumulative decline in the investment to GDP ratio is roughly on a par with the decline in output (but since we report the ratio, this naturally means that investment is declining faster than output). These declines are far more dramatic during fi nancial crisis recessions, almost three times as large in magnitude.\”

A key policy question from the Great Recession is what policy-makers should be looking at. Saying that it should be national policy to make sure that housing prices don\’t rise too fast or don\’t fall, or that the stock market won\’t fall, seems unrealistic and counterproductive in a market-oriented economy. (After all, part of what drives a leverage cycle is a belief that the danger of falling prices is so low.) But data on bank credit and total credit are available on a regular basis. At least a couple of years before the financial crisis first hit in late 2007, it would have been possible for the central bank and financial regulators to take various steps to slow the credit boom. Of course, it would have been politically unpopular at that time for them to do so! But as the economy staggers through a shaky recovery, with unemployment rates predicted to stay above 8% into 2014, maybe serious policy-makers can find the courage to forestall the next credit boom before it leads to such a devastating crash.

How Has Structured Finance Evolved?

As Mahmoud Elamin and William Bednar of the Cleveland Fed point out: \”Structured finance has been vilifi ed as the culprit behind the worst recession since the Great Depression. Every aspect of its design has been disparaged: faulty underlying loans, bad incentives for originators, dubious AAA ratings and mispriced risks.\” In the March 2012 issue of Economic Trends, Cleveland Federal Reserve, they update the story by asking: \”How Is Structured Finance Doing?\”

Start with defining terms: \”Structured finance securities are debt instruments collateralized by a securitization pool of loans. The pool’s cash inflow supports the cash outflow to pay the securities off. The securities are divided into multiple tranches characterized by their seniority. The most senior tranche is paid first; the second senior gets paid only after the first senior is paid and so on. Investors buy the tranche that best fits their risk appetites. We look at three products that fall under the general
heading of structured finance: mortgage-backed securities (MBS), asset-backed securities (ABS),
and collateralized debt obligations (CDO). MBS are backed by mortgages, ABS are backed by assets
such as credit card loans, auto loans, student loans, and the like, while CDO are backed by investment grade loans, high-yield loans, other structured finance products, and the like.\”

What happened in each of these three categories? In the first category, the mortgage market, the total value of mortgage originations dropped off after about 2003. However, the share mortgage originations that were packaged as securities has continued to rise. Here are a couple of illustrative figures.

Why has the share of mortgages packaged as securities continued to rise? Elamin and Bednar name three possible reasons, but don\’t try to quantify them: a rise in private demand for such instruments, polices of government-sponsored enterprises like Fannie Mae and Freddie Mac, and the Federal Reserve \”quantitative easing\” policies, which have involved direct purchase of about a $1 trillion in mortgage-backed securities.

The second broad category of securitized finance is asset-backed securities. The biggest categories here are securities backed by auto loans and by credit card loans, with securities backed by student loans as another large category. Issuance of asset-backed securities dropped off by about half after 2006. In addition, the share of total auto-loan debt that is securities fell from above 40% to 30%, while the share of credit card debt repackaged as asset-backed securities fell from more than 30% to around 15%.

The third category is collateralized debt obligations. This is the category of structured finance most thoroughly implicated in the housing price bubble. Issuance of these securities rose from less than $100 billion in 2003 to about $500 billion in both 2006 and 2007, at the peak of the housing bubble, and since has fallen to near-zero. In addition, these collateralized debt obligations at the peak were largely based on mortgages, especially subprime mortgages. These were the financial instruments that started off with subprime mortgages, and then were divided into tranches. The junior tranches agreed to take the first of any losses that arose. Thus, the senior tranches–seemingly protected by the junior tranches–managed to get AAA credit ratings, and thus regulators let banks hold these \”safe assets.\” When the housing bubble burst, and many of these subprime mortgages went sour, the popping of the housing market bubble had leaked into the banking system. Today, CDOs aren\’t based on housing; instead, what remains of the market is main involve securitizing investment-grade bonds and high-yield loans.

The Relatively Mild U.S. Financial Recession: ERP #1

I always enjoy looking through the annual Economic Report of the President, but I confess that I impose a couple of rules. I focus almost entirely on the figures and tables, and how they are discussed in the text. I ignore all economic projections for the future, and all comments about specific policies of the current administration. At least for me, this approach is useful in stripping away the politics, and focusing instead on some vivid facts and analysis. I\’ll offer four posts today using figures from the 2012 ERP:

  1. The Relatively Mild U.S. Financial Recession
  2. Why Wasn\’t the Risk of a Housing Price Decline Taken Into Account?
  3. Job Market Churning is Slowing
  4. Same Income, Varying Taxes

The Great Recession has been brutally deep, and the aftereffects seem likely to persist for at least five years after it officially ended in June 2009 (by the dating of the National  Bureau of Economic Research). But in the context of financial recessions in other countries, the U.S. experience actually doesn\’t look so bad. Here\’s a table comparing the behavior of real GDP across 14 recessions associated with financial crises. The average peak-to-trough decline is a drop of 10.2%; in the U.S., the decline was 5.1%. The average length of these recessions was 6.6 quarters; in the U.S., peak-to-trough was 6 quarters.

The rise in U.S. unemployment rates has been similar to that in other financial crisis in this comparison group, but believe it or not, somewhat less prolonged. The next table shows the rising U.S. unemployment rate over time from the business cycle peak compared with the average of the other countries in the comparison group. The figure after that shows a country-by-country comparison of the total rise in the unemployment rate.

Even the pattern of the U.S. economic recovery, sluggish as it has been, has basically followed the time profile of the 14 comparison countries.

Sometimes people talk about the depth of the Great Recession as if it really couldn\’t have been any worse–as if the very depth of the recession and the sustained proves that macroeconomic policy to counter the recession was necessarily ineffective. The conclusion does not necessarily follow, of course. To me, these comparisons offer some (admittedly impressionistic) evidence that the monetary policy steps taken by the federal government–the huge budget deficits on the fiscal side, along with  the near-zero federal funds interest rates and quantitative easing on the monetary side–did have beneficial effects. The Great Recession and its aftermath have been gruesome, but without the aggressive fiscal and monetary policy response, it could have been even worse.

Europe\’s Growing Imbalances Before Its Debt and Financial Crisis.

Europe\’s financial and debt problems were doubtless made worse and brought to a head by the global financial crisis that began in late 2007. But in the U.S., the financial crisis is fundamentally about the bursting of the bubble in housing prices and overborrowing, while in Europe, the current financial and debt problems have different economic roots, tracing to the arrival of the euro as a common currency in the late 1990s.

Nils Holinski, Clemens Kool, and Joan Muysken  offer many key ingredients of the story in \”Persistent Macroeconomic Imbalances in the Euro Area: Causes and Consequences.\” It appears in the January/February 2012 issue of the Federal Reserve Bank of St. Louis Review. As a useful expository tool, they discuss \”North\” and \”South\” Europe, where North includes Austria, Germany, Finland, and Netherlands, while South includes Greece, Ireland, Portugal and Spain. In the figures that follow, North and South refer to the averages of these groups not weighted by economy or population–because if they were weighted in that way, \”North\” would basically be Germany and \”South\” would basically be Spain. They focus only on the period of time from 1992-2007–that is, the financial crisis has not yet erupted. But their analysis strongly suggests that an eruption of some sort was coming.

As a starting point, look at trade balances. For the euro countries as a whole, the trade balance has been fairly close to zero in recent years. But as the euro got started, North countries began to run ever-larger trade surpluses, while South countries began to run ever-larger trade deficits. 

What are the underlying causes of these trade deficits? A standard economic relationship, sometimes called the national savings and investment identity, lays out certain possibilities. If a trade deficit rises, it MUST be accompanied by some combination of the following: more government borrowing, less private saving, or more private investment. Conversely, if a trade deficit falls, it MUST be accompanied by some combination of the following: less government borrowing, more private saving, or less private investment. What was happening in Europe from 1992-2007?

When it comes to net public savings, both North and South countries were reducing their borrowing in the lead-up to the euro and in the early 2000s. In other words, the large trade deficits in the South weren\’t caused by higher government borrowing.


However, private saving did make a major contribution to the trade deficits in the South. Back in the mid-1990s, gross private saving was about the same in the North and South, at about 22-24% of GDP. It remained at about that level in the North, although there is an increase in the yeas from the arrival of the euro in 1999 up to 2007. But in the South, saving fell by more than one-third to about 14% of GDP by 2007. This drop in saving reflects higher consumption of imports, and thus is linked to the larger trade deficits of the South.

When it comes to private investment, the South has done shown a modest rise and the North a modest decline. 

When an economy runs trade surpluses, it accumulates financial capital to purchase foreign assets; for example, this is why the Chinese have come to own so much in U.S. Treasury bonds. When a country runs trade deficits, on the other side, it experiences an inflow of financial capital from other countries. At least in theory, such inflows and outflows of financial capital can in some cases be a healthy form of economic adjustment. For example, one can imagine the possibility of German investment capital flowing into Spain, being invested prudently, and helping Spain\’s economy grow rapidly while providing a good rate of return to German investors. One can also come up with less-pleasant scenarios, in which German investment capital flows into Spain, is not invested prudently, and leads to a situation where German investors do not receive a good rate of return. As the authors put it:\” In particular, in the presence of integrated real and financial markets, countries with a lower per capita income would be expected to attract domestic and foreign investment since higher productivity and economic growth rates promise above-average rates of return. The productivity of the invested capital ensures that the accumulated foreign debt can ultimately be repaid.\”

Of course, now that the debt and financial crisis has hit, all earlier expectations have been confounded. But the evidence up to 2007 doesn\’t suggest that the South countries–with the exception of Ireland–were using their inflows of financial capital to increase levels of productivity. Thus, it appears that the inflows of financial capital were either being invested unproductively or were financing a consumption boom.

Long story short: The situation in the euro zone between North and South was already headed toward severe instability before the financial and debt crisis. Large and unsustainable imbalances of trade and capital flows were already happening within the euro area. This story is a re-telling of what I called in a November 18 post The \”Chermany\” Problem of Unsustainable Exchange Rates. When trading partners are locked together by fixed exchange rates that are generating large surpluses in one country and large deficits in the other–whether in the case of China and the U.S economy, or in the case of Germany and northern Europe as compared to much of southern Europe–substantial economic stresses can be created.

Holinski, Kool, and Muysken conclude this way: \”In our view, in a common currency area—or an irrevocably fixed exchange rate system, for that matter—fiscal policy in the end will be forced to step in to address unsustainable current account imbalances. This is exactly what experience in the euro area over the past few years shows. To maintain and defend the euro area, northern euro area countries will need to bail out southern countries, willingly or not, and are doing so as witnessed by implicit and explicit guarantees and continuing emergency financial support. And they probably will need to keep doing so for a substantial period ahead.\”

This perspective emphasizes that Europe\’s debt and financial crisis isn\’t just another chapter of the U.S. financial crisis, but has distinctively European roots. It also emphasizes that Europe\’s imbalance aren\’t something that can be solved by cutting one mega-deal. Either the South needs to increase its saving so that its trade deficits diminish, or else raise productivity so that it can pay off the financial consequences of its trade deficits over time–or else the North will have to pay continued subsidies if it wishes to keep the fixed exchange rate of the euro area.

McKinsey on Reducing Debt and the Pathway to Economic Health

 The McKinsey Global Institute has just published \”Debt and deleveraging: Uneven progress on the
path to growth.\” The report uses the cases of Sweden and Finland in the 1990s as a map for how recovery from too much debt, asset bubbles, and financial crisis might proceed.  MGI writes:
\”The examples of deleveraging in Sweden and Finland during the 1990s have particular relevance today. Both nations experienced credit bubbles that led to asset bubbles and, ultimately, financial crises. But both also moved decisively to bolster their banking systems and deal with debt overhang. And—after painful recessions—both nations went on to enjoy more than a decade of strong GDP
growth.  The experiences of the two Nordic economies illustrate that deleveraging often proceeds in two stages. In the first, households, the financial sector, and nonfinancial corporations reduce debt, while economic growth remains very weak or negative. During this time, government debt typically rises as a result of higher social costs and depressed tax receipts. In the second phase, economic growth rebounds and then the longer process of gradually reducing government debt begins.\”

With this pathway to eventual recovery in mind, MGI makes an argument that the U.S. economy is actually further down the road to recovery than most other high-income countries:

\”Since the end of 2008, all categories of US private-sector debt have fallen relative to GDP. Financial-sector debt has declined from $8 trillion to $6.1 trillion and stands at 40 percent of GDP, the same as in 2000. Nonfinancial corporations have also reduced their debt relative to GDP, and US household debt has fallen by $584 billion, or a 15 percentage-point reduction relative to disposable income. Two-thirds of household debt reduction is due to defaults on home loans and consumer debt. With $254 billion of mortgages still in the foreclosure pipeline, the United States could see several more percentage points of household deleveraging in the months and years ahead as the foreclosure process

Historical precedent suggests that US households could be as much as halfway through the deleveraging process. If we define household deleveraging to sustainable levels as a return to the pre-bubble trend for the ratio of household debt to disposable income, then at the current pace of debt reduction, US households would complete their deleveraging by mid-2013. …\”

Here\’s a figure showing the rapid increase in U.S debt by sector, and the recent change. In contrast to this U.S. pattern, MGI notes that in Japan private-sector debt levels didn\’t start falling until eight years after the bursting of the bubble.

 What steps should we be seeing along the way in the next year or two that would reassure us that the U.S. economy is returning to health? The MGI report offers six \”markers.\” Here, I\’ll focus on how the U.S. economy measures up on these markers, although the report offers many intriguing comparisons to other countries, especially the United Kingdom and Spain.

\”Marker 1. Is the banking system stable?\”
The U.S. economy does seem to have stabilized the banking system (at some cost!). \”Net new mortgage lending only recently turned positive in the United States.\”

\”Marker 2. Is there a credible plan for long-term fiscal sustainability?\”
In terms of what Congress has enacted and President Obama has signed into law, the answer is clearly \”no.\”

\”Marker 3. Are structural reforms in place to unleash private-sector growth?\”
\”The United States should encourage business expansion by speeding up regulatory approvals for business investment, particularly by foreign companies, and by simplifying the corporate tax code and lowering marginal tax rates in a revenue-neutral way. Business leaders also say that the United States can improve infrastructure and the skills of its workforce and do more to encourage innovation.\”

\”Marker 4. Are the conditions set for strong export growth?\”
This step was especially important for Sweden and Finland, as small open economies. It\’s less crucial for the U.S., with its huge internal market and, by world standards, relatively low trade-to-GDP ratio. Still, the U.S. economy should be recognizing that the most rapid growth in the world economy in the next few decades is going to be happening outside our borders, and we need to be thinking about how we can tap into this growth, with everything from building connections for exporters to encouraging tourism.

\”Marker 5. Is private investment rising?\”
\”Today, annual private investment in the United States and the United Kingdom is equal to roughly 12 percent of GDP, approximately 5 percentage points below pre-crisis peaks. Both business investment and residential real estate investment declined sharply during the credit crisis and the ensuing recession. While private business investment has been rising in recent quarters, total investment remains low because of slow housing starts.\” My own expectation is that real estate investment isn\’t going to be driving the U.S. economy forward in the next few years–at best, we can hope that it won\’t be a drag. So the key to U.S. investment is business investment levels.

\”Marker 6. Has the housing market stabilized?\”
\”Both Macroeconomic Advisers and the National Association of Home Builders predict that new housing starts will not approach pre-crisis levels until at least 2013—coincidentally the year in which we estimate that US households may be finished deleveraging.\”

In my own view, the most important policy steps that flow from this analysis are the importance of building to an agreement on a credible middle-term plan for holding down the ongoing rise in U.S. government debt levels, and finding ways to encourage business investment.

Thoughts on Ultra-Low Interest Rates

Philip Turner asks \”Is the long-term interest rate a policy victim, a policy variable or a policy lodestar? in a December 2011 working paper for the Bank of International Settlements.

Not all long ago, a number of papers tried to estimate the \”normal\” long-term real interest rate on safe assets. Estimates were typically in the range of 2-3%, which is a substantially higher than the barely-above zero percent rates of interest on safe borrowing, like 10-year U.S. bonds that pay an interest rate above the rate of  inflation.  Here\’s Turner: \”There has been much debate among economists about the “normal” long-term interest rate. Hicks (1958) found that the yield on consols over 200 years had, in normal peacetime, been in the 3 to 3½% range. After examining the yield on consols from 1750 to 2006, Mills and Wood (2009) noted the remarkable stability of the real long-term interest rate in the UK – at about 2.9%. (The only exception was between 1915 and 1964, when it was about one percent lower). Amato’s (2005) estimate was that the long-run natural interest rate in the US was around 3% over the period 1965 to 2001 and that it varied between about 2½% and 3½%.\” [For the record, a \”consol\” is a kind of perpetual bond issued by the British government: that is, it paid interest but had no date of maturity.]

Here\’s a figure showing the U.S. federal funds rate, as well as yields on 10-year inflation-linked Treasuries in the U.S. and the UK:

Turner sorts through the possibilities: Are these ultra-low interest rates a result of U.S. monetary policy? Are they a result of a \”savings glut\”–historically high rates of saving in the global economy, driven primary by the growing and high-saving economies of Asia, which drives down interest rate? Or are they the result of the ability of private financial markets to produce a huge supply of \”safe\” financial assets–although many of those assets then turned out not to be so safe.

My own sense is that although other explanations may have been more relevant a few years ago, longer-term interest rates now are low largely as a result of policy decisions, and that the \”quantitative easing\” policies in which central banks buy and hold government debt are a sign that such debt would not be sold at the same low interest rate without a policy intervention. However, as Turner rightly points out after a discussion of the relevant theory:  \”This paper argues great caution is needed in drawing policy implications based on the real long-term interest rate currently prevailing in markets. This interest rate has moved in a wide range over the past 20 years. At present, it is clearly well below longstanding historical norms. Several explanations come to mind. But not enough is known about how far the long-term rate has been contaminated by government and other policies. Nor is the persistence of such effects clear. And the various policies will have impacted different parts of the yield curve in ways that are hard to quantify.\”

But whatever the reason behind the ultra-low long-term interest rates, what possible risks do they raise? The obvious possibility is that low interest rates encourage borrowing and discourage saving. At present, the ultra-low interest rates are keeping debt payments low, despite the historically high underlying levels of debt. Turner touches on this point in several places:

\”From the mid-1950s to the early 1980s, this aggregate [debt of domestic US non-financial borrowers – governments, corporations and households] was remarkably stable – at about 130% of GDP. It was even described as the great constant of the US financial system. The subcomponents moved about quite a bit – for instance, with lower public sector debt being compensated by higher private debt. But the aggregate itself seemed very stable. During the 1980s, however, this stability ended. Aggregate debt rose to a new plateau of about 180% of GDP in the United States. At the time, this led to some consternation in policy circles about the burden of too much debt. It is now about 240% of GDP. Leverage thus measured – that is, as a ratio of debt to income – has increased. Very many observers worry about this. Whatever the worries, lower rates do make leveraged positions easier to finance. Once account has been taken of lower real interest rates, debt servicing costs currently are actually rather modest: Graph 3 illustrates this point.\”

Graph 3 shows nonfinancial debt in the U.S. economy as a share of GDP with the solid line, rising to aboug 240% of GDP as measured on the right-hand axis. It shows the falling real long-term Treasury yields as a measure of interest rates on the left-hand scale, with the thin dashed line. And it shows interest expenses as a share of GDP with the thick dashed line, measured on the left-hand axis. Notice that even thought debt is historically very high, interest payments are historically low.\”

In this setting, an ever-larger share of private assets are locked into very low real returns. Institutions that have liabilities far into the future, like insurance companies and pension funds, suffer greatly when interest rates are so low. It becomes much easier for the federal government to finance its huge budget deficits with such low interest rates. The pressure on households and firms to reduce their borrowing and to save more is greatly reduced, too.

This combination of high debt and low interest rates creates a potentially unstable situation. If or when interest rates rise again, the oversized debt burdens will be tougher to finance. All of those who are locked into long-term low interest rates–including large financial institutions and the Federal Reserve–would see the value of those investments fall if higher interest rates become available. Turner concludes:

\”The concluding note of caution is this: beware of the consequences of sudden movements in yields when long-term rates are very low. Accounting and regulatory changes may have made bond markets more cyclical. There is no evidence that bond yields have become less volatile in recent years. Indeed, data over the last decade or so mirror Mark Watson’s well-known finding that the variability of the long-term rate in the 1990s was actually greater than it had been in the 1965–78 period. A change of 48 basis points in one month …  would have a larger impact when yields are 2% than when they are 6%. With government debt/GDP ratios set to be very high for years, there is a significant risk of instability in bond markets. Greater volatility in long-term rates may create awkward dilemmas in the setting of short-term rates and decisions on central bank holdings of government bonds. Because interest rate positions of financial firms are leveraged, sharp movements could also threaten financial stability.\”

One sometimes hears the argument that as long as inflation isn\’t noticeably rearing its head, ultra-low interest rates should continue onward, for years if necessary. I quite agree that inflation isn\’t a threat just now, or in the near future. But historically ultra-low interest rates raise other dangers, too.

Lessons for Europe\’s Debt Crisis from Early U.S. History

For much of the last decade, all European governments that borrowed using the euro were viewed as equal credit risks: that is, they paid essentially the same interest rate when borrowing. For an American, the obvious parallel involves borrowing by state and local governments, who all borrow in the same currency of U.S. dollars but have different credit ratings and borrow at different interest rates. Not coincidentally, the U.S. federal government has a long tradition of not bailing out state or local governments in financial trouble, while there is clearly a widespread expectation that the European Union will somehow act to bail out Greece and others.

At a first glance, pointing out that the U.S. federal government doesn\’t bail out the state or local governments might seems to make the case that Europe should also avoid such bailouts.  But C. Randall Henning and Martin Kessler point out that the historical patterns and potential lessons are more nuanced in \”Fiscal Federalism: US History for Architects of Europe\’s Fiscal Union.\” It\’s available here as Working Paper 12-1 from the Peterson Institute for International Economics and also here as part of the Bruegel Essay and Lecture Series. They point out that in some ways, the centrality of the federal level of the U.S. system was created by assuming the debts of the states after the Revolutionary War. But around 1840, the federal government then ended this practice. Here is Henning and Kessler (footnotes and citations omitted):

\”The first secretary of the Treasury, Alexander Hamilton, is by all accounts credited with creating a “modern” financial system for the new United States. The magnitude of his achievements emerges from considering the prior condition of the US economy. Before 1790, the United States was effectively bankrupt, in default on most of its debt incurred during the Revolutionary War, and had no banking system, regularly functioning securities markets, or national currency. Reliant on the 13 states to collect and share tax revenue, the federal government was unable to pay war veterans or service, let alone redeem, debts. Under the Articles of Confederation, the federal government had no executive branch, judicial branch, or tax authority….\”

\”The debt assumption plan involved the transfer of state debt to the federal government in the amount of $25 million. Added to existing federal debt incurred to foreign governments (France) and domestic investors in the amount of $11.7 million and $42.1 million, respectively, federal debt would then amount to $79.1 million —a very large sum compared with nominal GDP in 1790 estimated at $187 million.\”

Hamilton\’s plan was controversial at the time–so controversial that by around 1790, was a real chance that the new country might break up. Was the plan constitutional? How to deal with the fact that some states had borrowed far more than others, but after the federal government assumed the debt, all states would now need to repay it? Hamilton was also restructuring the debt at about the same time. However, as Hamilton and others perceived, making the federal government central in this way could help bind the states together into a union.  In the end, the federal government did assume the debts of the states, did restructure them, and did pay them off. But would this pattern continue?  Henning and Kessler: 

\”[T]he debt assumption of 1790 set a precedent that endured for several decades. The federal government assumed the debt of states again after the War of 1812 and then for the District of Columbia in 1836. During this period, the possibility of a federal bailout of states was a reasonable expectation; moral hazard was substantially present. This pattern was broken in the 1840s, when eight states plus Florida, then a territory, defaulted.  … The indebted states petitioned Congress to assume their debts, citing the multiple precedents. British and Dutch creditors, who held 70 percent of the debt on which states later defaulted, pressed the federal government to cover the obligations of the states. They argued that the federal government’s guarantee, while not explicit, had been implied. Prices of the bonds of even financially sound states fell and the federal government was cut off from European financiers in 1842. …John Quincy Adams evidently believed that another war with Britain was likely if state debts were not assumed by the federal government.\”

What were the underlying reasons that caused the U.S. Congress to break the assumption that it would take over the debts of the states as needed?

\”However, on this occasion Congress rejected the assumption petition and was able to do so for several reasons. First, debt had been issued primarily to finance locally beneficial projects, rather than national public goods. Second, domestically held bonds were not a large part of the US banking portfolio, and default had limited contagion effects at least through this particular channel. Third, the financially sound states were more numerous than the deeply indebted ones. And, finally, the US economy had matured to the point where it was less dependent on foreign capital. Foreign loans were critical to Hamilton’s plan in 1790, but they were a minority contribution when investments eventually resumed in the 1850s.\”

\”Eventually, most states repaid all or most of their debt as a condition for returning to the markets. …The rejection of debt assumption established a “no bailout” norm on the part of the federal government. The norm is neither a “clause” in the US Constitution nor a provision of federal law. Nevertheless, whereas no bailout request had been denied by the federal government prior to 1840 , no such request has been granted since, with one special exception discussed below [the District of Columbia in the 1970s].

\”The fiscal sovereignty of states, the other side of the no-bailout coin, was thereby established. During the 1840s and 1850s, states adopted balanced budget amendments to their constitutions or other provisions in state law requiring balanced budgets. This was true even of financially sound states that had not defaulted and their adoption continued over the course of subsequent decades, so that eventually three-fourths of the states had adopted such restrictions.\”

Henning and Kessler suggest three lessons from U.S. history that Europeans should consider as they look at whether or how to assume some of the debts of countries like Greece.

\”First, debt brakes are likely to be more durable and effective when “owned” locally rather than mandated centrally.\”

The U.S. states didn\’t have a no-deficits rule imposed on them. They volunteered for such rules as part of wanting to borrow for infrastructure projects. U.S. states could drop their no-deficits rules at any time if they wanted. This is fundamentally a different situation than having the European Union or the European Central Bank try to imposed debt limits on recalcitrant countries.

\”\’Second, maintaining a capacity for countercyclical macroeconomic stabilization is essential. Balanced budget rules have been viable in the US states because the federal government has a broad set of fiscal powers, including countercyclical fiscal action.

When a recession  hits, U.S. states and their citizens often get some help from the federal government. With a common central bank and a common currency, many countries in the EU have already given up the paper to react to a recession within their borders by cutting interest rates or by depreciating their currency. If they also have debt limits imposed on them, they may be unable to react to a recession with fiscal policy, either. In the modern economy, arrangements that have the effect of preventing governments from reacting at all when their countries are in a recession are not likely to work well.

\”Finally, because debt brakes threaten to collide with bank rescues, the euro area should unify bank regulation and create a common fiscal pool for restructuring the banking system.\”

 The interaction between bank failures and government debt needs to be addressed. In some cases, like Ireland, bank failures were the main cause of government debt–when government offered guarantees that the banks would not go under. In other cases, like Greece, excessive government debt risks bringing a wave of bank failures, because Greek debt is so widely held by many large European banks. A unified and funded system of bank regulation across Europe would reduce both of these risks.

I don\’t have a trail map for how Europe should tiptoe through its current debt and financial crises. The middle of an economic crisis can be a poor time to try to implement the long-term arrangements, that if only they had been in place, would have reduced the risk of the crisis in the first place. But the U.S. model of not bailing out states does depend, in part, on the fact that states adopted their no-borrowing rules themselves, on a powerful federal fiscal authority, and on a unified and funded system of banking regulation. Without these conditions in place, Europe may have set itself up for a situation where intermittent bank bailouts and government debt bailouts are better than the even less-palatable alternatives.

The Role of Safe Assets in a Financial System

Gary Gorton, Stefan Lewellen, and Andrew Metrick presented \”The Safe-Asset Share,\” one of those rare academic papers with a basic empirical finding that shakes up your mental landscape,  at the annual meetings of the Allied Social Science Associations a couple of weeks ago in Chicago. Here is their opening (citations and footnotes omitted):

\”Over the past sixty years, the total amount of assets in the United States economy has exploded, growing from approximately four times GDP in 1952 to more than ten times GDP at the end of 2010. Yet within this rapid increase in total assets lies a remarkable fact: the percentage of all assets that can be considered “safe” has remained very stable over time. Specifically, the percentage of all assets represented by the sum of U.S. government debt and by the safe component of private financial debt, which we call the “safe-asset share”, has remained close to 33 percent in every year since 1952.\”

The dynamics of the safe-asset share are important for economists, policymakers, and regulators to understand because “safe” debt plays a major role in facilitating trade. … Most financial-sector debt has the primary feature that it is information-insensitive, that is, it is immune to adverse selection in trading because agents have no desire to acquire private information about the current health of the issuer. Treasuries, Agencies, and other forms of highly-rated government debt also have this feature. To the extent that debt is information-insensitive, it can be used efficiently as collateral in financial transactions, a role in finance that is analogous to the role of money in commerce. Thus, information-insensitive or “safe” debt is socially valuable. Importantly, the stability of the safe asset share implies that the demand for information-insensitive debt has been relatively constant as a fraction of the total assets in the economy. Given the rapid amount of change within the economy over the past sixty years, the relatively constant demand for safe debt suggests an underlying transactions technology that is not well understood.\”

 Here\’s figure showing the safe asset share over time: 

However, the composition of these safe assets has shifted dramatically in recent decades. It used to be mainly bank deposits, but it has now become mainly private securities. They write: \”The figure shows that bank deposits were near 80 percent of the total through the 1950s and 1960s, and remained as high as 70 percent as late as 1978. This percentage then began a steep 30-year decline, with the rise of money market mutual funds, broker-deal commercial paper, securitized debt from GSEs, and other asset-backed securities. On the eve of the financial crisis, the share of bank deposits had fallen to 27 percent. At the end of 2010, it stood at a little less than 32 percent.\”

Having documented the pattern, they end their paper with more questions than answer: \”[W]e currently know very little about the demand for and supply of “safe” debt. While we hope that our work is a start in the right direction, our paper raises a number of important questions. Why is the safe-asset share constant? Did the demand for safe assets play a role in the rise of the shadow banking system? What is the underlying transactions technology that relates the safe asset share to the rest of the economy? We hope that these and other questions regarding safe debt will be addressed through future research.\”

However, there is a bit more to say here. Gorton in particular has been thinking through the role of safe assets in an economy and a financial system for some time. For example, the subject came up in an interview he did with the Region magazine, published by the Federal Reserve Bank of Minneapolis in December 2010. Here\’s Gorton from that interview, on how a \”safe asset\” can be conceived of as an asset that is insensitive to information, and how when that an asset thought to be safe becomes sensitive to information, a financial crisis can result:

\”Global financial crises are about debt. About debt. But, obviously, we need to have a theory of debt to understand why people would use a security, bank debt, and how that could lead to a crisis. … In my work with Tri Vi Dang and Bengt Holmström, we develop this idea, that you mention, of the optimality of debt arising from its information insensitivity. Roughly speaking, the argument for the optimality of debt is simply that it’s easiest to trade if you’re sure that neither party knows anything about the payoff on the debt. …

That intuitive logic applies to repo as well. Nobody wants to be given collateral that they have to worry about. And the mechanics of how repo works is exactly consistent with this. Firms that trade repo work in the following way: The repo traders come in in the morning, they have some coffee, they go to their desks, they start making calls, and in a large firm they’ve rolled $40 to $50 billion of repo in an hour and a half. Now, you can only do that if the depositors believe that the collateral has the feature that nobody has any private information about it. We can all just believe that it’s all AAA.

This is a feature of an economy that is fundamental. It is fundamental that you have these kinds of bank-created trading securities. And the fact that it’s fundamental and that you need these is not widely understood in economics.  …

The way standard models deal with it is, I think, incorrect. A lot of macroeconomists think in terms of an amplification mechanism. So you imagine that a shock hits the economy. The question is: What magnifies that shock and makes it have a bigger effect than it would otherwise have? That way of thinking would suggest that we live in an economy where shocks hit regularly and they’re always amplified, but every once in a while, there’s a big enough shock … So, in this way of thinking, it’s the size of the shock that’s important. A “crisis” is a “big shock.”

I don’t think that’s what we observe in the world. We don’t see lots and lots of shocks being amplified. We see a few really big events in history: the recent crisis, the Great Depression, the panics of the 19th century. Those are more than a shock being amplified. There’s something else going on. I’d say it’s a regime switch—a dramatic change in the way the financial system is operating. This notion of a kind of regime switch, which happens when you go from debt that is information-insensitive to information-sensitive is different conceptually than an amplification mechanism.\”

 In a post last June 17, I quoted Ricardo Caballero about \”Demand for Safe Assets in an Financial Crisis.\” He argues that the world economy as a whole, with the rise of economies in Asia in particular, is suffering from a shortage of safe assets, that the financial sector tried to manufacture the desired safe assets out of mortgage-backed securities, and that when these assets were clearly seen to be not safe [Gorton would say they switched from being information-insensitive to being information-sensitive], the crisis erupted.

This story of how safe assets relate to the financial system and to the possibility of crisis is still being fleshed out. But to misquote Gertrude Stein, \”There is a there there.\”

Iceland, Ireland, and Latvia: Three Stories of Banking Crisis and Recovery

Zsolt Darvas offers a useful meditation in \”A Tale of Three Countries: Recovery After Banking Crisis,\”a December 2011 working paper for Bruegel, a Brussels-based think tank. In effect, Darvas offers a case study approach by picking three small economies that went through a broadly similar banking crisis, but reacted with different policy choices.He starts this way (footnotes and references to tables and figures omitted):
\”Three small, open European economies —Iceland, Ireland and Latvia with populations of 0.3, 4.4 and
2.3 million respectively—got into serious trouble during the global financial crisis. Behind their problems were rapid credit growth and expansion of other banking activities in the years leading up to the crisis, largely financed by international borrowing. This led to sharp increases in gross (Iceland and Ireland) and net
(Iceland and Latvia) foreign liabilities. Credit booms fuelled property-price booms and a rapid increase in the contribution of the construction sector to output – above 10 percent in all three countries. While savings-investment imbalances in the years of high growth were largely of private origin, public spending kept up with the revenue overperformance that was the consequence of buoyant economic activity. During the crisis,
property prices collapsed, construction activity contracted and public revenues fell, especially those related to the previously booming sectors. All three countries had to turn to the International Monetary Fund and their European partners for help.\”

Darvas points out that \”the crisis hit Latvia harder than any other country, and Ireland also suffered heavily, while Iceland exited the crisis with the smallest fall in employment,despite the greatest shock to the financial system.\” What policy difference across the three countries might explain this pattern?

Iceland let its currency depreciate as part of its policy response, while Ireland was locked into the euro and Latvia stayed fixed with the euro.
\”Ireland has been a member of the euro area since 1999, and therefore adjustment through the nominal
exchange rate against the euro was not an option. Latvia has had a fixed exchange rate with the euro since 2004, and Latvian policymakers chose not to exercise the option to devalue. Both Ireland and Latvia decided to embark on a so called ‘internal devaluation’, ie efforts to cut wages and prices. Iceland has a floating exchange rate. When markets started to panic and withdrew external lending, given the size of the country’s obligations, there was no choice but to let the currency depreciate. The Icelandic krona depreciated by about 50 percent in nominal terms– depreciation would have been sharper without
capital controls …\”

In Iceland, the banks were allowed to fail. In Ireland, the government assumed the liabilities of the banks. In Latvia, most banks were foreign-owned and absorbed losses.
\”In Iceland, where credit to the private sector reached 3.5 times Icelandic GDP, the combined balance sheet of banks reached an even greater number, and banks heavily borrowed from the wholesale market, the government did not have the means to save the banks. Therefore, there was no choice but to let the banks default when global money markets froze after the collapse of Lehman Brothers in September 2008….

In Ireland, the balance sheet of Irish-owned banks was 3.7 times GDP in 2007 … . The Irish government guaranteed most liabilities of Irish-owned banks. … Taxpayers’ money was used to cover bank losses above bank capital (which was wiped out) and subordinated bank bondholders (whose loss is estimated to be about
10 percent of Irish GDP in the form of retiring €25 billion subordinated debt for new debt or equity of
€10 billion). …

In Latvia about two thirds of the banking system was owned by foreign banks (mostly Scandinavian banks), which assumed banking losses and supported their Latvian subsidiaries, thereby making the lender-of-last-resort role of the Latvian central bank less relevant. … According to the ECB’s data on consolidated banking statistics, the loss incurred by foreign banks was about 5.7 percent of GDP and the loss of domestic banks about 3.6 percent of GDP by 2010 – a large amount, but well below the banking sector losses in the two other case study countries. IMF  calculated that bank support boosted the public debt/GDP ratio by about 7 percentage points of GDP by 2010.

Iceland introduced capital controls; Ireland and Latvia did not. 
\”Due to fear of further capital outflows and additional depreciation of the Icelandic krona, in late 2008 strict capital controls were introduced in Iceland. This has locked in non-resident deposits and government paper holdings in Iceland and locked out Icelandic krona assets held outside the country, in addition to prohibiting
transfers across the border by both residents and non-residents.\”

Comparing the outcomes across these three countries, Latvia\’s GDP fell 25%, with an employment drop of 17%. Ireland had a GDP decline of 10%, with a fall in employment of 13%. Iceland had the biggest shock to its financial system, but had a GDP decline of 9%, and a fall in employment of 5%.

Without overinterpreting the lessons to be learned from this three-country comparison, a few themes do emerge.

1) Latvia was fearful of allowing its currency to depreciate against the euro. But the Iceland example suggests that in time of crisis, if you have the flexibility to let your exchange rate fall, do it. Of course, Ireland was locked into the euro without such flexibility.

2) Think twice before socializing bank losses. Iceland didn\’t take this step; Ireland did. As Darvas writes: \”Little is known about what would have happened to financial stability outside Ireland in the event of letting Irish banks default, but one thing is clear: other countries have benefited from the Irish socialisation of a large share ofbank losses, which has significantly contributed to the explosion of Irish public debt.\” The result is that while Iceland and Latvia have their public debt under control, it has risen by much more in Ireland. Darvas writes: \”Before the crisis, gross government debt was below 30 percent of GDP in all three countries, but started to balloon quickly. … [B]ank support boosted Irish public debt by about 40 percent of GDP, Icelandic public debt by about 20 percent and Latvian public debt by about 7 percent. Since Iceland and Latvia gained bettercontrol over the budget deficit than Ireland – partly due to the difference in bank support –European Commission forecasts stabilisation of the debt ratio in the two countries, but in Ireland a further 20
percentage points of GDP increase is expected till 2012.\”
3) In the short run of the time during and immediately after the crisis, imposing capital controls hasn\’t seemed to hurt Iceland\’s economic recovery. But it\’s not clear when or how these controls will be loosened over time.

Of course, applying lessons from particular countries is always tricky. But economic recovery has started in all three of these countries. As Darvas writes: \”If the adjustment experiences of the three countries could be a lesson for other countries, such as the Mediterranean countries of the euro area, should be the subject of a different study.\”

Will U.S. Government Debt Lead to Higher Interest Rates?

As the PIIGS economies of Europe–Portugal, Ireland, Italy, Greece, and Spain–have staggered into a sovereign debt and monetary crises, the interest rates on their government debt have risen substantially. Pedro Amaral and Margaret Jacobson of the Cleveland Fed point out that on certain basic measures of government indebtedness, the U.S. seems to be in the same neighborhood as the PIIGS countries. However, drawing on analysis from the IMF\’s September 11 Fiscal Monitor Report, they also point out some ways that the holders of U.S. debt are significantly different from holders of government debt in these other countries, which at least so far has helped to shelter the U.S. government from an interest rate spike.

Here\’s a table that puts U.S. borrowing in the context of the PIIGS. The first three columns apply to 2011. The first column shows \”Maturing debt\” as as share of GDP: that is, how much of what was borrowed in the past comes due in 2011. The second column shows the budget deficit: that is, how much additional borrowing in 2011. The third column, \”Total Financing Needs,\” adds up the first two, for the total amount that needs to be borrowed in 2011 both to roll over past borrowing and to cover new borrowing. The next three columns show the same calculations as projected for 2012. The last two columns show the \”Average years to maturity\” of government debt, because obviously it matters how soon the debt needs to be paid off. The final column shows the debt-to-GDP ratio for these countries.

What jumps out from the table is that the \”Total financing need\” for the U.S. is larger than in any of the PIIGS economies in 2011 and 2012. The U.S. budget deficits as a share of GDP are larger in 2011 and 2012 than for any of the comparison countries, except Ireland. The U.S. debt has a shorter average maturity than the other countries. And while the U.S. debt-to-GDP ratio is mercifully nowhere near that of Greece or Italy, and well behind that of Portugal, it is similar to Ireland and substantially larger than Spain.

These other countries have faced higher and rising interest rates in 2011, as shown in the figure for Spain and Italy, while U.S. borrowing has faced lower and declining interest rates. Why? 

Amaral and Jacobson provide some discussion of why U.S. interest rates haven\’t been rising. They draw on  the IMF Fiscal Monitor for September 2011, which has a Chapter 3 called \”The Dog that Didn\’t Bark (So far): Low Interest Rates in the United States and Japan.\”  The IMF writes (references to figures and tables omitted):

\”The relatively benign treatment by market participants of sovereign bonds issued by Japan and the United States, however, may not fully reflect fiscal fundamentals: current general government debt and deficits, and projected increases in debt over the next five years, are at least as high for the United States and Japan as they are for several euro area economies under market pressure or the euro area in general. In addition, projected long-term increases in pension and health care spending in the United States are larger than in many euro area economies. Japan and the United States face the largest gross financing requirements among all advanced economies this year and are projected to do so in 2012 and 2013 as well, reflecting their large deficits and debt stocks as well as their still relatively short debt maturity profiles, notwithstanding some success in lengthening maturities in recent years. Fiscal adjustment in the United States and Japan is lagging that in other advanced economies.\”

The IMF lists a number of  \”structural factors\” that have kept the the U.S. and Japan to keep interest rates on government borrowing low, at least so far. Most of the reasons relate to the basic idea that if government debt is held by large domestic investors, then those investors are less likely to flee to other financial investments. Here\’s the IMF on such factors (again, footnotes and references to tables and figures omitted):

Low interest rates in the United States and Japan partly reflect structural factors, including some that do not seem likely to change abruptly in the near term:

  • A substantial share of domestic debt holdings. In Japan, close to 95 percent of public debt is held domestically. The share is lower for the U.S. federal government, but rises to 70 percent for the general government. Moreover, the share of debt held domestically increases further for the United States if holdings by foreign central banks are excluded. This is significant, because private nonresidents may be more willing to shift their investments out of a country than are domestic investors, and foreign central banks may follow different investment practices than do other market participants …
  • Significant local central bank debt purchases. The U.S. Federal Reserve has purchased 7½ percent of GDP in Treasury securities (cumulative, under its quantitative easing programs), an amount equivalent to 12 percent of publicly held Treasury securities. …

  • Strong demand by a relatively stable investor base. Institutional investors—including insurance companies, mutual funds, and pension funds—hold 24 percent of government securities in Japan and 12 percent of Treasury securities in the United States. A further 22 percent of U.S. Treasuries and an estimated 2 percent of Japanese government bonds are held by foreign official entities. In addition, more than one third of U.S. Treasuries issued by the federal government are held by other government agencies, including the Social Security Fund …
  • Lower banking sector risks. Banking risks, which as the recent crisis has shown can dramatically affect fiscal developments, are perceived to be lower in the Unites States and Japan than in Europe …\”

So, can the U.S. government keep borrowing with impunity? After all, the dog of higher interest rates hasn\’t barked yet. The IMF offers a few cautionary remarks:

\”The widening crisis in the euro area shouldnevertheless serve as a cautionary tale for the United States and Japan, as well as other countries with high debts and deficits. Recent developments in Spain and Italy demonstrate how swiftly and severely market confi dence can weaken and how even large advanced economies are exposed to changes in market sentiment. … Low borrowing costs in Japan and the United Stateshave arguably created a false sense of security, but should be viewed instead as providing a window
of opportunity for policies to address fiscal vulnerabilities. In the absence of a new round of quantitative easing, higher interest rates could be required to attract new buyers of sovereign debt. …  Perhaps most importantly, Japan and the United States have also benefited from large stores of credibility—in other words, the implicit belief among investors that both countries will implement policies to ensure the sustainability of their debt. Such credibility might weaken suddenly if market participants became less convinced that such policies were forthcoming.\”