Willem Buiter Issues His Most Dire Prediction Yet: Sees “Unprecedented” Fiscal Crises, US Debt Inflation And Fed Monetization

Willem Buiter Issues His Most Dire Prediction Yet: Sees "Unprecedented" Fiscal Crises, US Debt Inflation And Fed Monetization

Courtesy of Tyler Durden

Doomsday scenarios from the establishment periphery always come fast and furious, especially in our day and age when bankrupt sovereigns are the norm, not the exception. And the "faster and furiouser" these come, the more steadfast the core is in refuting that the reality is much, much worse than portrayed on the mainstream media. Which is why we were very surprised when we read Willem Buiter’s latest Global Economic View (recall that he works for Citi now). In it the strategist for the firm that defines the core of the establishment could not be more bearish. In fact, at first we thought that David Rosenberg had ghost written this. Once the apocryphal truthsayers such as Buiter become mainstream within the mainstream, it is only a matter of time before the marginal opinion shifts to match that of those who have been prognosticating doom all along (for all the right reasons).

In the below piece, Buiter presents a game theory type analysis, which concludes that the US and other sovereigns will soon be forced into fiscal austerity. Among his critical observations (we recommend a careful read of the entire 68 pages), are that the US is highly polarized, and that the Fed, which is "the least independent of leading central banks" would be willing to implement "inflationary monetisation of public debt and deficits than other central banks." The next step of course would be hyperinflation. And Buiter sees America as the one country the most likely to follow this route. Most troublingly, Buiter predicts that a massive crisis is the only thing that can break the political gridlock in the US in order to fix the broken US fiscal situation. Must read.

Key highlights:

• Unless the US, the UK, France, Japan (currently AA rated) and even Germany change course quite radically and sooner rather than later towards a sustained higher degree of fiscal tightening, there may not be a single AAA-rate sovereign left 5 years from now.
• For the US, with a structural primary deficit in 2009 of 7.3 percent of GDP, the arithmetic of solvency indicates the need for at least 7.3 percent of GDP worth of permanent fiscal tightening (not counting the long-term fiscal tightening required to accommodate future age-related public spending ambitions). For the UK, with a structural primary deficit in 2009 of 6.8 percent of GDP, the required permanent fiscal tightening (beyond what is achieved automatically by a cyclical recovery) would be at least 6.8 percent of GDP. In neither country are policy makers debating how to achieve anything like these degrees of fiscal tightening. In the US, beyond the expiration of part of the Bush tax cuts, no additional fiscal tightening has been planned. With the policy makers in denial, the fiscal situation is likely to deteriorate further, with the result that the magnitude of the permanent fiscal tightening that is required, when the markets eventually demand an immediate fiscal adjustment, will keep on rising.
• The US is, in our view, a more polarized and divided society today than at any time since World War II, including the Vietnam war era. Its government institutions are so encumbered by checks and balances that decisive prompt action is only possible during times of national emergencies – times, that is, that are widely recognized across the political spectrum as national emergencies. We don’t believe that the fiscal threat is as yet perceived as a likely candidate for a national emergency. Things will have to get worse, say through the country being put on negative outlook for its sovereign credit rating, or indeed losing its triple-A sovereign credit rating, before a fiscal burden sharing agreement is likely to be achieved. The way things are now, the Republicans will veto all tax increases and the Democrats all public spending cuts.
• As regards motive, a significant share of the US nominally denominated debt is held abroad. Between 55% and 70% of total US currency stock (around $928 bn in circulation at the end of 2009) is estimated to be held  abroad. As this is non-interest-bearing, it is eroded by both unanticipated and anticipated inflation. In addition, about 51.4 percent of US Treasuries are held abroad – $3.6 trillion out of $7.0 trillion held outside the Fed and excluding Intragovernmental Holdings – at end of December 2009. Motive is strengthened by a longer maturity or duration of the nominally denominated debt. Here the situation is currently less inviting for the US than it was in 1946, the all-time peak of the US public debt to GDP ratio, as the average maturity of the US Treasury debt is only half of what it was in 1946, falling to around 4 years by the end of 2009. Unanticipated inflation also affects the real burden of servicing private domestic-currency denominated debt: it redistributes resources from private creditors who hold domestic currency denominated private debt to the issuers of that debt. Such intra-private sector redistribution of wealth is not politically neutral (nor is it likely to be devoid of macroeconomic effects). With much US mortgage debt still at fixed rates for long maturities, unanticipated inflation would redistribute wealth towards households owing mortgage debt and away from banks and other mortgage lenders. In the current political climate, this might not be unwelcome to many would-be voters and their representatives.
• There is, we believe, a greater chance of the Fed being cajoled or pushed into inflationary monetisation of public sector debt and deficits than the other leading central banks. For this to happen, it would be necessary that the current majorities on the Board and the FOMC, which would not go along with an inflationary solution to the US public debt problem, be replaced, or for the mandate of the Fed to be changed. In practice this would require either a strongly populist majority in both houses of the Congress and a strongly populist president in the White House, or a sufficiently large populist majority in the Congress to override a presidential veto. Either configuration looks currently unlikely but not impossible – a low-probability event but not a tail event, although were it to occur, it is likely to be at least 3 to 5 years in the future.
• We argued earlier that none of the major industrial countries was likely to choose an inflationary solution to its public debt problems, but that of the US, the Euro Area and the UK, the US was least unlikely to pursue such a course of action. The country also has form as regards using inflation to amortize the real value of the public debt, as is apparent from Figure 10, taken from Reinhart and Rogoff (2009b). It shows that, historically (since 1790), the US has exhibited a tendency to respond to high public debt burdens with high inflation.
• We argued earlier that none of the major industrial countries was likely to choose an inflationary solution to its public debt problems, but that of the US, the Euro Area and the UK, the US was least unlikely to pursue such a  course of action. The country also has form as regards using inflation to amortize the real value of the public debt, as is apparent from Figure 10, taken from Reinhart and Rogoff (2009b). It shows that, historically (since 1790), the US has exhibited a tendency to respond to high public debt burdens with high inflation.
• An inflationary solution to the problem of an excessive public debt is all but impossible in the Euro Area and unlikely in all advanced industrial nations. It is least unlikely for the US.

Full report.