John Cochrane is upset that people didn’t like his article about how the US government is about to encounter a debt crisis. I love Cochrane’s finance work. But he seems to let some politics seep into his economic work. I thought this one was missing some key elements connecting the probable dots and outcomes. So let me see if I can explain my point and turn this into a good thought experiment so we can all learn from it.
In my view Cochrane’s article was missing a first principles approach. He just sorta assumed that certain things must happen without explaining why they might happen. For instance, he writes:
“In recent months, we have seen an inevitable rise in interest rates from their low levels of recent years. Rising interest rates and increasing deficits threaten to build upon each other to send public debt spiraling upward even faster. “
If I were a professor I would take a big red marker and write “SHOW YOUR WORK”. The key variable in this comment is the assumption that rates must rise. Really? Why? Why is it “inevitable” that rates must rise? More importantly, as I’ve shown in recent articles, the math on rising rates is pretty clear and interest costs aren’t nearly the problem that many assume. Yeah, the interest cost figures sound big and scary, but they were big and scary through most of the Reagan Presidency and we didn’t go bankrupt then.
But Cochrane goes on:
“When treasury debt holders start to doubt our government’s ability to repay, or to attract future lenders, they will demand higher interest rates to compensate for the risk. “
First of all, we own the printing press and can control the maturity and cost of our short-term funding. The “ability to repay” is never in doubt. So there seems to be some version of the “government is a household” fallacy going on here which is evidence of a rather basic (though common) misunderstanding.
More importantly, the USA is the issuer of the world’s reserve currency because we produce the most productive and high quality output in the world. Our equity markets are valued at 50% of global market cap. The next closest region is ALL OF EUROPE at 22%. The world clearly values our assets above and beyond any other country. So you have to explain why other countries would suddenly lose faith in US government debt? What are the other high quality options? There is no supranational Euro bond. It’s certainly not German bonds given the sheer difference in economic size. Japan? They are in far worse fiscal shape. Chinese bonds? Ha. You see, there is no logical alternative for safe assets. And there is no logical argument where the USA’s quality output collapses in a relative sense that makes the revenue to the government somehow less reliable and “in doubt”.
Look, I am not making an argument for unchecked government deficits, spending or Trump’s tax cuts. I don’t really care about the politics involved here. I didn’t love Trump’s tax cut and I don’t love how our government seems to be growing exponentially. Instead, I am trying to step back and objectively analyze the risks. To me, the risk of investors losing faith in US government debt is extremely low because our ability to repay is not in question and the quality of income streams funding US government debt are the highest quality income streams in the world (and will likely remain so for a very long time). And while rising rates are certainly a risk I have yet to read a really convincing argument for why the 1970’s or Weimar Republic are in the USA’s future.
So, I hate to say it, but that debt article was not well thought out and seems more like politically charged rhetoric than anything else. But hopefully these kinds of articles bolster our thinking by becoming a platform for more informed thinking. One can hope, right?
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.