Keynesians Are Wrong: We CAN (And Very Well May) Have Disinflation With Rising Real Interest Rates, Which Could Hasten the Decline of American Power

One of the world’s leading economic historians – Niall Ferguson – has previously pointed out that too much debt can drive countries into default:

There are economic professors in American universities who think they are masters of the universe, but they don’t have any historical knowledge. I have never believed that markets are self correcting. No historian could…

“The idea that countries don’t go bust is a joke… The debt trap may be about to spring … for countries that have created large stimulus packages in order to stimulate their economies.”

(Keen, Roubini, Morgan Stanley and many others are warning about a debt crisis as well).

Ferguson now points out in a must-read article he wrote for Newsweek that we might get falling inflation (disinflation or deflation) and rising real interest rates:

So here’s another scenario—which in many ways 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. According to a substantial amount of empirical research by economists, including Peter Orszag (now at the Office of Management and Budget), significant increases in the debt-to-GDP ratio tend to increase the real interest rate. One recent study concluded that “a 20 percentage point increase in the U.S. government-debt-to-GDP ratio should lead to a 20–120 basis points [0.2–1.2 percent] increase in real interest rates.” This can happen in one of three ways: the nominal interest rate rises and inflation stays the same; the nominal rate stays the same and inflation falls; or—the nightmare case—the nominal interest rate rises and inflation falls.


Today’s Keynesians deny that this can happen. But the historical evidence is against them. There are a number of past cases (e.g., France in the 1930s) when nominal rates have risen even at a time of deflation. What’s more, it seems to be happening in Japan right now. Just last week Hirohisa Fujii, Japan’s new finance minister, admitted that he was “highly concerned” about the recent rise in Japanese government bond yields. In the very same week, the government admitted that Japan was back in deflation after three years of modest price increases.

It’s not inconceivable that something similar could happen to the United States. Foreign investors might ask for a higher nominal return on U.S. Treasuries to compensate them for the weakening dollar. And inflation might continue to surprise us on the downside. After all, consumer price inflation is in negative territory right now.

Why should we fear rising real interest rates ahead of inflation? The answer is that for a heavily indebted government and an even more heavily indebted public, they mean an increasingly heavy debt-service burden. The relatively short duration (maturity) of most of these debts means that a large share has to be rolled over each year. That means any rise in rates would feed through the system scarily fast.

Already, the federal government’s interest payments are forecast by the CBO to rise from 8 percent of revenues in 2009 to 17 percent by 2019, even if rates stay low and growth resumes. If rates rise even slightly and the economy flatlines, we’ll get to 20 percent much sooner. And history 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….

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.

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  • Uh, no. A sovereign issuer of a nonconvertible currency cannot default on debt issued in that currency.On the other hand, the problem that Keen, Hudson (Kucinich's economic advisor) and others point out is that non-government debt is at unsustainable levels and deflation will result unless there is a cramming down or writing off of debt that cannot be serviced or reasonably repaid. They are right.The fallacy lies in confusing the debt of the government as currency issuer with debt of firms and households, who are currency users. No parallel there.

  • Spot on, Tom. George W, may I suggest you read and introduce this perspective into your blog?

  • Keynesian economists are central banker employees supporting international banking goals of world domination.Does it matter what type of government you have if one small group of bankers lend ALL the money?It does, Thomas Jefferson new this, he said let bankers control the money supply and future generations will awake one day homeless in the nation their forefathers gave them.End the Fed

  • In the world of economics, to use Keynes and Freeman in the same sentence is blasphemy. The author neglects the fact that under his Ludwig Van Misses analyses, government would be powerless over regulatory oversight of banks. He/she claims they do not believe in efficient markets, but puts faith that it will be if government is dissolved. In another blog, the author claims Hayek warned of these bubbles. I cannot argue with him because I am not schooled in Austrian economics nor do I believe in there radical ideas. What I do know is that Milton Freedman was spurn form the sperm of Hayek. Unfettered free markets and efficiency of markets as a main stable of growth. It now seems after 30 years of New-Classical School polices, with the George Mason Grads cheerleading behind them the whole time, the Austrian School has walked away from the dismal result claiming to have clean hands from the whole affair and disingenuously denounce the side line economic policies that have given power to the renter and landlords of this nation, leaving the common man in debt and insecure. Hindsight is truly 20/20. The author cannot put the blood in the hands of Keynesian, for the policies have brought prosperity to so many of the proletarian class for 40 years. Allen Greenspan is a self proclaimed Liberian, even though schooled in the Chicago School fashion of New-Classical, nuanced in distinction to the Austrian school. It is his policies that the author now decries as unjust and the root of speculation, not Keynesian thought. It was Hyman P. Minsky that warned of these bubbles, not Hayek. It is confounding how Keynesian economics has been marginalized for over 30 years, controlled by Libertarians, as when their policies come crashing down, they blame Keynesian for all the problems, proclaiming, see we told you fiscal and monetary policy intervention will not work. It is as if government mandates foxes to watch the hen house, but then blame the farmer for the demise of live stock. I have one question for the author, if “End the Fed” comes to pass, and money is pegged to gold, what is stopping the speculative renters and landlords from driving up and down the currency at their whim. I could only imaging proprietary trading and carrier trading to dominate the landscape, causing turmoil throughout global markets. Anthony G Malin