Just What Are the Risks That Alarm Ken Rogoff?
As I say, repeatedly: everything that Ken Rogoff writes is very interesting, nd almost everything is correct.
This part of Ken Rogoff’s piece appears to me to be very much on the wrong track:
small changes in the market perception of tail risks can lead both to significantly lower real risk-free interest rates and a higher equity premium…. Martin Weitzman has espoused a different variant of the same idea…. Those who would argue that even a very mediocre project is worth doing when interest rates are low…. It is highly superficial and dangerous to argue that debt is basically free. To the extent that low interest rates result from fear of tail risks a la Barro-Weitzman, one has to assume that the government is not itself exposed to the kinds of risks the market is worried about, especially if overall economy-wide debt and pension obligations are near or at historic highs already. Obstfeld (2013) has argued cogently that governments in countries with large financial sectors need to have an ample cushion, as otherwise government borrowing might become very expensive in precisely the states of nature where the private sector has problems…
First, we need to be clear about what the relevant tail-risk states that Ken Rogoff is talking about are. There are definitely potential future states of the world in which nothing has value except for sewing machines, ammunition, and bottled water; in which even your gold Krugerrands are sources of risk as they attract theft and violence rather than stores of value. But those future states of the world are irrelevant for pricing financial assets because all financial assets–even government bonds–are worthless in them. Thus worry about those states of the world provides no reason for a government to issue debt. They are not the relevant tail-risk states.
The relevant tail-risk states are those in which (a) there is still an economy, (b) there is still a government, (c) the government is either imposing taxes to amortize its debt or choosing some costly and dissipative default procedure, and yet (d) investments in corporate debt (and presumably corporate equities) are strongly negative in net terms. It is those states of the world that people think that government debt provides insurance against. It is insuring against those states of the world that have driven the prices of government debt sky-high. And it is with respect to those states of the world that Ken Rogoff claims that the actual costs to the government at borrowing at those very low interest rates are high because:
the government is… itself exposed to the kinds of risks the market is worried about, especially if overall economy-wide debt and pension obligations are near or at historic highs already. Obstfeld (2013) has argued cogently that governments in countries with large financial sectors need to have an ample cushion, as otherwise government borrowing might become very expensive in precisely the states of nature where the private sector has problems…
And thus, even though it was sold at a high price and carries a low interest rate, the issuing of government debt is very expensive to the government: when the time comes in the bad state of the world for it to raise the money to amortize the debt, it finds that it really would very much rather not do so.
It is clear if you are Argentina or Greece what the risk is: it is of a large national-level terms-of-trade or political shock, something that you can insure against by investing in the ultimate reserves of the global monetary system.
If you are the United States or Germany or Japan or Britain, what is the risk?
What is the risk that cannot be handled at low real resource cost by a not-injudicious amount of inflation, or of financial repression?