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2010 CFA Institute cfapubs.org SEPTEMBER 2010 15

History in the Making: Lessons andLegacies of the Financial CrisisNiall FergusonWilliam Ziegler Professor of Business Administration

Harvard Business SchoolCambridge, Massachusetts

The developed world has come to think of a financial crisis as something that occurs only inless economically advanced countries. But the truth is that financial crises can, and have,occurred everywhere. History teaches a lot about the ways countries have dealt with financial

crises in the past.

want to offer some historical insights into thecurrent financial state of the world. I will partic-

ularly emphasize the sovereign debt problem that I

think is going to dominate financial discussionsglobally in the future. I am not going to review thecauses of the financial crisis because I hope they areunderstood by now. It is what comes next that inter-ests me. My approach is to use historical under-standing rather than mathematical models to get asense of possible future scenarios.

We are living through an extraordinary debtexplosion in the developed world. The graph inFigure 1 is from a very recent International Mone-tary Fund (IMF) study and charts the general gov-ernment gross debt ratios of advanced economies

in the G20, all advanced economies, emergingeconomies in the G20, low-income economies, anda broad sample of all emerging economies. Thefigure depicts a world turned upside down. At onetime, it was the emerging markets, particularlylow-income countries, that had public debt crises.Now, rich countries have excess public debt prob-lems as their ratios of debt to GDP average about100 percent. In a recent paper, Carmen Reinhartand Kenneth Rogoff (2010) pointed out that debtratios of 90 percent of GDP appear to be an impor-tant threshold; ratios above 90 percent can lead toserious economic problems of higher inflation

and/or lower growth.The reasons for this debt explosion are not hard

to find. One reason lies with the bailouts and emer-gency measures taken in response to the financialcrisis, and another reason is found in the calamitousdecline in revenues caused by the great recession.Also embedded in the debt ratios is a structuraldeficit that has been growing for years as Western

democracies have refused year after year to raise asmuch in taxation as they spend on various publicservices and transfers. I have argued for years that

this issue is the weakest point in the Western eco-nomic model, and many of the warnings that I madein the past are proving to have been prescient.

These big debts have the power to scare gov-ernments into emergency action, mainly becausethe bond market forces governments to act evenwhen politicians would prefer to avoid emergencyaction. What occurred during early 2010 in Greeceand, to a lesser extent, in Portugal is something thatcan happen to any economy with excessive publicdebt. It is important to note the nonlinearity of thistype of progression. A country is fine until it is not

finein other words, it is possible to sustain anexcessive public debt for a considerable time iffinancial markets remain benign or ignore the prob-lem. But when market sentiment turns against thegovernment and the credibility of its fiscal policy iscalled into question, that country very quickly findsitself in a downward spiral. The rising costs ofinterest payments cause the deficit to becomeuncontrollable, and then the government has toborrow money just to pay the interest on the moneyit borrowed before, much like a Ponzi scheme.

Debt Crises of the PastCrises of the sort I have just described are nothingnew. They are, in fact, as old as the bond marketitself, which is very old. The original sovereign debtmarkets date back to the 12th and 13th centuries innorthern Italy. For example, Figure 2 shows thespread between French debt and U.K. consolidatedannuities (consols) from 1753 to 1813. It captures thefinancial history of the great conflict between theUnited Kingdom and France that dominated thelatter half of the 18th century and continued until

This presentation comes from the 2010 CFA Institute AnnualConference held in Boston on 1619 May 2010.

I

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16 SEPTEMBER 2010 2010 CFA Institute cfapubs.org

CFA Institute Conference Proceedings Quarterly

Figure 1. Government Gross Debt as a Percentage of GDP for Various

Economies, 20002015

Notes: IMF estimates based on April 2010 World Economic Outlook projections using weighted averagesbased on 2009 gross domestic product in terms of purchasing power parity.

Source: Based on data from the IMF.

Figure 2. Spread between French Debt and U.K. Consols, 17531813

Source: Based on data kindly provided by Larry Neal.

Percent

120

100

80

60

40

20

0

00 0402 100806 1412

G20 Advanced Economies All Advanced Economies

Low-Income Economies G20 Emerging Economies

Broad Sample Emerging Economies

Spread (bps)

1,000

900

800

700

600

500

400

300

200

100

0

1753 68 83 98938873 7858 63 1803 08 13

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History in the Making

1815. This period was the age of revolution in which,among other things, the British Empire experienceda little local difficulty with some minor colonies onthe eastern coast of North America. That crisisbrought U.K. borrowing costs closer to French bor-rowing costs than at any other time in the 18thcentury, which highlights an important pattern inwhich negative political newsparticularly nega-

tive military newsaffects perceptions of defaultrisk and inflation risk premiums in the bond market.It was only really at the time of the Battle of York-town that the spread came close to vanishing. Forthe rest of the period, from the beginning of theSeven Years War in 1756 to Napoleons defeat atWaterloo in 1815, a consistently significant pre-mium existed for lending to the French government.And that, in my view, is one reason why the UnitedKingdom ultimately won this great contest. Becauseit had a wider and deeper bond market than France,the United Kingdom was able to finance its huge

navy and its huge global empire at significantly lesscost than had to be borne by France.This pattern tends to repeat itself. Financial

history is generally a succession of sovereign debtcrises. In fact, unlike lightning, sovereign debt crisestend to strike the same place over and over. Forexample, during the 1870s, a political crisis in noneother than Greece caused a huge spike in its yields(relative to U.K. debt). Other countries in the late19th century that experienced sovereign debt criseswere Mexico, Uruguay, and Argentina. Also in the1870s, the Ottoman Empire defaulted after a disas-trous war with Russia. Interestingly, in the subse-quent period from the 1890s to World War I, atremendous convergence in bond spreads occurred.Sovereign spreads relative to the risk-free U.K.benchmark, which had been very large in the mid-19th century, came down to around 100200 bps fornearly all countries. Then World War I began, andthe complacency that had developed among bondinvestors was shattered by the huge public debts thatcountries ran up fighting the war. During the GreatDepression, many countries did defaultoften thesame countries that had gone through periods ofdefault and inflation before the war. By the second

half of the 20th century, it was widely assumed thatsovereign debt crises were confined to relativelypoor countries in such places as South America,Central Europe, and the Middle East.

But advanced economies are not exempt fromthis phenomenon. If countries are measured on thebasis of the percentage of years in default or resched-uling, Honduras, Ecuador, and Greece are at the topof the list. But Russia also has defaulted regularly.Russia was responsible for two of the biggest sover-eign defaults of all timeafter the Russian Revolu-

tion and again in 1998. Further downbut at still asurprisingly high place in the ranking of countriesyears in defaultis Germany, appearing just belowTurkey. One reason behind Germanys appetite forfiscal discipline is the distinct memory not only ofthe defaults on postWorld War I reparations in1922 and 1932 but also of two episodes of hyperin-flation that completely destroyed the German cur-

rency and rendered German government bondsworthless in 1923 and again in 1945. So, the key pointis that debt crises do not just happen to Latin Amer-ica, Eastern Europe, and the Middle East. They canhappen to anyone.

Table 1 shows a list of European countries andtheir associated number of banking crises, defaults,episodes of inflation, and episodes of hyperinfla-tion. This list makes it clear that no country has anunblemished record. Even the United Kingdomshould, in fact, have a number in the default columnbecause it defaulted on its war debt to the United

States in 1945. Nearly all countries are in some waytainted by default.

Today and BeyondThe charts in Figure 3, recently published by theBank for International Settlements (BIS), show theratio of public debt to GDP for four countries whosedebt problems have been in the news: Portugal, Ire-land, Greece, and Spain. The trajectory is forecast forthree scenarios for 20102040: no fiscal reform, somefiscal reform, and serious fiscal reform. In the thirdscenario, the problems with revenue and expendi-

ture, including the problems associated with agingpopulations, are at least partly addressed. In thescenario of no reform, debt ratios for all four coun-tries increase to 300400 percent by 2040. Even in theserious fiscal reform scenario, however, the debt/GDP is never below 100 percent in these countries.Naturally, these ratios seem to indicate shockinglevels of debt and are not unexpected from countriesthat notoriously lack fiscal discipline. But accordingto the BIS, the situation in the United Kingdom andthe United States is, in fact, worse.

Using the BIS measures, the fiscal crisis is more

acute in the U.S. and U.K. economies than it is inPortugal, Ireland, Greece, and Spain. In the sce-nario with no reform, the debt-to-GDP ratio wouldincrease to 500 percent in the United Kingdom and425 percent in the United States. Some say thatbecause the United States is not in a monetaryunion with Germany, it can print more money as asolution to the problem. But that approach is onlyconsoling to those who regard a surge in inflationas a legitimate solution to a problem of an exces-sively large public debt.

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Table 1. History of Banking Crises and Associated Effects in European Countries, 18002009

Country

Since Independence or 1800 Since 1800

Years in aBanking Crisis

Years in Defaultor Rescheduling

Total Defaultsor Reschedulings

Years InflationExceeded 20%

Years InflationExceeded 40%

Years ofHyperinflation

Austria 2 17 7 21 12 2

Belgium 7 10 7

Denmark 7 2 1

Finland 9 6 3

France 12 8 6 2

Germany 6 13 8 10 4 2

Greece 4 51 5 13 5 4

Hungary 7 37 7 16 4 2

Italy 9 3 1 11 6

Netherlands 2 6 1 1

Norway 16 5 2

Poland 6 33 3 28 17 2

Portugal 2 11 6 10 4

Spain 8 24 13 4 1

Sweden 5 2

United Kingdom 9 2

Source: Based on data from Reinhart and Rogoff (2010).

Figure 3. Current Debt/GDP and Three Possible Trajectories for Portugal,

Ireland, and Spain, 19802040, and Greece, 19702040

Source: Based on data from the Bank for International Settlements.

Percent

A. Portugal

300

250

200

150

100

50

0

80 4090 00 10 20 30

Serious Fiscal ReformSome Fiscal Reform

No Fiscal ReformCurrent Debt/GDP

Percent

B. Ireland

400

300

200

100

0

80 4090 00 10 20 30

Percent

C. Greece

500

400

200

300

100

0

70 409080 00 10 20 30

Percent

D. Spain

400

300

200

100

0

80 4090 00 10 20 30

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Metrics of DoomTable 2 shows the cyclically adjusted primary bal-ance of various countries. This measure tries todetermine a countrys underlying fiscal budget sur-plus (deficit) position relative to GDP by adjustingfor the effects of the economic cycle and by excludinginterest payments currently being made on pastdebt. The calculation is 6 percent of GDP for Greece,

but the calculation is 6.8 percent for the UnitedKingdom and 7.3 percent for the United States.

Table 3 shows the results of a study recentlyconducted by the IMF. The researchers asked thequestion, What would countries need to do to stabi-

lize their ratio of debt to GDP at 60 percent by 2030?The right column sorts the countries included in thestudy by the fiscal contraction, whether through taxhikes or spending cuts, they would have to achieveto stabilize their debt/GDP at 60 percent, measuredin terms of percentages of GDP. The country in theworst position is Japan. But the United Kingdom isin second-worst place with a fiscal contraction of12.8 percent needed to stabilize its debt/GDP.Following the United Kingdom are Ireland, Spain,Greece, and the United States. The fiscal position ofthe large, English-speaking economies is clearly

extremely serious, and unfortunately, few people inthe decision-making bodies responsible for fiscalpolicy want to confront this reality.

Although I have been focusing on the ratio ofdebt to GDP, it is in fact not a good measure of theimpact of deteriorating fiscal conditions because,historically, little correlation has existed betweendebt/GDP and bond spreads. A statistically signif-icant relationship, however, does exist between thepercentage of GDP needed to meet interest pay-ments and the risk spread on a countrys bonds.

Prior to the current crisis, the United States wasspending only 7 percent of its GDP on interest pay-ments. Without a truly radical change in fiscal pol-icy, the United States is projected to be spending22.3 percent of its GDP on interest payments by2040, which is more than the Congressional BudgetOffices estimate for total federal tax revenue in thatyear, which is 22 percent of GDP. Thus, by 2040 the

United States would be facing the prospect of need-ing all of its tax dollars to meet the interest paymentson the federal debt. Additionally, about half of theinterest payments will be going out of the countrybecause the United States has relied heavily on for-eign capital to finance its deficit, a situation notwholly dissimilar to the one in Greece. In contrast,the public debts of Japan and the United Kingdomare mainly financed domestically.

Practically, the United States can never allow 100percent of federal tax revenues to go exclusively tointerest payments. Nevertheless, this analysis high-

lights the fact that investors, private citizens, andvoters will have to decide what is going to change.

What Causes Debt Crises?Some causes of a debt crisis, such as an excessivelylarge debt, are obvious. A less obvious but impor-tant cause is excessive dependence on foreign capi-tal. This factor is important when trying to assess acountrys sovereign credit risk. The United Stateshas to worry about this problem because a largeproportion of U.S. Treasuries have been bought byChina, a strategic rival of the United States, duringthe last 10 years.

Table 2. Cyclically Adjusted Primary Balanceof Various Countries

CountryCyclically Adjusted

Primary Balance

Italy 1.9%

Japan 5.6

Greece 6.0

Belgium 0.4

Hungary 2.3United States 7.3

Portugal 2.8

France 3.7

Germany 0.3

United Kingdom 6.8

Source: Based on data from BIS.

Table 3. Current Gross Debt/GDP and

Percentage of Fiscal Adjustment

Necessary for Listed Countries to

Reduce Ratio to 60 Percent by 2030

CountryCurrent Gross

Debt/GDP

Fiscal Adjustmentto Reduce Ratioto 60% by 2030

Japan 227.0% 13.4%

United Kingdom 81.7 12.8Ireland 75.7 11.8

Spain 69.6 10.7

Greece 115.0 9.0

United States 93.6 8.8

Portugal 81.9 6.5

France 85.4 6.1

Belgium 102.7 5.6

Austria 74.9 5.1

Source: Based on data from the IMF.

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Other causes of a debt crisis exist as well. Onecause is economic weakness. A countrys ratio ofdebt to GDP will tend to rise if its economic growthrate is low. Indeed, if the real interest rate exceedsthe real growth rate, debt will grow very rapidly.Political weakness is another cause. A lack of polit-ical leadership often translates into excessiveexpenditures and insufficient taxation, which are

ways of trying to buy popularity. Adapting MiltonFreidmans famous proposition, which stated thatinflation is always and everywhere a monetary phe-nomenon, I would say that crises of public debt arealways and everywhere political phenomenons.Another cause of these crises is irrational exuber-ance, which mainly happens because investors donot learn from history. For example, Figure 4 showsthe spread of Argentine bonds over U.K. consols for18701914. The chart shows two crises, whichoccurred about 15 years apart, in which spreadssoared to more than 1,400 bps. Something similar

happened, as we have seen, during the interwaryears. Looking at the events of the early 2000s,which culminated in yet another default, one isdriven to the inevitable conclusion that some peoplenever learn. The same story can easily be told aboutother countries, such as Turkey.

A study done by Lindert and Morton (1989)illustrates why investors never seem to learn. Theauthors studied the anticipated or ex ante premiumversus the realized or ex post premium (over eitherU.K. consols or U.S. Treasuries, depending on the

time period) on the bonds of 10 countries. Table 4shows that only 1 country of the 10 (Canada) hadrealized spreads that exceeded anticipated spreads,and that occurred in only two of the subperiods. Inevery other case, realized spreads were disappoint-ing and sometimes massively so.

Ways Out of a Debt CrisisIn theory, there are six ways out of a debt crisis. Thefirst way is a higher GDP growth rate that allows acountry to grow faster than its debt burden grows.The second way is lower interest rates on the publicdebt to reduce the impact of excess debt. The thirdway is a bailout in the form of either a currentaccount transfer payment or a capital transfer fromabroad. These three options are not very traumatic.

The next three options are more traumatic waysout of a debt crisis. The fourth way involves thefiscal pain of raising taxes and/or cutting expendi-

tures to build a primary budget surplus that allowsa country to start paying down its debt. The fifthway is what economists politely call recourse toseigniorage (i.e., inflation). The central bank sim-ply prints the money to pay down the debt, whichis possible only when the debt is denominated in thesame currency as the countrys money. The sixthway, if all else fails, is default. Default seems con-ceptually simple, but in fact, a default can be anyform of noncompliance with the original terms of

Figure 4. Spread of Argentine Bonds over U.K. Consols, 18701914

Sources: Based on data from National Bureau of Economic Research and Global Financial Data.

Spread (bps)

1,600

1,400

1,200

1,000

800

600

400

200

0

1870 85 0590 95 190075 80 10

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the debt contract including repudiation, standstill,moratorium, restructuring, rescheduling of interest,or principal repayments.

Those are the six options for dealing with a debtcrisis, but as a practical matter, three of thoseoptions are not available in the current crisis. Theprobability of the United States growing its way outof the debt crisis is small because a consequence ofexcessive debt is that it tends to lower the trendgrowth of GDP. The second option presents a simi-lar problem because the perception of a debt crisisincreases risk premiums, which drives interest rateshigher, not lower. A particularly painful feature of

debt crises is that the rise in the risk premium wors-ens the situation and can lead to a downward spiralof ever larger debt service costs and hence deficits.As for the third option, a bailout is really a possibil-ity only for small countries.

Thus, the United States has only three options:fiscal pain, inflation, or default. Only one majoreconomy has ever escaped from a debt burden sim-ilar to the size of the projected U.S. debt burdenwithout either defaulting or inflating, and that wasBritain between 1815 and 1914. Britains debt/GDPat the end of the Napoleonic wars was around 250

percent. By the eve of World War I, however, thedebt/GDP had decreased to less than 70 percent asa result of economic growth and primary budgetsurpluses, not default or inflation. But Britain hadmany advantages in the 19th century: the IndustrialRevolution, the worlds biggest empire, and anundemocratic franchise, which meant that propertyowners were over-represented in Parliament and alarge section of the working class did not get to vote.These factors made radical fiscal retrenchmentmuch easier than it is for the United States today.

Every other case of a major crisis of public debthas produced an inflationary episode among coun-tries that have control over their own monetarypolicy and whose debts are denominated in theirown currency. In contrast, defaulters tend to becountries with little or no control over their mone-tary policy (for example, countries in the eurozoneor countries with fixed exchange rate regimes) orcountries whose debts are denominated in curren-cies other than their own.

To illustrate, Figure 5 graphs the reduction inthe debt ratios for the United States and the UnitedKingdom following World War II. At the end of the

war, the debt/GDP of the United States was morethan 100 percent and the debt/GDP of the UnitedKingdom was more than 250 percent. By 1991, bothcountries debt ratios were around 50 percent. Theimprovement of the debt ratio in the United Stateswas accomplished partly by growth and partly byinflation. Budget surpluses played no role whatso-ever. In fact, the United States has run a budgetsurplus during only eight years of the postwar era.In the United Kingdom, the reduction was almostentirely the result of inflation because modestgrowth roughly offset continued fiscal deficits.

Lessons of HistoryThe first lesson to learn from history is how govern-ments do not deal with their debt burdens. First,countries do not slash expenditures and entitle-ments. Moreover, they do not reduce marginal taxrates on income and corporate profits to stimulategrowth. Second, they do not raise taxes on consump-tion to stimulate savings and reduce deficits. Finally,they do not grow their way out of the problem with-out defaulting or depreciating their currencies. As

Table 4. Anticipated vs. Realized Premiums on the Bonds of 10 Countries,

18501983

18501914 19151945 19451983

Country Ex ante Ex post Ex ante Ex post Ex ante Ex post

Argentina 2.15% 1.71% 2.05% 1.95% 4.93% 4.70%

Brazil 1.91 0.88 3.34 1.48

Chile 2.42 1.48 3.30 1.90

Mexico 2.87 2.72 2.39 2.31

Australia 1.34 1.01 1.16 1.21 0.95 0.72

Canada 1.30 1.27 0.64 0.65 2.23 2.25

Egypt 4.07 2.92 0.65 0.73

Japan 1.47 1.25 3.24 2.26 2.91 2.25

Russia 2.01 1.63

Turkey 4.23 1.56 1.00 0.88 0.11 0.34

Total 2.36% 0.13% 1.75% 1.21% 1.38% 1.30%

Note: Premiums are calculated over either U.K. consols or U.S. Treasuries, depending on the time period.

Source: Based on a study by Lindert and Morton (1987).

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previously mentioned, the only exception is Britainafter 1815, and the possibility does not exist for theUnited States to repeat that performance in our time.

The second lesson from history is what stepsgovernments do take to deal with world-war-sizedebt burdens. First, governments subtly or unsubtlyencourage the central bank and commercial banksto load up on government debt. Second, they oftendiscourage alternative avenues of investment (e.g.,foreign investment) for their citizens to ensure thatinvestors have little choice but to load up on publicdebt. Third, they tend to default on their commit-ments to weak domestic creditor groups and toforeign creditors. Finally, when all else fails, theycondemn bond investors to negative real returns.

Figure 6 shows the real inflation-adjustedreturns on U.K. and U.S. bonds for 19001995. Thesereturns were consistently negative from the 1940s

through the 1970s, which is really the story of howthe postwar debt burdens were dealt with. Anotherlesson from history is that such inflationary epi-sodes are associated with currency volatility. In afiat money world in which every country has anincentive to depreciate its currency, a series of quitesignificant moves in developed market exchangerates is to be expected. The euro and the Britishpound have already shown considerable volatility.At some point, there will be a question mark aboutthe U.S. dollar. The possibility exists that in 5 or 10

years there will not be a fiat money that deserves thename reserve currency.

The third, and most important, lesson from his-tory is that not all debt crises are the same. This timeit may very well be different. It is not 1945; backthen, my grandmother was a bondholder. Shebought war bonds out of patriotism and becausethere was not much else for the average person todo with his or her savings. For four decades, shecontinued to lose money on that investment. And asa housewife in those days, she probably did notunderstand real interest rates very well. Today, theterm structure of debt is short, which raises thepossibility that nominal yields can rise ahead ofinflation with bond vigilantes as the primary bond-holders. This possibility is important to understandand is not in the macroeconomic textbooks. Theresult could be rising nominal and thus rising real

yields in a deflationary world. France experiencedthis situation in the 1930s because its perceiveddefault risk overcame the deflationary conditions inthe macroeconomic environment. Rising real ratesat a time when public debt and private debt are atunprecedented levels in relation to GDP are notgood for any country. Currently, the United Statespublic debt and private debt together equal 370percent of GDP, so rising real rates would kill theeconomy. The United States also cannot assume thatit can inflate its way out of this situation because it

Figure 5. Ratio of Debt to GDP for the United States and the United

Kingdom, 19461991

Source: Based on data kindly provided by Paul Masson.

Percent

United Kingdom

United States

300

250

200

150

100

50

0

46 56 66 8151 61 7671 86 91

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could happen that the money is printed, in the sense

that the Federal Reserve resumes quantitative eas-ing, but that broad money continues to contract andthe velocity of circulation remains low. If inflationdoes not provide the classic solution to the publicdebt crisis, the United States could face intensedomestic political pressure to default in some wayon its obligations.

ConclusionThe United States is rapidly reaching a crossoverpoint at which it will begin to spend a greater

percentage of its revenues on interest payments

than on defense. For a superpower, this issuebecomes a tipping point because the creditors aresuddenly getting more than the soldiers. In arecent article published in Foreign Affairs (Fergu-son 2010a), I argue that when great powers

decline, it can happen a great deal faster than onewould think. And the bond market is often asignificant driver of such major shifts in the geo-political landscape.

This article qualifies for 0.5 CE credits.

REFERENCES

Ferguson, Niall. 2001. The Cash Nexus: Money and Power in the

Modern World, 17002000. Jackson, TN: Basic Books.

. 2010a. Complexity and Collapse: Empires on the

Edge of Chaos. Foreign Affairs (Council on Foreign Relations),

vol. 89, no. 2 (March/April):1832.

. 2010b. The End of the Euro: How the Crisis in GreeceCould Lead to the Demise of Europes Most Ambitious Project.

Newsweek(7 May).

Lindert, Peter H., and Peter J. Morton. 1989. How SovereignDebt Has Worked. In Developing Country Debt and EconomicPerformance, Volume 1: The International Finance System. Edited

by Jeffrey D. Sachs. Chicago: University of Chicago Press.

Reinhart, Carmen M., and Kenneth S. Rogoff. 2010. Growth ina Time of Debt. NBER Working Paper No. 15639 (January).

Figure 6. Real Annual Returns on U.K. and U.S. Bonds, 19001995

Source: Based on data from Global Financial Data.

Return (%)

12

10

8

6

4

2

0

2

4

6

8

10

United Kingdom United States

2029 3039190009 1019 4049 5059 6069 7079 8089 9095

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Question and Answer SessionNiall Ferguson

Question: Does democracyinevitably lead to debt?

Ferguson: That is a key ques-tion. For most of history, it waswar that caused big crises of publicdebt. But the world has changedfrom one in which warfare drivesthe debt crisis to one in which wel-fare drives the debt crisis. The rea-son is because governments havetransitioned from unrepresenta-tive, through partially representa-tive, to fully representative. About10 years ago, I wrote a book called

The Cash Nexus (Ferguson 2001) inwhich I tried to rethink distribu-tional conflicts because I was verybored with my colleagues in eco-nomics and social science whosefocus was on class as the key topolitical economy. I wanted to saythat, in fiscal terms, class is a verymessy concept.

What I really want to knowabout is the relationship betweenthe people who pay direct taxa-

tion or receive interest on theirTreasuries and those who do notpay direct taxation and are recipi-ents of some form of governmentpayment, whether as governmentemployees or as recipients oftransfers. The argument in TheCash Nexus is that a criticalmoment occurs in any democracywhen the number of people whoreceive money from but do not

contribute to the state throughincome tax becomes too large.Once that number approaches 50percent of voters, then fiscalreform becomes impossible. Ithink most European countriesare in that position now, and it isunclear whether or not the UnitedStates is getting there.

If a country cannot reform, itcannot stabilize public finances

because when too many people

are receiving too much through

the tax system, it causes a gridlock.

At some point, reform is forced onthe country by a big crisis in the

bond market, which is not a nice

way to reform finances, as Greece

is discovering. Unfortunately, the

call for preemptive fiscal action to

avoid a crisis of public finance falls

on politically deaf ears, which sug-

gests to me that this problem in

democracies cannot be resolved

through conventional political

negotiation and legislation.

Question: Does an opportunity

exist for China, which is financing

much of the U.S. debt, to insist on

the use of gold as a true reserve

currency, and how should inves-

tors view gold in this context?

Ferguson: Many investors are

sensing that the world is on the

edge of chaos. The end of the era of

fiat money could be near. It hasbeen nearly 40 years since Richard

Nixon closed the gold window,

making it clear that all currencies

were essentially fiat currencies.

China has certainly considered

that holding a large share of $2.5

trillion of reserves in the form of

U.S. Treasuries, among other

dollar-denominated securities,

could be a poor investment strat-

egy. The question is, What does a

country do if a reserve currency is

not really a reserve currency? Gold

seems to be part of the answer

because it has a time-honored

appeal as a portable, indestructible

store of value. Other commodities

are also available that can protect

investors in this storm. For exam-

ple, the world might be on an

implicit oil standard.

Currently, Chinas strategy isto diversify out of paper claimsand into commodity assets; even

if that means paying a premium,it still makes more sense thanholding the bulk of $2.5 trillion ofinternational reserves in variousforms of the U.S. dollar. Finally, itis important to note that suchcountries as Norway, Switzer-land, Finland, Sweden, and Can-ada have kept their fiscal house inorder. Intelligent investors willswitch from the currencies ofcountries that are in a fiscal mess

to the currencies of countries thatare not in a fiscal mess.

Question: Will the euro survive?

Ferguson: I wrote an article forNewsweek(Ferguson 2010b) onthis subject that they wronglytitled, The End of the Euro,which is not the argument I wasmaking. My argument is that thetime of the strong euro is at an

end. I do not accept the idea thatthe euro will disintegrate; thecosts of exiting are prohibitivelyhigh to any country, includingGermany. For example, if Ger-many decided to declare its inde-pendence from the euro andrestore the German mark, themark would soar in value andGerman exporters would behowling. So, Germany will not beleaving the euro. Also, Greece

cannot leave. If Greece were tosuddenly attempt to restore thedrachma, it would destroy itsbanking sector because its assetswould suddenly be drachmadenominated while its liabilitieswould be euro denominated. Ithink the end game for Greece willbe to default. It may be calledsomething else, but that will bethe economic effect.

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Q&A: Ferguson

Question: What is your outlookfor the U.S. dollar?

Ferguson: The dollar is in aninteresting position in which itappears to be a relatively strongcurrency because of the defaultsetting among the worlds inves-

tors that drives them toward theU.S. dollar and U.S. Treasuriesduring uncertain times. This fac-tor means that we will continue tosee 3.5 percent yields on 10-yearTreasuries despite being in a timeof fiscal crisis. I think this phe-nomenon is temporary because, inmy opinion, the reality of fiscalarithmetic is inexorable. It mighttake 612 months or even longer,but at some point the markets willask questions about the sustain-ability of U.S. fiscal policy. Whenthat starts to happen, nominalyields will begin to increase and

the fiscal arithmetic will get evenworse. I also think this shift willhappen before the next U.S. pres-idential election.

Question: For those who needto invest in some form of secure,debt-oriented instruments and

are not interested in sovereigndebt, is there an opening for cor-porate bonds?

Ferguson: I think there is, and Ithink we may be entering one ofthese great paradigm shifts ininvesting in which there are noAAA rated sovereign bonds. Atthe same time, there could beAAA rated corporate debtbecause many corporate balancesheets look a lot healthier thansovereign balance sheets. Ofcourse, a problem with corporatedebt is that corporations tend not

to live as long as countries, so a

AAA rated corporate bond has to

be viewed in a different light than

a AAA rated sovereign bond. I

would still rather rely on corpo-

rate bonds to cover me in retire-

ment than rely on the politicians.

One consequence of a shift

toward corporate bonds is that

investors may have to rethink con-

ventional asset allocation rules,

which could be difficult because of

ingrained patterns of behavior

that are passed from one genera-

tion to the next. As an alternative,

emerging market debt might be

worth considering. Investors tend

to focus on equities when they talk

about emerging markets, but

emerging market corporate bondsmight prove to be an interesting

investment proposition.

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