Tuesday, August 25, 2009

"It's good to be an advanced country"

. Tuesday, August 25, 2009

Yep. But it's also good to have a history of credibility. As Michael Tomz argues, a country's reputation plays a big role in the supply of funds available for them to borrow, and the rates a country must pay to get those loans. That reputation is forged over long and short time horizons, and investors update their beliefs about the true "type" of a borrower according to the country's behavior. The U.S. has a pretty long history of paying its debts. Not only that, but it has a pretty long history of not inflating the value of its debt away, which is why the spread on inflation-protected Treasury securities has stayed tight despite the fact that the U.S. has been racking up debt over the past year.

(That's what the above picture shows: the difference in yields between inflation-protected securities and regular securities. As you can see, the historical spread is between 2 and 3 percentage points, reflecting the unofficial inflation target of roughly 2%.)

As Tomz's book Reputation and International Cooperation shows, a good track record can reassure investors even in bad times. This has made it easy for the U.S. to sell Treasury securities at very low cost during this downturn, while some other countries can't get funding at almost any rate.

That said, the benefit of the doubt doesn't last forever. A reputation can be built up or torn down; it is not a bottomless resource. If the U.S. shows signs of defaulting on its loans or a tendency to inflate the value away, investors will punish the U.S. for a long time to come. The more debt the U.S. adds, the more incentive it has to do some such thing, and the closer it moves to the point where investors lose confidence in the capability or willingness of the Treasury to pay up when the bill comes due. So the U.S.'s long-constructed credibility should not be squandered; if it is, the negative consequences will be far-reaching and long-lasting.


"It's good to be an advanced country"




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