History in the Making: Lessons and Legacies of the Financial Crisis

Niall Ferguson William Ziegler Professor of Business Administration Harvard Business School Cambridge, Massachusetts
The developed world has come to think of a financial crisis as something that occurs only in less 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 the current financial state of the world. I will particularly emphasize the sovereign debt problem that I think is going to dominate financial discussions globally in the future. I am not going to review the causes of the financial crisis because I hope they are understood by now. It is what comes next that interests me. My approach is to use historical understanding rather than mathematical models to get a sense of possible future scenarios. We are living through an extraordinary debt explosion in the developed world. The graph in Figure 1 is from a very recent International Monetary Fund (IMF) study and charts the general government gross debt ratios of advanced economies in the G20, all advanced economies, emerging economies in the G20, low-income economies, and a broad sample of all emerging economies. The figure depicts a world turned upside down. At one time, it was the emerging markets, particularly low-income countries, that had public debt crises. Now, rich countries have excess public debt problems as their ratios of debt to GDP average about 100 percent. In a recent paper, Carmen Reinhart and Kenneth Rogoff (2010) pointed out that debt ratios of 90 percent of GDP appear to be an important threshold; ratios above 90 percent can lead to serious 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 emergency measures taken in response to the financial crisis, and another reason is found in the calamitous decline in revenues caused by the great recession. Also embedded in the debt ratios is a structural deficit that has been growing for years as Western

democracies have refused year after year to raise as much in taxation as they spend on various public services and transfers. I have argued for years that this issue is the weakest point in the Western economic model, and many of the warnings that I made in the past are proving to have been prescient. These big debts have the power to scare governments into emergency action, mainly because the bond market forces governments to act even when politicians would prefer to avoid emergency action. What occurred during early 2010 in Greece and, to a lesser extent, in Portugal is something that can happen to any economy with excessive public debt. It is important to note the nonlinearity of this type of progression. A country is fine until it is not finein other words, it is possible to sustain an excessive public debt for a considerable time if financial markets remain benign or ignore the problem. But when market sentiment turns against the government and the credibility of its fiscal policy is called into question, that country very quickly finds itself in a downward spiral. The rising costs of interest payments cause the deficit to become uncontrollable, and then the government has to borrow money just to pay the interest on the money it borrowed before, much like a Ponzi scheme.

Debt Crises of the Past

Crises of the sort I have just described are nothing new. They are, in fact, as old as the bond market itself, which is very old. The original sovereign debt markets date back to the 12th and 13th centuries in northern Italy. For example, Figure 2 shows the spread between French debt and U.K. consolidated annuities (consols) from 1753 to 1813. It captures the financial history of the great conflict between the United Kingdom and France that dominated the latter half of the 18th century and continued until

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

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Figure 1.
Percent 120

Government Gross Debt as a Percentage of GDP for Various Economies, 20002015

100

80

60

40

20

0 00 02 04 06 08 10 12 14 G20 Advanced Economies Low-Income Economies All Advanced Economies G20 Emerging Economies

Broad Sample Emerging Economies

Notes: IMF estimates based on April 2010 World Economic Outlook projections using weighted averages based on 2009 gross domestic product in terms of purchasing power parity. Source: Based on data from the IMF.

Figure 2.
Spread (bps) 1,000 900 800 700 600 500 400 300 200 100 0 1753

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

58

63

68

73

78

83

88

93

98

1803

08

13

Source: Based on data kindly provided by Larry Neal.

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History in the Making

1815. This period was the age of revolution in which, among other things, the British Empire experienced a little local difficulty with some minor colonies on the eastern coast of North America. That crisis brought U.K. borrowing costs closer to French borrowing costs than at any other time in the 18th century, which highlights an important pattern in which negative political newsparticularly negative military newsaffects perceptions of default risk and inflation risk premiums in the bond market. It was only really at the time of the Battle of Yorktown that the spread came close to vanishing. For the rest of the period, from the beginning of the Seven Years War in 1756 to Napoleons defeat at Waterloo in 1815, a consistently significant premium existed for lending to the French government. And that, in my view, is one reason why the United Kingdom ultimately won this great contest. Because it 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 less cost than had to be borne by France. This pattern tends to repeat itself. Financial history is generally a succession of sovereign debt crises. In fact, unlike lightning, sovereign debt crises tend to strike the same place over and over. For example, during the 1870s, a political crisis in none other than Greece caused a huge spike in its yields (relative to U.K. debt). Other countries in the late 19th century that experienced sovereign debt crises were Mexico, Uruguay, and Argentina. Also in the 1870s, the Ottoman Empire defaulted after a disastrous war with Russia. Interestingly, in the subsequent period from the 1890s to World War I, a tremendous convergence in bond spreads occurred. Sovereign spreads relative to the risk-free U.K. benchmark, which had been very large in the mid19th century, came down to around 100200 bps for nearly all countries. Then World War I began, and the complacency that had developed among bond investors was shattered by the huge public debts that countries ran up fighting the war. During the Great Depression, many countries did defaultoften the same countries that had gone through periods of default and inflation before the war. By the second half of the 20th century, it was widely assumed that sovereign debt crises were confined to relatively poor countries in such places as South America, Central Europe, and the Middle East. But advanced economies are not exempt from this phenomenon. If countries are measured on the basis of the percentage of years in default or rescheduling, Honduras, Ecuador, and Greece are at the top of the list. But Russia also has defaulted regularly. Russia was responsible for two of the biggest sovereign defaults of all timeafter the Russian Revolu-

tion and again in 1998. Further downbut at still a surprisingly high place in the ranking of countries years in defaultis Germany, appearing just below Turkey. One reason behind Germanys appetite for fiscal discipline is the distinct memory not only of the defaults on postWorld War I reparations in 1922 and 1932 but also of two episodes of hyperinflation that completely destroyed the German currency and rendered German government bonds worthless in 1923 and again in 1945. So, the key point is that debt crises do not just happen to Latin America, Eastern Europe, and the Middle East. They can happen to anyone. Table 1 shows a list of European countries and their associated number of banking crises, defaults, episodes of inflation, and episodes of hyperinflation. This list makes it clear that no country has an unblemished record. Even the United Kingdom should, in fact, have a number in the default column because it defaulted on its war debt to the United States in 1945. Nearly all countries are in some way tainted by default.

Today and Beyond

The charts in Figure 3, recently published by the Bank for International Settlements (BIS), show the ratio of public debt to GDP for four countries whose debt problems have been in the news: Portugal, Ireland, Greece, and Spain. The trajectory is forecast for three scenarios for 20102040: no fiscal reform, some fiscal reform, and serious fiscal reform. In the third scenario, the problems with revenue and expenditure, including the problems associated with aging populations, are at least partly addressed. In the scenario of no reform, debt ratios for all four countries increase to 300400 percent by 2040. Even in the serious fiscal reform scenario, however, the debt/ GDP is never below 100 percent in these countries. Naturally, these ratios seem to indicate shocking levels of debt and are not unexpected from countries that notoriously lack fiscal discipline. But according to the BIS, the situation in the United Kingdom and the 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 in Portugal, Ireland, Greece, and Spain. In the scenario with no reform, the debt-to-GDP ratio would increase to 500 percent in the United Kingdom and 425 percent in the United States. Some say that because the United States is not in a monetary union with Germany, it can print more money as a solution to the problem. But that approach is only consoling to those who regard a surge in inflation as a legitimate solution to a problem of an excessively large public debt.

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Table 1.

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

Since Independence or 1800 Since 1800 Years Inflation Exceeded 20% 21 10 2 6 6 10 13 16 11 1 5 28 10 4 2 2 Years Inflation Exceeded 40% 12 7 1 3 2 4 5 4 6 2 17 4 1 Years of Hyperinflation 2 Years in a Banking Crisis 2 7 7 9 12 6 4 7 9 2 16 6 2 8 5 9 Years in Default or Rescheduling 17 Total Defaults or Reschedulings 7

Country Austria Belgium Denmark Finland France Germany Greece Hungary Italy Netherlands Norway Poland Portugal Spain Sweden United Kingdom

13 51 37 3 6 33 11 24

8 8 5 7 1 1 3 6 13

2 4 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

A. Portugal
Percent 300 250 300 200 150 100 100 50 0 80 90 00 10 20 30 40 0 200 Percent 400

B. Ireland

80 90 00 10 20 30 40

C. Greece
Percent 500 400 300 200 200 100 0 70 80 90 00 10 20 30 40 Current Debt/GDP Some Fiscal Reform 100 0 Percent 400 300

D. Spain

80 90 00 10 20 30 40 No Fiscal Reform Serious Fiscal Reform

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

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History in the Making

Metrics of Doom
Table 2 shows the cyclically adjusted primary balance of various countries. This measure tries to determine a countrys underlying fiscal budget surplus (deficit) position relative to GDP by adjusting for the effects of the economic cycle and by excluding interest payments currently being made on past debt. The calculation is 6 percent of GDP for Greece, but the calculation is 6.8 percent for the United Kingdom and 7.3 percent for the United States. Table 2. Cyclically Adjusted Primary Balance of Various Countries
Cyclically Adjusted Primary Balance 1.9% 5.6 6.0 0.4 2.3 7.3 2.8 3.7 0.3 6.8

Country Italy Japan Greece Belgium Hungary United States Portugal France Germany United Kingdom Source: Based on data from BIS.

Prior to the current crisis, the United States was spending only 7 percent of its GDP on interest payments. Without a truly radical change in fiscal policy, the United States is projected to be spending 22.3 percent of its GDP on interest payments by 2040, which is more than the Congressional Budget Offices estimate for total federal tax revenue in that year, which is 22 percent of GDP. Thus, by 2040 the United States would be facing the prospect of needing all of its tax dollars to meet the interest payments on the federal debt. Additionally, about half of the interest payments will be going out of the country because the United States has relied heavily on foreign capital to finance its deficit, a situation not wholly dissimilar to the one in Greece. In contrast, the public debts of Japan and the United Kingdom are mainly financed domestically. Practically, the United States can never allow 100 percent of federal tax revenues to go exclusively to interest payments. Nevertheless, this analysis highlights the fact that investors, private citizens, and voters will have to decide what is going to change. Table 3. Current Gross Debt/GDP and Percentage of Fiscal Adjustment Necessary for Listed Countries to Reduce Ratio to 60 Percent by 2030
Current Gross Debt/GDP 227.0% 81.7 75.7 69.6 115.0 93.6 81.9 85.4 102.7 74.9 Fiscal Adjustment to Reduce Ratio to 60% by 2030 13.4% 12.8 11.8 10.7 9.0 8.8 6.5 6.1 5.6 5.1

Table 3 shows the results of a study recently conducted by the IMF. The researchers asked the question, What would countries need to do to stabilize their ratio of debt to GDP at 60 percent by 2030? The right column sorts the countries included in the study by the fiscal contraction, whether through tax hikes or spending cuts, they would have to achieve to stabilize their debt/GDP at 60 percent, measured in terms of percentages of GDP. The country in the worst position is Japan. But the United Kingdom is in second-worst place with a fiscal contraction of 12.8 percent needed to stabilize its debt/GDP. Following the United Kingdom are Ireland, Spain, Greece, and the United States. The fiscal position of the large, English-speaking economies is clearly extremely serious, and unfortunately, few people in the decision-making bodies responsible for fiscal policy want to confront this reality. Although I have been focusing on the ratio of debt to GDP, it is in fact not a good measure of the impact of deteriorating fiscal conditions because, historically, little correlation has existed between debt/GDP and bond spreads. A statistically significant relationship, however, does exist between the percentage of GDP needed to meet interest payments and the risk spread on a countrys bonds.

Country Japan United Kingdom Ireland Spain Greece United States Portugal France Belgium Austria

Source: Based on data from the IMF.

What Causes Debt Crises?

Some causes of a debt crisis, such as an excessively large debt, are obvious. A less obvious but important cause is excessive dependence on foreign capital. This factor is important when trying to assess a countrys sovereign credit risk. The United States has to worry about this problem because a large proportion of U.S. Treasuries have been bought by China, a strategic rival of the United States, during the last 10 years.

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Other causes of a debt crisis exist as well. One cause is economic weakness. A countrys ratio of debt to GDP will tend to rise if its economic growth rate is low. Indeed, if the real interest rate exceeds the real growth rate, debt will grow very rapidly. Political weakness is another cause. A lack of political leadership often translates into excessive expenditures and insufficient taxation, which are ways of trying to buy popularity. Adapting Milton Freidmans famous proposition, which stated that inflation is always and everywhere a monetary phenomenon, I would say that crises of public debt are always and everywhere political phenomenons. Another cause of these crises is irrational exuberance, which mainly happens because investors do not learn from history. For example, Figure 4 shows the spread of Argentine bonds over U.K. consols for 18701914. The chart shows two crises, which occurred about 15 years apart, in which spreads soared to more than 1,400 bps. Something similar happened, as we have seen, during the interwar years. Looking at the events of the early 2000s, which culminated in yet another default, one is driven to the inevitable conclusion that some people never learn. The same story can easily be told about other countries, such as Turkey. A study done by Lindert and Morton (1989) illustrates why investors never seem to learn. The authors studied the anticipated or ex ante premium versus the realized or ex post premium (over either U.K. consols or U.S. Treasuries, depending on the Figure 4.
Spread (bps) 1,600 1,400 1,200 1,000 800 600 400 200 0 1870

time period) on the bonds of 10 countries. Table 4 shows that only 1 country of the 10 (Canada) had realized spreads that exceeded anticipated spreads, and that occurred in only two of the subperiods. In every other case, realized spreads were disappointing and sometimes massively so.

Ways Out of a Debt Crisis

In theory, there are six ways out of a debt crisis. The first way is a higher GDP growth rate that allows a country to grow faster than its debt burden grows. The second way is lower interest rates on the public debt to reduce the impact of excess debt. The third way is a bailout in the form of either a current account transfer payment or a capital transfer from abroad. These three options are not very traumatic. The next three options are more traumatic ways out of a debt crisis. The fourth way involves the fiscal pain of raising taxes and/or cutting expenditures to build a primary budget surplus that allows a country to start paying down its debt. The fifth way is what economists politely call recourse to seigniorage (i.e., inflation). The central bank simply prints the money to pay down the debt, which is possible only when the debt is denominated in the same currency as the countrys money. The sixth way, if all else fails, is default. Default seems conceptually simple, but in fact, a default can be any form of noncompliance with the original terms of

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

75

80

85

90

95

1900

05

10

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

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Table 4.

Anticipated vs. Realized Premiums on the Bonds of 10 Countries, 18501983

18501914 19151945 Ex ante 2.05% 3.34 3.30 1.16 0.64 0.65 3.24 1.00 1.75% Ex post 1.95% 1.48 1.90 2.39 1.21 0.65 0.73 2.26 0.88 1.21% 2.91 0.11 1.38% 2.25 0.34 1.30% 0.95 2.23 2.31 0.72 2.25 19451983 Ex ante 4.93% Ex post 4.70% Ex ante 2.15% 1.91 2.42 2.87 1.34 1.30 4.07 1.47 2.01 4.23 2.36% Ex post 1.71% 0.88 1.48 2.72 1.01 1.27 2.92 1.25 1.63 1.56 0.13%

Country Argentina Brazil Chile Mexico Australia Canada Egypt Japan Russia Turkey Total

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).

the debt contract including repudiation, standstill, moratorium, restructuring, rescheduling of interest, or principal repayments. Those are the six options for dealing with a debt crisis, but as a practical matter, three of those options are not available in the current crisis. The probability of the United States growing its way out of the debt crisis is small because a consequence of excessive debt is that it tends to lower the trend growth of GDP. The second option presents a similar problem because the perception of a debt crisis increases risk premiums, which drives interest rates higher, not lower. A particularly painful feature of debt crises is that the rise in the risk premium worsens the situation and can lead to a downward spiral of ever larger debt service costs and hence deficits. As for the third option, a bailout is really a possibility only for small countries. Thus, the United States has only three options: fiscal pain, inflation, or default. Only one major economy has ever escaped from a debt burden similar to the size of the projected U.S. debt burden without either defaulting or inflating, and that was Britain between 1815 and 1914. Britains debt/GDP at the end of the Napoleonic wars was around 250 percent. By the eve of World War I, however, the debt/GDP had decreased to less than 70 percent as a result of economic growth and primary budget surpluses, not default or inflation. But Britain had many advantages in the 19th century: the Industrial Revolution, the worlds biggest empire, and an undemocratic franchise, which meant that property owners were over-represented in Parliament and a large section of the working class did not get to vote. These factors made radical fiscal retrenchment much easier than it is for the United States today.

Every other case of a major crisis of public debt has produced an inflationary episode among countries that have control over their own monetary policy and whose debts are denominated in their own currency. In contrast, defaulters tend to be countries with little or no control over their monetary policy (for example, countries in the eurozone or countries with fixed exchange rate regimes) or countries whose debts are denominated in currencies other than their own. To illustrate, Figure 5 graphs the reduction in the debt ratios for the United States and the United Kingdom following World War II. At the end of the war, the debt/GDP of the United States was more than 100 percent and the debt/GDP of the United Kingdom was more than 250 percent. By 1991, both countries debt ratios were around 50 percent. The improvement of the debt ratio in the United States was accomplished partly by growth and partly by inflation. Budget surpluses played no role whatsoever. In fact, the United States has run a budget surplus during only eight years of the postwar era. In the United Kingdom, the reduction was almost entirely the result of inflation because modest growth roughly offset continued fiscal deficits.

Lessons of History
The first lesson to learn from history is how governments do not deal with their debt burdens. First, countries do not slash expenditures and entitlements. Moreover, they do not reduce marginal tax rates on income and corporate profits to stimulate growth. Second, they do not raise taxes on consumption to stimulate savings and reduce deficits. Finally, they do not grow their way out of the problem without defaulting or depreciating their currencies. As

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Figure 5.
Percent 300

Ratio of Debt to GDP for the United States and the United Kingdom, 19461991

250

200 United Kingdom

150

100 United States 50

0 46 51 56 61 66 71 76 81 86 91

Source: Based on data kindly provided by Paul Masson.

previously mentioned, the only exception is Britain after 1815, and the possibility does not exist for the United States to repeat that performance in our time. The second lesson from history is what steps governments do take to deal with world-war-size debt burdens. First, governments subtly or unsubtly encourage the central bank and commercial banks to load up on government debt. Second, they often discourage alternative avenues of investment (e.g., foreign investment) for their citizens to ensure that investors have little choice but to load up on public debt. Third, they tend to default on their commitments to weak domestic creditor groups and to foreign creditors. Finally, when all else fails, they condemn bond investors to negative real returns. Figure 6 shows the real inflation-adjusted returns on U.K. and U.S. bonds for 19001995. These returns were consistently negative from the 1940s through the 1970s, which is really the story of how the postwar debt burdens were dealt with. Another lesson from history is that such inflationary episodes are associated with currency volatility. In a fiat money world in which every country has an incentive to depreciate its currency, a series of quite significant moves in developed market exchange rates is to be expected. The euro and the British pound have already shown considerable volatility. At some point, there will be a question mark about the U.S. dollar. The possibility exists that in 5 or 10

years there will not be a fiat money that deserves the name reserve currency. The third, and most important, lesson from history is that not all debt crises are the same. This time it may very well be different. It is not 1945; back then, my grandmother was a bondholder. She bought war bonds out of patriotism and because there was not much else for the average person to do with his or her savings. For four decades, she continued to lose money on that investment. And as a housewife in those days, she probably did not understand real interest rates very well. Today, the term structure of debt is short, which raises the possibility that nominal yields can rise ahead of inflation with bond vigilantes as the primary bondholders. This possibility is important to understand and is not in the macroeconomic textbooks. The result could be rising nominal and thus rising real yields in a deflationary world. France experienced this situation in the 1930s because its perceived default risk overcame the deflationary conditions in the macroeconomic environment. Rising real rates at a time when public debt and private debt are at unprecedented levels in relation to GDP are not good for any country. Currently, the United States public debt and private debt together equal 370 percent of GDP, so rising real rates would kill the economy. The United States also cannot assume that it can inflate its way out of this situation because it

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Figure 6.

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

Return (%) 12 10 8 6 4 2 0 2 4 6 8 10 190009 1019 2029 3039 4049 5059 6069 7079 8089 9095

United Kingdom
Source: Based on data from Global Financial Data.

United States

could happen that the money is printed, in the sense that the Federal Reserve resumes quantitative easing, but that broad money continues to contract and the velocity of circulation remains low. If inflation does not provide the classic solution to the public debt crisis, the United States could face intense domestic political pressure to default in some way on its obligations.

Conclusion
The United States is rapidly reaching a crossover point at which it will begin to spend a greater

percentage of its revenues on interest payments than on defense. For a superpower, this issue becomes a tipping point because the creditors are suddenly getting more than the soldiers. In a recent article published in Foreign Affairs (Ferguson 2010a), I argue that when great powers decline, it can happen a great deal faster than one would think. And the bond market is often a significant driver of such major shifts in the geopolitical landscape.
This article qualifies for 0.5 CE credits.

R EFERENCES
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. Lindert, Peter H., and Peter J. Morton. 1989. How Sovereign Debt Has Worked. In Developing Country Debt and Economic Performance, 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 in a Time of Debt. NBER Working Paper No. 15639 (January).

. 2010b. The End of the Euro: How the Crisis in Greece Could Lead to the Demise of Europes Most Ambitious Project. Newsweek (7 May).

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Question and Answer Session

Niall Ferguson
Question: Does democracy inevitably lead to debt? Ferguson: That is a key question. For most of history, it was war that caused big crises of public debt. But the world has changed from one in which warfare drives the debt crisis to one in which welfare drives the debt crisis. The reason is because governments have transitioned from unrepresentative, through partially representative, to fully representative. About 10 years ago, I wrote a book called The Cash Nexus (Ferguson 2001) in which I tried to rethink distributional conflicts because I was very bored with my colleagues in economics and social science whose focus was on class as the key to political economy. I wanted to say that, in fiscal terms, class is a very messy concept. What I really want to know about is the relationship between the people who pay direct taxation or receive interest on their Treasuries and those who do not pay direct taxation and are recipients of some form of government payment, whether as government employees or as recipients of transfers. The argument in The Cash Nexus is that a critical moment occurs in any democracy when the number of people who receive money from but do not contribute to the state through income tax becomes too large. Once that number approaches 50 percent of voters, then fiscal reform becomes impossible. I think most European countries are in that position now, and it is unclear whether or not the United States is getting there. If a country cannot reform, it cannot 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 on the 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 suggests 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 investors 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 has been 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 strategy. 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 example, the world might be on an implicit oil standard. Currently, Chinas strategy is to diversify out of paper claims and into commodity assets; even if that means paying a premium, it still makes more sense than holding the bulk of $2.5 trillion of international reserves in various forms of the U.S. dollar. Finally, it is important to note that such countries as Norway, Switzerland, Finland, Sweden, and Canada have kept their fiscal house in order. Intelligent investors will switch from the currencies of countries that are in a fiscal mess to the currencies of countries that are not in a fiscal mess. Question: Will the euro survive? Ferguson: I wrote an article for Newsweek (Ferguson 2010b) on this subject that they wrongly titled, The End of the Euro, which is not the argument I was making. My argument is that the time of the strong euro is at an end. I do not accept the idea that the euro will disintegrate; the costs of exiting are prohibitively high to any country, including Germany. For example, if Germany decided to declare its independence from the euro and restore the German mark, the mark would soar in value and German exporters would be howling. So, Germany will not be leaving the euro. Also, Greece cannot leave. If Greece were to suddenly attempt to restore the drachma, it would destroy its banking sector because its assets would suddenly be drachma denominated while its liabilities would be euro denominated. I think the end game for Greece will be to default. It may be called something else, but that will be the economic effect.

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Q&A: Ferguson

Question: What is your outlook for the U.S. dollar? Ferguson: The dollar is in an interesting position in which it appears to be a relatively strong currency because of the default setting among the worlds investors that drives them toward the U.S. dollar and U.S. Treasuries during uncertain times. This factor means that we will continue to see 3.5 percent yields on 10-year Treasuries despite being in a time of fiscal crisis. I think this phenomenon is temporary because, in my opinion, the reality of fiscal arithmetic is inexorable. It might take 612 months or even longer, but at some point the markets will ask questions about the sustainability of U.S. fiscal policy. When that starts to happen, nominal yields will begin to increase and

the fiscal arithmetic will get even worse. I also think this shift will happen before the next U.S. presidential election. Question: For those who need to invest in some form of secure, debt-oriented instruments and are not interested in sovereign debt, is there an opening for corporate bonds? Ferguson: I think there is, and I think we may be entering one of these great paradigm shifts in investing in which there are no AAA rated sovereign bonds. At the same time, there could be AAA rated corporate debt because many corporate balance sheets look a lot healthier than sovereign balance sheets. Of course, a problem with corporate debt 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 corporate bonds to cover me in retirement than rely on the politicians. One consequence of a shift toward corporate bonds is that investors may have to rethink conventional asset allocation rules, which could be difficult because of ingrained patterns of behavior that are passed from one generation 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 bonds might prove to be an interesting investment proposition.

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