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Ken Rogoff to Investors: "The Fed Doesn't Have Your Back"

|Includes: SPDR Dow Jones Industrial Average ETF (DIA), QQQ, SPY
AP interview with Ben Bernanke's close friend below:

Q: The U.S. hit the $14.3 trillion debt ceiling today, and now the Treasury is moving cash around to stave off default till August. What's that mean for markets?

A: I don't think it means anything immediately, but it doesn't seem like any way to run the government. I think they should raise the debt ceiling unconditionally, despite the fact that some reforms are desperately needed. When you're the world's biggest debtor there are repercussions when you take it to the brink and scare people (with the idea) that you just might consider a default.

Q: You're not in favor of the artificial cap, or debt ceiling, because it threatens creditors. But debt is still your biggest worry about the economy, yes?

A: The greatest concern at the moment is the huge debt overhang. All U.S. government debt, including state and local, is higher than at the end of World War II. But equally significantly, private debt (like mortgages and credit cards) is almost at its all-time high. If you combine the two, there's never been anything like it.

Q: What's the risk in the U.S. having so much debt? Other countries, like Japan, have larger debt burdens.

A: It doesn't automatically cause a crisis, but it certainly weighs on the recovery. Very roughly speaking, when a country has public debt over 90 percent of income, growth is about 1 percent lower for a very long time.

Q: A government can't increase spending as easily if it has too much debt, which you say makes a country vulnerable. How so?

A: That's the fundamental problem. You see it when a country loses tax revenues and needs to borrow money. They have wars and natural catastrophes and need to spend to pay for things, reconstruction, bridges. You don't want to be forced in the middle of a recession to raise tax rates (to pay for those things). That's a disaster.

Q: Politicians use your work to argue for deep spending cuts now to trim our debt. Do you agree?

A: If we tighten too fast, the economy will implode on itself. We didn't get here in two years, and we shouldn't try to get out of it in two years. But at the same time the idea that we can worry about the future later, that's false.
It's not just about cutting spending. The tax take probably needs to go up. We need to clean up the tax system.

Q: Where would you start?

A: I'm one of many economists who favor scrapping the current system entirely in favor of some form of a flat tax, with a very high deductible for low-income earners.
And you know what? The very wealthy would pay more. They pay less under the current system because there are these smoke and mirrors they can hide behind, all these deductions and all these ways of avoiding taxes.

Q: Your friend and former classmate Ben Bernanke has taken flak for the most recent quantitative easing program, known as QE 2. What do you make of the effort to keep prices from falling through pushing $600 billion into the economy?

A: I thought QE 2 was absolutely right when they did it. But the way quantitative easing works best is you announce a goal and then say you will do whatever it takes (to get there). If you don't have a blank check, it doesn't do much. Because of all the pushback from the Chinese, the Germans and Sarah Palin, they couldn't keep going. The Fed needed a free hand, and it doesn't have one. A second problem was the Fed was not careful enough to tell the market clearly, "This is not going to solve all your problems." The biggest mistake they made was the suggestion that part of the way quantitative easing operates is through the stock market.There are all these traders on Wall Street who said, "This means the Fed's got our back. The Fed is just determined to drive up the market."

Q: What's wrong with traders thinking that?

A: Well, the Fed doesn't have their back. The Fed cares about stable inflation. So the worry now is when these traders see that QE 2 is coming to an end, will they get really depressed and all their trades will unwind? That's the concern.

Q. At Bernanke's first press conference in April, he joked that playing chess with you was a "big mistake." Most people don't know you're an International Grandmaster. Did Bernanke ever ask for a rematch?

A: No. I went cold turkey after leaving graduate school. I teach my children how to play (chess) but that's it. I'm completely addicted and need to guard myself from playing. I still think about chess all the time.

Q: Has your expertise in chess helped inform your work?

A: Chess teaches you to think about what the other person is thinking. Obviously, there are other ways besides chess to come to that. Chess is just a disciplined approach. At the IMF, we had crises in Argentina, Brazil, Turkey and Lebanon. And it helped to put myself in their position: "What are they thinking."

Source: AP