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US outlook: The perils of a fiscal mess

The US is part of an elite of highly indebted developed nations. Bond vigilantes have attacked some of the eurozone states but have largely ignored the US. As the eurozone sovereign debt crisis resolves itself, the US fiscal position will attract more scrutiny.

The publicly held debt/GDP ratio of the US is currently 66.7%, the highest in the post-Second World War period. The Congressional Budget Office (CBO) projects that it will rise to 72.8% in 2013 before gradually declining to a more manageable 61% in 2021.

These baseline projections, however, assume that the legislation in place in August 2011 remains as is, including the expiration of the payroll tax holiday and emergency unemployment compensation at the end of 2011; reducing payments to Medicare physicians; expanding the alternative minimum tax base; and ending the 2001, 2003, and 2010 tax cuts at the end of 2012.

In an alternative projection, where some or all of these provisions are extended, the CBO estimates that public debt/GDP will exceed 80% by 2021. These projections include the Budget Control Act of 2011, which provides for $2.1 trillion in budget cuts through 2021, most of which will come in the form of automatic reductions in defence and non-defence discretionary spending starting in 2013.

Gross debt/GDP, which includes intra-governmental Treasury security holdings (such as in the Social Security and Medicare Trust Funds) and is most comparable to other countries’ reported debt statistics, is currently 97.4%, similar to Ireland and Portugal, both of which required bailouts.

In 2008, the government placed housing finance institutions Fannie Mae and Freddie Mac into conservatorship, effectively assuming their liabilities. If those were included as part of gross debt, then debt/GDP would rise to a startling 138.8%, placing the US debt burden higher than Italy’s and close to that of Greece.

There are obvious downsides to a large fiscal burden: it impairs the government’s ability to respond appropriately and in a timely way to future financial or economic crises; it could adversely affect investors’ trust in the government’s ability or willingness to meet its financial obligations; or it could raise fears that the government would create inflation, thus effectively reducing the real value of debt. But perhaps most importantly, persistent budget deficits could stifle long-term economic growth by reducing national saving and thus depressing investment as a share of GDP.

Since the early 1980s, the US has financed its budget deficits mostly through foreign borrowing, thus limiting the crowding-out effect on private investment but creating the “twin deficit” phenomenon (government budget and current account deficits).

As a result, the share of foreign holdings of US public debt has risen from 15% in 1984 to about 48% currently, most of it held by official institutions. About a quarter of it is owned by China, which surpassed Japan in 2008 as the largest holder of US public debt.

Although this policy has financed growth over the past three decades, it requires that interest payments be made to foreigners, and could present a problem should foreign demand for treasuries wane, which could lead to higher interest rates.

Net interest payments amount to about 1.5% of GDP, the lowest share since the early 1970s. The Office of Management and Budget, however, projects that interest costs will rise to a record high 3.5% of GDP by 2021, as the economy gradually recovers and interest rates return to more normal levels.

As a result, a reduction in the budget deficit will become more difficult, but ever more important for the long-term sustainability of government finances, as more resources will have to go towards paying interest.

The US primary deficit, which excludes interest payments, peaked at –8.7% of GDP in 2009 and is near –7% in 2011. The CBO projects that, under its baseline scenario, it will be eliminated by 2015, although we think that is highly unlikely.

Budget deficits typically spike during recessions, as government expenditures rise to counteract the decline in private demand, thus smoothing aggregate output over the business cycle. When recessions were followed by a V-shaped recovery, which was usually the case before 1980, the budget gaps were filled relatively quickly.

A double-dip recession, as in 1980-81, or a long sluggish recovery, as in 1991 and 2001, were associated with persistent budget deficits. The 2008 financial crisis and the associated recession led to an explosion of the budget deficit, as government receipts dropped off precipitously while spending, both automatic and discretionary, ascended. The budget deficit exceeded $1 trillion in each of the past three fiscal years, and, as a share of GDP, remains near 8.5%, the highest since the Second World War.

But recessions are not the only culprits for large budget gaps, as the government has run deficits for most of the time since 1930. From 1947 to 1980, deficits averaged 0.8% of GDP. From 1980 through 2010, however, deficits have more than tripled to an average of 3% of GDP, as spending rose at a faster pace than revenues.

The fiscal challenges for the government will only grow with time, as Social Security and Medicare outlays, which account for the bulk of government spending, are projected to increase along with the ageing population and rising real health care costs.

As a share of GDP, social security and Medicare costs are projected to grow rapidly from 8.4% currently to 11.9% in 2040, and then flat-line through 2085. According to the 2011 trustees’ report, the social security trust fund will be exhausted in 2036, while the Medicare trust fund will run out of money in 2024. After that, the government will not be able to fully meet its entitlement obligations. That is why, in order to have a meaningful impact on the debt outlook, any deficit reduction bill should contain a practical reform of the entitlement programmes.

So why are policymakers so complacent about the US fiscal debt issues? The financial markets have not yet forced them to act, because of several important factors that are keeping demand for treasuries strong, and thus interest rates low:

—The US treasuries market is the largest and most liquid in the world.

—Investors consider treasuries safe haven securities, which became particularly evident during the 2008-09 global financial crisis and more recently during the European sovereign debt crisis. Even after the US credit rating was downgraded by Standard & Poor’s last August, treasury yields fell.

—Banks and non-bank institutions, such as pension funds, insurance companies and mutual funds, hold treasuries for liquidity and capitalization purposes. Currently, they hold about 23% of US outstanding marketable debt.

—As a result of massive quantitative easing, the Federal Reserve purchased large quantities of treasuries. The Fed’s portfolio currently has about $1.67 trillion of treasuries, or about 17% of outstanding debt.

—Foreign central banks hold large amounts of treasuries (currently 35% of outstanding debt), as the US dollar is a reserve currency. Although some of its status has been eroded since the euro came into existence, 60% of the world’s currency reserves are still in US dollars.

Additionally, the current institutional environment has all the markings of financial repression which, in combination with moderate inflation, can erode the real value of government debt.

The term “financial repression” was first introduced in the 1970s by economists Edward Shaw and Ronald McKinnon and resurrected recently by Carmen Reinhart and M Belen Sbrancia.* It generally refers to an environment in which certain government policies, such as capital controls, interest rate caps, lending restrictions, and high reserve requirements for banks and non-bank institutions, redirect funds to government use that would otherwise have been used differently.

At the same time, consumer price inflation has averaged 2% a year since the end of the last recession, and over 3% in 2011, resulting in negative real yields across most of the yield curve. This facilitates the financing of government debt.

The government is taking advantage of this favourable environment by extending the average debt maturity, which is projected to reach 5.66 years by 2020, the longest since 2001. Longer maturities lock in the currently low coupon rates and reduce refinancing needs. Furthermore, with low interest rates and moderate inflation, real interest rates will stay depressed, thus eroding the real value of government debt at the expense of savers and fixed-income investors.

But all of these long-term factors shouldn’t be a reason for complacency on the part of policymakers. As Joe Kalish, senior macro strategist at Ned Davis Research, points out, the US might get a free pass for another year, until after the next elections. But if sufficient progress is not made by then to put the debt/GDP ratio on a sustainable path, financial markets might turn quickly and demand a higher inflation premium or a higher risk premium for the government’s inadequate actions. Just ask Greece, Portugal, Ireland, Italy, and Spain.

*Reinhart, Carmen and Sbrancia, M. Belen. The Liquidation of Government Debt. NBER Working Paper 16893,  March 2011

Veneta Dimitrova is a US financial economist at Ned Davis Research, a leading independent research group.

This article, plus supporting data, will be published in the January edition of Euromoney.

For more information on Ned Davis Research Group, please visit

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