In August 2011, the United States lost one of its AAA credit ratings, a designation first bestowed around 100 years ago, which when combined with the debt ceiling debate, created one of the
sharpest market corrections in post-war US
history. Financial markets remain concerned
about the ability and willingness of the US
and Europe to tackle their respective fiscal challenges. With US federal debt approaching its highest level since the formation of the
federal government in 1789 (other than during
WWII and its immediate aftermath), rating
agencies aretaking a close look at rising US
debt and what thelegislature does to contain it.
The appetite of foreign central banks to
accumulate Treasuries has provided the US
with a reprieve; these entities, plus
Federal Reserve holdings, now account
for half of all Treasury bonds. But monetary
policy in Asia and the Middle East
is subject to change, and we have seen in Europe the suddenness with which sovereign debt can be re-priced by financial markets. Downgrades, government shutdown rumors
and political impasse on deficit reduction
have not lost their ability to negatively affect
equity markets, business activity and confidence.
This note details 10 reasons why we believe
financial markets will take a close look at what Congress does in the year ahead.
1. Assuming that sequestration takes place as
planned,the Budget Control Act reduces the trajectory of the debt from the CBO’s explosive AlternativeCase, but does not yet set federal debt on a sustainable path. Even after
incorporating all phases of the BCA and
assuming expiration of various business
and household tax relief provisions,
future debt ratios still rise into
the mid-80s as a percentage of US GDP.
The CBO Baseline shows a decline in federal
debt since it assumes the following three
policy options: a sunset of all Bush tax cuts,
an end to indexation of AMT to
inflation, and reductions to Medicare
doctor reimbursements which Congress
has agreed to but never enacted. These
three cuts and associated interest savings
would amount to roughly $6 trillion in
deficit reduction over a 10 year period.
However, it remains unclear what political
support there would be to do so.
2. Financial markets are focused on this issue since large deficits and debt levels can affect growth. There are plenty
of debates in the economic community these
days (e.g., why haven’t monetary or fiscal
stimulus multipliers behaved the way their supporters believed they would). One possible
explanationis that fiscal stimulus loses its effectiveness when debt ratios rise too high.
In the chart below, we summarize
Ken Rogoff’s findings that when debt ratios in the US and in other advanced economies have exceeded 90%,economic growth suffered notably. With the US
federal debt ceiling now over 100% of GDP
(on a gross debt basis) and projections
of net debt rising above 80%, financial
markets have reason to be concerned.
Supporting Rogoff’s findings is a paper
prepared by BIS economists for the
Fed’s 2011 Jackson Hole symposium.
In a study of sovereign, corporate and
household debt over the last 3 decades,
the authors find that at around 85% of GDP,
government debt exerts a significant negative
drag on growth. Their conclusion:
“the immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds.”
3. Hoping for growth might not be the best strategy. The post-Budget
Control Act debt ratio of 85% by 2022
includes the CBO growth assumptions
shown in the chart below. Growth is
assumed to spike to 5% in 2015, and
average 2.7% over the decade. Some argue
that faster growth may bail out the US
from its budget problem, reducing the
need for deficit reduction measures.
It is true that the US has experienced
growth surges before, and it is always
possible another one will occur. In the
1950’s, real GDP growth averaged 4.3%
for the entire decade [see table in Appendix],
which resulted in debt ratios declining from 80% to 46%. However, the unique economic conditions and productivity gains of the 1950’s (e.g., interstate highway, rebuilding of Europe and Japan) may not be repeated. While we are
hopeful that the US economy recovers more
quickly, if it doesn’t, debt ratios might not
decline below the mid 80’s, risking another
round of rating agency downgrades.
Other areas of potential budget slippage: projections of military spending declines are not the same as structural deficit reduction.
One item in the President’s budget proposal
was an assumed $800 billion in savings
from troop withdrawals out of
Iraq and Afghanistan (so-called
“OCO” spending). While progress has
been made on this front, uncontrollable
geopolitical events could require OCO
spending to rise again. In addition, as
shown above, the Budget Control Act
already projects that non-OCO
military spending as a % of GDP will
fall to its lowest level since 1940, barely
above the levels now spent by Japan
and Germany after decades of
demilitarization. As a result, financial
markets may not ascribe a high likelihood
to deficit reduction achieved through
lower estimates of future military spending.
4. It’s not just rating agencies that are unnerved by polarization of political parties.Markets are aware of
the polarization in Congress, a trend that
can be understood by empirical analysis
of Congressional voting patterns.
As shown below, the polarization in the House and the Senate is as high
as it has ever been, even higher than
after Reconstruction, one of the most
acrimonious periods in the country’s history. A closer look at the Senate in particular (below, right) shows that the number of party non-conformists has plummeted.
Without a political middle, there is a
greater risk that the ideological divide
between the parties cannot be bridged,
leading to intermittent government
shutdowns (or the threat of them)
and market disruptions.
5. Entitlements: where we are now.
Market participants are increasingly focused
on entitlements relative to discretionary
spending. First, some history. When Medicare
was introduced in 1960’s, it was described
as “brazen socialism” in the Senate.
When Truman proposed a national healthcare
program in the 1940’s, the plan was called
a Communist plot by a House subcommittee.
And when President Roosevelt introduced
Social Security in the 1930’s, he was branded
as a Communist sympathizer by Republican
Senators from Ohio, Pennsylvania and
Minnesota, publisher William Randolph Hearst
and Alf Landon (Roosevelt’s GOP opponent
in the 1936 Presidential election). So in
1969 when the US Census found that one
quarter of Americans over the age of 65 lived
in poverty, politicians showed courage
in creating a larger social safety net.
However, it may take even greater courage to examine and adjust what was created. In the late 1960’s, the
government estimated that Medicare expenses would grow by 7 times by 1990 (unadjusted for inflation); they grew by 61
times instead. As shown in the table,
healthcare spending has overtaken education spending (a); entitlements have grown sharply compared to growth
in population, household income and
overall government spending (b);
price-sensitive medical spending
(paid out-of-pocket) has collapsed (c); and more “productive” forms of government spending have fallen to an all-time low (d). David Walker, the former Comptroller of the US, refers to this as the “crowding out” of productive discretionary programs.
6. Entitlements: where we go from here.Markets generally look at financial
statements which are governed by GAAP
accounting, which requires accrual of
future commitments. Countries and states are not bound by accrual accounting, leaving markets to wonder (and sometimes
panic) when they find out what hasn’t been accrued. The existing federal debt, which is already at elevated levels, does not include the present value of unfunded future entitlement payments. Government agencies have estimated this latter number at $36-63 trillion, which is 3-6 times the existing stock of federal debt held by the public.
How much would tax rates have to
rise to support entitlements growing
at 5%-7% per year, if nominal GDP
grew at 4%-5%? First, the 2001 tax cuts
would have to expire on all brackets,
and then tax rates would have to be
raised by the same amount on everyone.
At that point, federal debt to GDP would
still be well above 2007 levels, but at
least it would create some borrowing
capacity to fund entitlement payments. The question is what such a policy would do to growth and employment.
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7. How long will China keep buying?
US Treasury markets have benefited
substantially from the appetite of Chinese
and other central banks to accumulate
Treasury bonds. As shown below, China’s
purchases of $1.5 trillion in Treasuries
and Agencies is unprecedented, even
when compared to other industrializing
countries with managed exchange
rates. While China has prospered
by doing this (keeping its exchange
rate cheap and exporting more),
it is a policy that carries substantial risk,
primarily in the form of higher Chinese
inflation. As a result, it would be risky
to expect this pace of reserve accumulation
to last forever. Eventually, the US Treasury
will once again have to rely on private markets
to finance its deficits and stock of debt.
Japan has been able to sustain high federal
debt and low interest rates, but it has a stock of
domestic buyers prepared to hold them:
93% of all Japanese government bonds
are held by Japanese locals.
8.Risks to the status of the dollar as the world’s reserve currency.
The primary reason that China accumulates
Treasury bonds is that its central bank
is looking for large, liquid, secure places
to put trillions of their own currency.
The most sensible place to find such
an investment: the world’s reserve
currency. The percentage of global
reserves held in dollars has not changed
much recently (around 65%), nor has
the percentage of global FX transactions
denominated in dollars (85%). However, financial markets are well aware of the catalysts that led to the end of reserve currency status over the last few centuries. In general, they are: an over-extended fiscal budget, too much money-printing, declines in productivity, military adventurism and the inability to adjust to changing times, circumstances and adversaries. Financial markets
understandably look at the actions of
the Congress and the President on
issues like these. Congress’ actions
will be an important marker on the
timeline of the United States and its
ability to sustain its economic primacy
of the last 100 years. For the record,
as shown in the chart above, that’s
about as long as most reserve currencies last.
10. The risk of premature fiscal tightening does not preclude Congressional work on the long term deficit issue.At a recent event we held with
Pete Peterson regarding his foundation’s
mission on budget dynamics, he reiterated
his view that the reported choice between
“jobs and deficit reduction” is a false one.
There has been a lot of debate around
what to do regarding the fiscal cliff facing
the US next year (see first chart below).
Current law would impose one of the
largest fiscal drags in decades. Economists
Larry Summers and Brad DeLong have
argued against too much fiscal consolidation
right now, asserting that (a) additional
government spending can ease the long-term
budget constraint in conditions similar
to today’s, and (b) tightening policy now
would risk permanent loss of human capital,
lower labor productivity growth and lower
trend growth. Let’s assume they are right,
and that now is not the time for current
law to be imposed in full. That doesn’t
mean that progress cannot be made on
the longer term entitlement issues like
Social Security and Medicare.
The risk of inaction should be
considered as well; in the second chart,
the Government Accountability Office
estimates rising net interest costs over
the next few decades under different
budget assumptions. While we consider
the CBO’s Alternative Case too pessimistic,
the risk is that it falls somewhere in between,
consuming a greater and greater share
of government tax revenue. We have added
a line showing the current share of education
spending for context.
9. What economic model does the United States want to use? This chart below reflects
the implicit fiscal dilemma of the last decade:
the US mixes a European style welfare state with
a libertarian tax regime. The result is that even
after an economic recovery boosts tax receipts,
the IMF projects the US structural deficit to still
be around 4.4% in 2013.
My son recently asked me what I thought was
the most important document in US history.
There are a lot to choose from, but of all the
possibilities, I picked GeorgeWashington’s
Farewell Address, written in 1796. The relevance
of Washington’s warnings regarding the importance
of unity, the threat of political factions, the
importance of the separation of powers,
the dangers of permanent foreign alliances
and the need for public morality and education
have not diminished with time. One entire
section in Washington’s Farewell Address
is devoted to the use of public credit, and
Washington is quite clear about what he
thinks about Congress passing the buck
to future generations:
“As a very important source of strength and security, cherish public credit. One method of preserving it is to use it as sparingly as possible… avoid accumulation of debt, not only by shunning occasions of expense, but by vigorous exertions in time of peace to discharge the debts which unavoidable wars have occasioned, not ungenerously throwing upon posterity the burden which we ourselves ought to bear.”