August 1st, 2011 | By Nick Sargen
In recent weeks investors have been riveted over negotiations in Europe to resolve the debt crisis in the euro-zone and the budget impasse in the United States. While both sets of deliberations contained high drama, the US situation is very different than Europe’s in that is has been self-inflicted. There is no question that the United States has the means to service its debt -- it is not a bankrupt country. However, politicians used the debt ceiling deadline as a lever to extract concessions on how to achieve deficit reduction. The danger in this situation is that a political dispute could have triggered a financial crisis at a time when the economy is vulnerable to shocks.
Fortunately, the proposal under consideration will avert a technical default: It will extend the debt ceiling until after the 2012 election in return for measures to reduce projected government spending by about $900 billion dollars cumulatively over ten years (notably, current Federal Government spending is $3.5 trillion annually, or approximately 25% of US GDP). It also provides for a bipartisan committee to propose a second round of deficit reduction measures that would bring the combined tally to $2.4 trillion dollars cumulatively. While this outcome has alleviated market worries about an imminent default, S&P and other rating agencies could still downgrade U.S. treasuries from AAA status if the proposed plan is deemed insufficient to put the United States on a path for fiscal stability.
Unfortunately, what has been lost in the shuffle for most people is a clear explanation of why deficit reduction is critical and where the biggest problem areas are. In this regard, I have found the Congressional Budget Office’s (CBO) recent report on the long-term budget outlook to be a useful guide.
The principal reason that deficit reduction is essential is that the federal government debt outstanding is increasing at an unsustainable pace. Throughout most of the post war era the net debt of the federal government in relation to the size of the economy has been relatively low -- averaging about 37% of GDP. In the aftermath of the 2008-09 financial crisis, however, this ratio is projected to reach nearly 70% of GDP by the end of this year. Moreover, it threatens to reach 100% of GDP by 2021 if there are no modifications to existing government programs. Such a level exceeds the 90% threshold that has been identified as increasing the risk of default based on data spanning eight centuries. (Carmen Reinhart and Ken Rogoff, This Time Is Different).
How much deficit reduction is needed to stabilize the debt ratio over the next ten years? According to CBO, the answer is approximately $4 trillion (cumulatively over the next ten years). This is also the figure that President Obama and House Speaker Boehner were aiming for in the discussions about a “Grand Bargain.” This plan would have included cuts in entitlement programs and increases in revenues along with cuts in discretionary spending to achieve the stated goal.
Cuts in projected outlays for entitlement programs such as Medicare/Medicaid are essential, because they are the principal source of increased government outlays. For example, these two programs, which currently amount to 5.5% of GDP, are projected to reach 9.2% in 2030 and 13.0% in 2050. The increase in Social Security, by comparison, is much less – from 4.8% of GDP currently to 6% by 2050.
The other major component that affects spending outlays is interest payments on government debt. This item currently represents 1.4% of GDP. However, as the amount debt increases over time, interest payments to service it will grow substantially, reaching 7.2% of GDP by 2030 and 15.8% by 2050.
The revenue side of the equation is also of concern, because federal revenues today are unusually low in relation to the economy. They currently are around 15% of GDP versus an average of 18%-19% for the post-war era. This mainly reflects the impact of a severe recession and weak recovery, as well as tax cuts enacted over the past decade. Reform of the tax code is needed to close loopholes, as the U.S. has a relatively small tax base when compared with other developed countries.
What will it take to get tax revenues back to a more normal ratio? The answer that CBO arrives at is a more powerful recovery that will get the unemployment rate back to 5 ½% over the next five years and elimination of the tax cuts enacted in 2011. This is a tall order, however, as many economists question whether that is attainable.
Faced with this predicament, it is clear that if the United States is to get federal debt under control, the solution must entail a combination of significant cutbacks in entitlement programs along with measures to reform the tax code to boost revenues. The CBO is not alone in reaching this conclusion. Indeed, every bilateral group that has studied the issue has arrived at the same conclusion.
Yet, the gridlock in Congress continues, because the two sides have not found a way to compromise on the need to overhaul Medicare/Medicaid and to reform the tax code so that it is simpler and fairer. Nor does the plan being put forth commit the two parties to such a compromise. The initial round is slated to cut discretionary spending by $900 billion dollars over the next ten years, and a bipartisan committee will be established to achieve additional deficit reduction of approximately $1.5 trillion in the second stage. The latter is expected to include cutbacks in entitlement programs and increased revenues from closing tax loopholes. However, if the committee fails to act, or if Congress refuses to adopt its proposals, an array of prearranged cuts would kick in amounting to $1.2 trillion.
Assuming these targets can be achieved over the next ten years, they would stabilize the ratio of net public debt to GDP at about 85% by 2021. While this outcome is clearly better than doing nothing, it falls short of the “Grand Bargain” solution that S&P indicated it would use to judge whether the plan was adequate. Therefore, we cannot rule out the possibility of that S&P will downgrade U.S. government debt from AAA status, although we do not expect it to act until the results of the second stage are known.
Faced with this situation, the most likely outcome is that U.S. financial markets will fluctuate within ranges that have held this year. While there is still a risk of a ratings downgrade for U.S. treasuries, we believe the greater risk is the softness of the U.S. economy: Real GDP grew at less than a one per cent annual rate in the first half of this year. Even if growth improves somewhat in the second half, it is unlikely to generate monthly job growth of at least 200,000 people a month, which is critical to achieve a self-sustaining expansion.
The bottom line is that we see the Fed on hold indefinitely, while fiscal policy shifts from being expansionary to mildly restrictive. For us, this spells a long period of low U.S. bond yields.