|US Government Debt Crisis Hovers in the Background, Part 1|
By Satyajit Das NOV 28, 2011 8:40 AM
Unless the underlying debt levels and budget deficits are dealt with, the ability of the US to finance itself will deteriorate.
Greece and the other debt-burdened European countries are merely the first carriages in the derailment of the "Sovereign Debt" Express train service.
The failure of the congressional super committee to reach agreement on $1.2 trillion in budget cuts means that addressing the problem of US public finances is unlikely in the near term. The failure also casts doubts on the ability of US policy makers to overcome political differences to take actions to stabilize US government debt with potential consequences for the US and global economy
At Debt’s Door
Ralph Waldo Emerson wrote: "The World owes more than the world can pay." The US certainly owes more than it can repay. US government debt currently totals over $14 trillion.
The US Treasury estimates that this debt will rise to around $20 trillion by 2015, over 100% of America’s Gross Domestic Product ("GDP"). Even these dire forecasts rely on extremely robust assumptions about US growth around 5-5.5% per annum. Lower growth will translate into higher debt levels.
There are other current and contingent commitments not explicitly included in the debt figures reported by the government. Since July 2008, the US government has supported Freddie Mac and Fannie Mae (known as government sponsored enterprises ("GSEs")). This totals over $5 trillion in additional on or off-balance sheet obligations.
The debt statistics do not include a number of unfunded obligations -- the current value of mandatory payments for programs such as Medicare ($23 trillion), Medicaid ($35 trillion) and Social Security ($8 trillion). Projections show that payouts for these programs will significantly exceed tax revenues over the next 75 years and require funding from other tax sources or borrowing.
In addition to Federal debt, US state governments and municipalities have debt of around $3 trillion.
Apolitical Debt Blues
US public finances deteriorated significantly over recent years. Pimco’s Bill Gross observed: "What a good country or a good squirrel should be doing is stashing away nuts for the winter. The United States is not only not saving nuts, it’s eating the ones left over from the last winter."
In 2001, the Congressional Budget Office ("CBO") forecast average annual surpluses of approximately $850 billion from 2009-2012. Instead, the US government has run large budget deficits of approximately $1 trillion per annum in recent years. The major drivers of this turnaround include: tax revenue declines due to recessions (28%); tax cuts (21%); increased defense spending (15%); nondefense spending (12%) higher interest costs (11%); and the 2009 stimulus package (6%). German finance minister Wolfgang Schäuble told the Wall Street Journal on November 8, 2010 that: "The USA lived off credit for too long, inflated its financial sector massively and neglected its industrial base."
The US budget deficits and debt problems are apolitical, with bipartisan contribution to the accumulated mess in public finances.
Prior to the election of Ronald Reagan, deficit spending largely from military conflicts such as Vietnam and economic downturns created a national debt of around $1 trillion. President Reagan held firm views on government and the welfare state: "Government is like a baby. An alimentary canal with a big appetite at one end and no responsibility at the other." He quipped that: "Welfare’s purpose should be to eliminate, as far as possible, the need for its own existence." But between 1981 and 1989, tax cuts and peacetime defense spending contributed to an increase in the debt of $1.9 trillion. The President was disappointed at the growing national debt, joking that: "[The deficit] is big enough to take care of itself."
Under President George Bush Senior, the national debt increased a further $1.5 trillion, driven by the costs of the first Gulf War and fall in tax revenues from a recession.
Under President Bill Clinton, national debt increased $1.4 trillion. There were large budget surpluses in some years, but increased spending added to the debt. The surpluses were driven by increased tax revenues from corporate and personal tax revenue gains due largely to the Internet bubble. In addition, Treasury Secretary Robert Rubin’s "carry trade," shortening the maturity of US debt to take advantage of lower short term rates, resulted in interest costs savings.
Between 2001 and 2009, President George Bush Junior added $6.1 trillion in debt, driven by the wars in Afghanistan and Iraq, tax cuts and revenue losses of the economic downturn that started in 2007.
President Barrack Obama added a further $2.4 trillion in debt. The major contribution came from stimulus spending to counter the effects of recession, tax revenue losses due to the downturn, extension of the Bush tax cuts and the continued cost of two military actions.
Drowning in Debt
No borrower can incur debt on this scale without the complicity of its lenders.
The US government holds around 40% of the debt through the Federal Reserve ($1.6 trillion), Social Security Trust Fund ($2.7 trillion) and other government trust funds ($1.9 trillion). Individuals, corporations, banks, insurance companies, pension funds, mutual funds, state or local governments, hold $3.6 trillion. Foreigner investors hold the remainder including China ($1.2 trillion), Japan ($0.9 trillion) and "other," principally oil-exporting nations, Asian central banks or sovereign wealth funds ($2.4 trillion).
Until the global financial crisis, foreign lenders, especially central banks with large foreign exchange reserves, led by the Chinese, increased their purchases of US government debt.
These reserves arose from dollars received from exports and foreign investment that had to be exchanged into local currency. In order to avoid increases in the value of the currency that would affect the competitive position of their exporters, the exporting nations invested the reserves in dollar-denominated investment, primarily US Treasury bonds and other high quality securities. By the middle 2000s, foreign buyers were purchasing around 50% of US government bonds.
During this period, emerging countries, such as China fuelled American growth, both supplying cheap goods and providing cheap funding to finance the purchase of these goods. It was a mutually convenient addiction – China financed customers creating demand for exports and America received the money to buy cheap Chinese goods. Asked whether America hanged itself with an Asian rope, a Chinese official told a reporter: "No. It drowned itself in Asian liquidity."
Following the global financial crisis, foreign purchases have decreased to around 30% of new issuance. Around 70% of US government bonds (US$ 0.9 trillion) have been purchased by the Federal Reserve, as part of successive rounds of quantitative easing.
Historically, America has been able to run large budget and balance of payments deficits because it had no problems finding investors in US treasury securities. The unquestioned credit quality of the US, the unparalleled size and liquidity of its government bond market ensured investor support. Given its reserve currency and safe haven status, US dollars and US government bonds remained a cornerstone of investment portfolios.
The US dollar’s share of world trade and investment is extraordinary and out of proportion to its economic role. The dollar remains the principal currency for invoicing and settling trade. Eighty-five percent of foreign exchange transactions involve the dollar. Fifty percent of stock of international securities is denominated in US dollars. Central banks hold 60% of their foreign exchange reserves in dollars. All this is despite the fact that the US’s share of global exports is only 13% and foreign direct investment is 20%.
The US financing strategy is based on the "balance of financial terror.”
China, the major investor in US government bond investors, finds itself in the position that John Maynard Keynes identified: "Owe your banker £1000 and you are at his mercy; owe him £1 million and the position is reversed." Over recent years, Chinese concerns about the US debt position has become increasingly shrill.
In 2010, Yu Yongding, a former adviser to China’s central bank, mused: "I do not think U.S. Treasuries are safe in the medium-and long-run…Only God knows how much value that China has stored in the U.S. government securities will be left in the future when China needs to run down its reserves." In 2011, a Chinese government spokesperson could only "hope the US government will earnestly adopt responsible policies to strengthen international market confidence, and to respect and protect the interests of investors." In 2010, US Treasury Secretary told a gathering of Chinese students that US government bonds were "safe" investments, eliciting derisive laughter.
But China has America right where America wants China!
Existing investors, like China, must continue to purchase US dollars and government bonds to avoid a precipitous drop in the value of existing investments. This allows America time to correct its deteriorating public finances and reduce its borrowing requirements. It also allows increases in domestic savings to reduce reliance on foreign investors. The US Federal Reserve remains a buyer of last resort, although the long term consequences of this "printing money" strategy remains uncertain.
For the moment, this tenuous strategy appears to be holding. Demand for Treasury securities from investors and other governments has continued. Domestic investment, primarily from banks who are not lending but parking cash in government securities, has been strong. US government rates remain low. The government’s average interest rate on new borrowing is around 1%, with one-month Treasury bills paying less than 0.10% per annum. This has allowed the US to keep its interest bill manageable despite increases in debt levels.
In effect, the US requires artificially low interest rates to able to service its debt. Federal Reserve Chairman Ben Bernanke told the House Financial Services Committee that the US faces a debt crisis: "It’s not something that is 10 years away. It affects the markets currently…It is possible that the bond market will become worried about the sustainability [of deficits over $1 trillion] and we may find ourselves facing higher interest rates even today."
The current position is not sustainable in the longer term. Unless the underlying debt levels and budget deficits are dealt with, the ability of the US to finance itself will deteriorate. The US treasury must issue large amounts of debt almost continuously – weekly auctions regularly clock in at $50-70 billion unimaginable a few years ago. America’s ability to finances its need may not continue. As English writer Aldous Huxley observed: "Facts do not cease to exist because they are ignored."