Ever since the first rounds of quantitative easing (QE) by the US Federal Reserve, I’ve raised questions about how sound and sustainable this form of monetary policy is? How big is the risk that the greatest economic experiment in modern history may eventually fail? More than three years later, I’m still not sure. The only thing I’m sure of, is that the need for extreme measures is greater than ever.
“It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution. What matters is growth.”
George Irvin
(Photo by freakingnews.com)
While Mr. Ben Bernanke in the USA is trying to figure out new and more creative ways to flow the financial system with money in order to kick-start the nation’s economy, European politicians are obsessing over new and creative austerity measures in order to save money and regain the union’s financial balance. But nothing seems to work.
In 2008 I called for the launch of a so-called “Keynesian war” – but with a twist:
Instead of increasing public spending the traditional way, by investing in infrastructure like transport and housing or by upgrading public institutions like the military, I suggested to aim the financial “guns” at research and education, closing the gap between the rich and the poor, and developing clean energy.
The “Keynesian war” was launched, all right. But the ammunition was poured into the banks and other financial institutions who barely manged to save their own asses, in addition to dump the problems on their respective national governments.
The financial crisis is currently well beyond the stage I regarded as a “worst-case-scenario” only two years ago.
So, where do we go from here?
One thing ought to be clear: It’s no longer a question of method – the only thing that matters is the result.
Honorary professor George Irvin at University of London makes a pretty good summary in his latest blog post at the EUobserver.com.
The Debt Trap
“Europe is obsessed with the growing stock of public sector debt; fiscal austerity has become the watchword of our time. Little does it seem to matter that fiscal austerity means reducing aggregate demand, thus leading to economic stagnation and recession throughout the EU as all the main forecasts are now suggesting,” Professor Irvin writes.
Even the credit rating agencies are worried, as S&P’s downgrading of France and eight other countries shows. Whether it’s Angela Merkel or David Cameron speaking, public debt is denounced as deplorable, and all are told to get used to hard times.
“The notion that economic pain is the only route to pleasure was once the preserve of the British public school-educated elite, now it’s European economic policy”.
In Britain, immediately after the general election, the Tory-led coalition decreed that in light of the large government current deficit, harsh cuts were necessary to win the confidence of the financial markets.
But although the current deficit was high, the stock of debt (typically measured by the debt/GDP ratio) was relatively low and of long maturity, the real interest rate on debt was zero (and at times negative) and, crucially,
Britain had its own Central Bank and could devalue. As Harriet Harman argued in June 2010, Osborne’s cuts were ideologically motivated. The aim was to shrink the public sector, and the LibDems—fearing a new general election—chose to go along with the policy.
In the euro zone (EZ), where a balance of payments crisis at the periphery has turned into a sovereign debt crisis, the German public has been sold the idea that if only all EZ countries could be like Germany and adhere to strict fiscal discipline, all would be well.
The ultra-orthodox Stability and Growth Pact (SGP) has now been repackaged under the heading of ‘economic governance’ under which Germany and its allies will vet members’ fiscal policies and impose punitive fines on those failing to observe the deflationary budget rules to be adopted.
Never mind the fact that indebtedness in countries like Spain and Ireland was mainly private, or that the draconian fiscal measures imposed on Greece have, far from reducing public indebtedness, increased it.
Is debt always a bad thing?
In the private sector, obviously not since corporations regularly borrow money for expenditure they don’t want to meet out of retained earnings, while most households aim to hold long-term mortgages.
Public debt instruments like gilts in the UK or bunds in Germany are much sought after by the private sector, mainly because such instruments are thought to act as an excellent hedge against risk.
Remember, too, that when a pension fund buys a government bond, it is held as an asset which produces a future cash stream which benefits the private sector.
So ‘public debt’ is not a burden passed on from one generation to the next.
The stock of public debt is only a problem when its servicing (ie, payment of interest) is unaffordable; ie, in times of recession when growth is zero or negative and/or interest rates demanded by the financial market are soaring.
The question is when is debt sustainable?
Sustainability means keeping the ratio of debt to GDP stable in the longer term.
If GDP at the start of the year is €1,000bn and the government’s total stock of debt is €600bn, then the debt ratio is 60%; the fiscal deficit is the extra borrowing that the government makes in a year – so it adds to the stock of debt.
But although the stock of debt may be rising, as long as GDP is rising proportionately, the debt/GDP ratio can be kept constant or may even be falling.
Consider the following example. Suppose the real rate of interest on debt is 2% (say 5% nominal but with inflation at 3%, so 5 – 3 = 2). That means government must pay €12bn per annum of interest in real terms. But as long as real GDP, too, is rising—say at 2% per year—there’s no problem since real GDP at the year’s end will be €1020bn.
Even if the government were to pay none of the interest, the end-of-year debt/GDP ratio would be 612/1020 or 60%; ie, the debt ratio remains unchanged.
By contrast, if real GDP growth is zero, the ratio would be 612/1000 = 61.2; ie, the debt ratio rises only slightly.
The rule is that as long as the real economy is growing by at least as much as the real rate of interest on debt, the debt/GDP ratio doesn’t rise.
Moreover, this holds true irrespective of whether the debt ratio is 60% or 600%.
But there’s a catch.
In a modern economy, the public sector accounts for about half the economy.
If a country panics about its debt ratio and cuts back sharply on public sector spending, this reduces aggregate demand and may lead to stagnation or even recession.
When a country stops growing, financial markets decide that its debt ratio may rise and so become more cautious about lending and demand a higher bond yield (ie, interest rate).
The gloomy prophecy of growing public indebtedness becomes self-fulfilling. This is exactly the sort of “debt trap” which faces much of the EU and other rich countries. The way out cannot be greater austerity.
What works for a single household or firm doesn’t work for the economy as a whole. A household can tighten its belt by spending less, saving more, and thus ‘balancing the books’, but an economy cannot.
If everybody saves more, national income falls.
Of course, Germany and some Nordic countries can balance the government books because an export surplus offsets domestic private saving. But the Club-Med countries cannot match them.
When no EZ country can devalue, to ask each EZ country to balance the books by running an export surplus is empirically and logically impossible.
Even if all could devalue, what would follow is 1930′s-style competitive devaluation.
The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort.
It doesn’t matter whether new investment is financed by more government borrowing, quantitative easing or redistribution (some combination of the three would be optimal).
What matters is growth.
By George Irvin
George Irvin is a retired professor of economics and for many years was at ISS in The Hague. He is now honorary Professorial Research Fellow in Development Studies at the University of London, SOAS.
The total US debt have now passed 15 trillion dollar. It’s an unimaginable amount of money. If you think the European debt crisis is serious, just wait untill this baby blows – and, believe me, it will. From a historical point of view, the US nation is a baby. Just 244 years old. It has, however, managed to increase its debt by USD 5 trillion over the past three years. Experts suggest that a sovereign debt level above 60-90% of a country’s Gross Domestic Product (GDP) is not sustainable. According to the US Treasury, America’s national debt will reach 20 trillion by 2015 – more than 100% of the nations GDP.
“A major organ failure within the global economy is now inevitable.”
Satyajit Das
So, what do you think will happen when USA eventually finds themself in the same situation as Greece does now? I don’t think anyone can imagine the full impact of this financial Armageddon. But the worlds only economic superpower will fall from grace, fall hard, and the world’s number one reserve currency – the mighty dollar – may seize to exist. And from the ashes a brand new world will rise, for better or for worse…
Satyajit Das with eurointelligence.com – whom I’ve introduced you to before – has proven himself to be an outstanding analyst with extended knowledge, completly in touch with reality and crystal clear conclusions.
In this extremly good timed commentary he sums up the situation and tries to pinpoint exactly what may happen.
His main point, however, is: Be prepared!
Please take the time to read this – it’s really important stuff,
In February 2010, US Treasury SecretaryTimothy Geithner stated that the US was in no danger of losing its AAA debt rating, even though the US government had forecast a $1.6 trillion budget deficit in 2010. Geithner stated that downgrade was not a concern: “Absolutely not. That will never happen to this country.”
In 2011, the unseemly wrangling over the debt ceiling and the downgrade of the US’s credit rating focused attention on the issue of American debt. It has also focused attention on the role of the US dollar in global finance and the problem of large and persistent global imbalances, which remain unresolved.
“America is currently exhibiting is the worst kind of absurd theatrics. And the whole world is being held hostage.”
Non-American observers viewed the debt ceiling debate with morbid fascination and increasing concern.
Germany’s largest daily newspaper Bild Zeitung observed: “… America is currently exhibiting is the worst kind of absurd theatrics. And the whole world is being held hostage….Irrespective of what the correct fiscal and economic policy should be for the most powerful country on earth, it’s simply not possible to stop taking on new debt overnight. … The Republicans have turned a dispute over a technicality into a religious war, which no longer has any relation to a reasonable dispute between the elected government and the opposition….The political climate in the US has been poisoned to a degree that is hard for us (Germans) to imagine. But we should all fear the consequences.”
Germany’s conservative daily Die Welt pondered American lack of self-awareness about their position:
“In the middle of the poker game between the two political parties to prevent a national default on Aug. 2, polls show that 77 percent of Americans believe that they live in the world’s greatest system of government. Just as many are convinced that life is only worth living as an American.”
The inability of many European countries to access markets is an immediate danger that threatens financial markets and the global economy. But the US debt problems remain an equally serious problem.
The other two major rating agencies – Moody’s and Fitch – maintained America’s top notch AAA rating.
S&P was not the first rating agency to downgrade the US. China’s Dagong Global Credit Rating Company originally downgraded the US to A+ (4 levels lower than AAA) in late 2010 when the US Federal Reserve decided to continue loosening monetary policy.
In August 2011 Dagong subsequently lowered the United States to a single A indicating heightened doubts over Washington’s long-term ability to repay its debts. Dagong has also downgraded Germany, France and the UK.
Outlining the basis for its decision, S&P’s cited “political brinkmanship” in the debate over the debt ceiling as well as concern about the US government’s ability to manage its finances in a stable, effective and predictable way.
The planned $2.1 trillion in budget savings “fell short” of what was required, it argued, to reduce the nation’s debt to more manageable levels.
Despite the hyperbole from hyperventilating US government officials, media and pundits, the downgrade is economically insignificant. The psychological effect on markets and on Americans was more profound.
The market’s reaction was puzzling.
On 18 April 2011, S&P lowered the outlook for the US credit rating to negative, signalling a possible downgrade.
The credit default swap (CDS) market has been pricing US risk as less than AAA for some time.
The slight downgrade does not pose any imminent danger to the ability of the US to finance its requirements. The US’s cost of debt will not increase significantly as a result of the marginal downgrade. Despite the shrill rhetoric, the Chinese and other foreign investors are likely to continue purchasing US dollars and government bonds.
Japanese government bonds lost their AAA premium quality in 2002 and are now rated AA minus. The loss of the top rating has not affected their ability to finance at the lowest level of interest rates anywhere since pre-history (currently around 1.00% per annum for 10 years).
Rating the Raters…
Critics raged about the “unfairness” of the downgrade. Perhaps the most pungent criticism was on the Internet where one blogger compared S&P to Adam: “Oh, I think eating the apple would be fine”.
“Interestingly, critics seemed unconcerned by all these issues when S&P rated the US AAA. However, when the agencies downgraded the debt, the ratings were wrong and the methodology questionable.”
In the pages of the Financial Times, veteran investment manager Bill Miller railed against “a stunning ignorance and disregard for the potential consequences on a fragile global financial system.” He argued that S&P should have given weight to “the unique role the US plays in the global economy” and the dollar’s role as a global reserve currency.
It is not obvious why S&P should take into account these factors in establishing a nation’s ability to meet its obligations.
Miller found it “unacceptable that privately owned, for-profit companies” that operated secretly and with no accountability should play such an important role in financial markets. S&P and other rating agencies are reasonably transparent about their methodology. Miller did not mention that no one is required to accept or base its decisions on any agencies’ ratings. Investors and regulators choose to use ratings to determine what investments are permitted, how much capital a bank needs to hold and the borrowing costs of an issuer.
In Miller’s view, the ultimate proof of S&P’s error was that the market disregarded it, measured by the fact that the US enjoys among the lowest interest rates in its history.
If the S&P decision was as inconsequential as Miller argued, then it is unclear why it was causing him and others so much angst.
Interestingly, critics seemed unconcerned by all these issues when S&P rated the US AAA.
However, when the agencies downgraded the debt, the ratings were wrong and the methodology questionable.
The rating decision does raise important questions, just not the ones being asked.
Ratings measure the ability of the borrower to pay interest and principal on a timely basis. The rating does not measure the value of the payments received, only the making of contracted payments.
A sovereign, able to print money, should never default on securities issued in its own currency.
The real risk is that by printing money it devalues its currency and reduces the value of the payments received, which is what the US has done.
The fundamental question is whether ratings of sovereign obligations in its own currency are useful or meaningful at all.
S&P’s overstatement of the increase in debt by around $2 trillion was a significant error, even though the slightly lower debt hardly painted a good picture of US public finances.
It was reminiscent of mistakes in methodology or modelling that were discovered in the rating of many structured products during the global financial crisis.
Allegations that S&P may have proved selective access to information about the downgrade to some market participants were also troubling.
At Debt’s Door…
The rating, flawed as it is, should not distract from the real issue – the quantum of US government debt and the ongoing ability to finance America.
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 $15 trillion.
Commentator David Rosenberg passionately described the problem in a guest post at Zero Hedge:
“In the past three years…we had the U.S. public debt explode by $5 trillion— the country is 244 years old and over one-third of the national debt has been created in just the past three years. Incredible. The US government now spends $1.60 in goods and services for every dollar it is taking in with respect to revenues which is unheard of — this ratio never got much above $1.20, not even during the previous severe economic setbacks in the early 1980s and early 1990s.”
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 assumption about US growth around 5-5.5% per annum. Lower growth will translate into higher debt levels.
The rapid increase in debt will require Treasury to borrow heavily each year to repay maturing debt and raise new money. Annual interest payments will eventually exceed all domestic discretionary spending and rival the defence budget.
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.
With the budget balanced and forecasts of ever-larger annual surpluses indefinitely, the CBO estimated that Washington would have enough money by the end of the decade to pay off everything it owed.
The surpluses never emerged.
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 defence spending (15%); non-defence spending (12%) higher interest costs (11%); and the 2009 stimulus package (6%).
German finance minister Wolfgang Schäuble told the Wall Street Journal on 8 November 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 defence 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.
The US debt problems resemble Agatha Christie’s Murder on the Orient Express – everybody did it but no one is responsible.
Drowning by 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 ($2.4 trillion).
Until the global financial crisis, foreign lenders, especially central banks with large foreign exchange reserves, led by the Chinese, increased their purchases of US government debt as part of a giant global liquidity scheme.
These reserves arose from dollars received from exports and foreign investment that had to be exchanged into local currency.
In order to avoid increases in the value of the currency that would affect the competitive position of their exporters, the exporting nations invested the reserves in dollar denominated investment, primarily US Treasury bonds and other high quality securities.
By the middle 2000′s, foreign buyers were purchasing around 50% of US government bonds.
During this period, emerging countries, such as China fuelled American growth, both supplying cheap goods and providing cheap funding to finance the purchase of these goods. It was a mutually convenient addiction – China financed customers creating demand for exports and America received the money to buy cheap Chinese goods.
Asked whether America hanged itself with an Asian rope, a Chinese official told a reporter: “No. It drowned itself in Asian liquidity.”
Following the global financial crisis, foreign purchases have decreased to around 30% of new issuance.
Around 70% of US government bonds (US$ 0.9 trillion) have been purchased by the Federal Reserve, as part of successive rounds of quantitative easing.
Debt Reckoning…
The large stock of US debt and seemingly uncontrollable US budget deficits now pose several problems. Is the level of debt sustainable? How is it going to be funded? How can the deficits and debt be brought under control? What happens if the US finds itself unable to finances its requirements?
The answer to these questions will shape the global financial economic landscape for a long time to come.
In their book “This Time Is Different”, Carmen Reinhart and Kenneth Rogoff suggest that a sovereign debt level above 60-90% of a country’s Gross Domestic Product (“GDP”) is not sustainable.
But the level of tolerable sovereign debt depends on a multitude of factors.
One factor is the currency of the debt.
The US borrows in its own currency, meaning that its debt capacity is only constrained by the willingness of investors to purchase its securities and the cost of that borrowing.
As the US dollar is also a major reserve currency, used in global trade or favoured as an investment by central banks, the scope for borrowing to finance America’s budget and trade deficits is commensurately higher.
Where a country has a large domestic saving pool, like Japan, the ability of the government to finance its expenditure is significantly increased.
A country reliant on foreign investors for its funding is far more restricted, limiting its debt levels. Unfortunately, the US saving rate declined in recent years making the country increasingly reliant on foreign investors.
The level of interest rates and the proportion of public revenues needed to service the borrowing affect the level of debt. Low interest rates have allowed the US to maintain higher levels of borrowing.
Assuming a debt-to-GDP ratio of 100%, an average interest rate of 3% and federal revenue of 15% of GDP (the current level), the interest bill consumes around 20% of the budget. At an interest rate of 6%, it would be an unsustainable 40%.
Given that current interest rates are artificially low, critics have argued that: “The government is on ‘teaser’ rates. We’re taking out a huge mortgage right now, but we won’t feel the pain until later.”
The maturity structure of the debt is important.
Short term debt increases vulnerability to market disruptions, limiting the level of borrowing. Conversely, longer maturity and low concentration of maturing debt in an individual period can increase debt capacity.
The US’s average maturity of debt at one stage fell to under 4 years. Issue of longer dated bonds has increased it to just over 5 years. However, the US must still issue a substantial amount of securities each year making them financially vulnerable.
The most important factor is current and expected economic growth rates as well as the size and economic structure of the country.
A dynamic economy capable of high levels of growth, with the attendant ability to generate additional tax revenues, can maintain higher levels of debt than one with lower growth prospects.
Unfortunately, the structure of the US economy has changed in a deleterious way in recent years. The economy has become more narrowly based.
In addition, the majority of borrowings were not used to improve the productivity or economic base of the economy.
The debt was not used to finance a 21st-century equivalent of the 19th century railroads. The debt financed costly wars and consumer spending, including over investment in housing.
But the real issue is that the economic growth of recent years was debt fuelled.
Since 2001, borrowing contributed to around half the recorded economic growth in the US.
By 2008, $4 to $5 of debt was required to create $1 of growth. Reduction in debt will reduce growth, which in turn makes the level of borrowing more difficult to sustain.
Foreign Alms…
Historically, America has been able to run large budget and balance of payments deficits because it had no problems in 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. 85% of foreign exchange transactions involve the dollar. 50% 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%.
At one stage, around 85% of global capital flows was flowing into the US, including a significant portion (around $400 billion per year) into US government bonds.
The sheer quantum of US debt and credit concerns now means that foreign investors may be less willing to finance America. Investors may baulk at continuing to roll over debt or increase their exposure.
Foreign investors in Japan and Europe, struggling to finance their own government obligations, may simply not have the funds to invest.
In recent history, foreign investment in US government bonds reduced the interest rate by between 0.50% and 1.00% per annum (equivalent to $73-145 billion per year).
If foreign governments ceased to continue purchasing Treasuries, US bond interest rates could increase, potentially sharply.
If foreign governments actively reduced their investment by selling existing Treasury positions, then the rise in rates would be even greater. This would, over time, increase the borrowing cost of the US, reducing its ability to sustain the high level of debt.
In a more extreme case, if foreign investors cease to start to sell-off holding of US Treasuries and cease to purchase new bond, it is conceivable that the US would be unable to finances its requirements entirely.
This would register as failed government bond auctions.
The Balance of Financial Terror…
US financing strategy are 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 have 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 have 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.”
Debt Calm…
The solution lies in bringing budget deficits down, through spending cuts, tax increases or a mixture of both.
According to the CBO, spending increases have averaged 21% of GDP from 1980 to 2007 and are likely to increase to 25% by 2019.
In 2011, the major categories of government spending was defence (24%), social services (44%), non-defence discretionary (25%) and interest (7%).
Interest costs, currently around 7% of total spending, are expected to increase by as much as three times driven mainly by the increase in the level of debt.
The major increase in spending will come from social service entitlement programs. If current policies are maintained, pensions and health care for the retired (Social Security and Medicare) and health care for the poor (Medicaid) will increase from 10% of GDP in 2011 to 18% by 2050.
Winding back military overseas commitments and also reduced stimulus spending, assuming the economy and employment improve, will help reduce the deficit. But any significant reduction in government spending requires decreased spending on defence and entitlement programs.
Tax increases will be required. US Federal revenue is around 15% of GDP (down from 18-19%). Comparative levels of government tax revenues are Germany (37%) UK (34%) and Japan (28%).
Rating agency Fitch in maintaining America’s AAA status assumed that revenue raising measures totalling an extra $1 trillion would be found and government revenues would stabilise at 21% of GDP, a 40% increase and above historical average levels.
Increasing revenue will require a combination of increased taxes, fewer deductions, new taxes and changes in the tax system. Tax reform ideally requires reducing complexity and broadening the tax base, generally by increasing taxing on consumption.
The US tax system relies heavily on income tax (both individuals and corporations) and payroll taxes. The system discourages work and investment while encouraging borrowing and spending.
The tax code is riddled with tax credits and exemptions, worth as much as $1 trillion per annum.
The system distorts behaviour.
The mortgage interest deduction encourages borrowing, leverage and over-investment in housing. Deduction of employer-provided health insurance encourages more expensive programs and higher health care costs.
The system is regressive, favouring individuals with higher income. The tax system is complex (several million words long with changes, on average, more than once a day) increases compliance costs (estimated at $200 billion per year) and creates opportunities for avoidance.
Tax reform would require broadening the tax base, by eliminating loopholes and exemptions while lowering rates. Most exemption and deductions would need to be eliminated, with the possible exemption of incentives for retirement saving.
Around $500 billion per annum could be generated from eliminating deductions for employer-provided health care, mortgage interest, capital gains on homes and state and local taxes.
Other options including a broad tax on consumption.
A 5% value added tax, exempting education, housing, religious and charitable services, would raise $300-400 billion a year. Some of the proceeds would probably need to be directed to reduce the impact on the poor, to offset the tax’s regressive nature.
Another alternative would be a tax on carbon emissions or a higher fuel tax, which would raise revenue, penalize consumption and encourage energy efficiency.
The task is Herculean. Government revenues would need to be increased 20-30% or spending cut by a similar amount. In a nation where 45% of households do not pay tax (because they don’t earn enough or through credits and deductions) and 3% of taxpayers contribute around 52% of total tax revenues, it is difficult to see the necessary changes being made.
Reducing the budget deficit and reducing debt may also mire the US economy in a prolonged recession.
In 2009, students at National Defence University in Washington, DC, “war gamed” possible scenarios for bringing the US debt under control. Using a model of the economy, participants tried to get the federal debt down by increasing taxes and reducing spending.
The economy promptly fell into a deep recession, increasing the budget deficit and driving government debt to higher levels.
This is precisely the experience of heavily indebted peripheral European nations, such as Greece, Ireland, Portugal, Spain and Italy.
America’s ability to control its budget deficits and debt is a function of its politics. Major categories of spending (defence and entitlements) are politically sensitive and regarded as sacrosanct by both major political parties.
Tax reform may also be politically impossible.
Some political factions within the Republican Party will not countenance any tax increase at all. Even removing an exemption or credit, in their view, qualifies as a tax increase.
Given that tax code loopholes have fierce defenders and new federal taxes are politically toxic, it is difficult to see how any progress is possible.
As one participant in the National Defence University economic war game observed about the process of bringing US public finances under control: “You’ll never get re-elected and you may do more harm than good.”
Extortionate Privilege…
Given the magnitude of the US debt problem and the lack of political will, the most likely policy is FMD – “fudging”, “monetisation” and “devaluation”.
US states and municipalities demonstrate “fudging”.
In the boom years, local government revenues increased from rising property values and taxes allowing additional services and larger payrolls.
When the housing bubble burst and property values dropped an average of 35% reducing tax revenues, these entities found it difficult to cut expenses or increase taxes. Instead, some cities and states relied on fiscal “magic tricks” to close budget gaps each year but at great future cost.
Illinois, which has not made the required annual payments to its pension funds for years, borrowed $10 billion in 2003 and used the money to invest in its pension funds.
When the recession sent investment returns below their target, Illinois sold an additional $3.5 billion worth of pension bonds and is planning to borrow $3.7 billion more for its pension funds.
US state and local government have unfunded pension liabilities nearing $3.5 trillion. Others are selling off assets to temporarily plug budget holes, without viable plans to permanently fix finances.
There is no shortage of creative ideas of financing government debts. Bankers suggested the US issue perpetual debt, that is, the government would not be obligated to pay back the amount borrowed at all.
Peter Orzag, former director of the US Office of Management and Budget under President Obama and now a vice-chairman at Citigroup, suggested another creative way to correct the problem – lotteries. To encourage savings, banks should offer lottery-linked accounts offering a lower rate of interest, but also a one-in-a-million chance of winning $1 million for each $100 deposited.
As governments printed money to service their debts, US Post issued 44-cent first class “forever stamps” that had no face value but were guaranteed to cover the cost of mailing a first class letter, regardless of how high that cost might be in the future. Between 2007 and 2010 the public bought 28 billion forever stamps. The scheme summed up government approaches to public finance – US Post was cleverly hiding its financial problems, receiving cash up-front against the uncertain promise to pay back the money somewhere in the never, never future.
Debt monetization – printing money – is the second option.
The US Federal Reserve is already the in-house pawnbroker to the US government, purchasing government bonds in return for supplying reserves to the banking system. Expedient in the short-term, its risks debasing the currency and setting off inflation.
The absence of demand in the economy, industrial over capacity and the unwillingness of banks to lend have meant that successive rounds of “quantitative easing” – the fashionable moniker for printing money – have not resulted in higher inflation to date. But the longer term risks remain.
Monetization is inexorably linked to devaluation of the US dollar. The now officially confirmed zero interest rates policy (“ZIRP”) and debt monetization is designed to weaken the dollar.
On 19 October 2010, US Treasury Secretary Timothy Geithner told the Financial Times:
“It is very important for people to understand that the United States of America and no country around the world can devalue its way to prosperity and Competitiveness. It is not a viable, feasible strategy and we will not engage in it.”
The facts show otherwise.
Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened over the last 2 years in a culmination of a long-term trend which with minor retracements.
In 2007 alone, the US dollar weakened by about 8% improving America’s external position by $450 billion, as US foreign investments gained in value but its debt denominated in dollars were unaffected.
On a trade weighted basis, the US dollar has lost around 18% against major currencies since 2009.
The US dollar has lost around 30% against the Swiss Franc, 25% against the Canadian dollar, 37% against the Australian dollar and 16% against the Singapore dollar over the same period.
US dollar devaluation makes it easier for the US to service its debt. In the balance of financial terror, it forces existing investors to keep rolling over debt to avoid realising currency losses on their investments.
It also encourages existing investors to increase investment, to “double down” to lower their average cost of US dollars and US government debt.
The weaker US dollar also allows the US to enhance its competitive position for exports – in effect; the devaluation is a de facto cut in costs. This is designed to drive economic growth.
Valery Giscard d’Estaing, French Finance Minister under President Charles de Gaulle, famously used the term “exorbitant privilege” to describe the advantages to America of the role of the US dollar as a reserve currency and its central role in global trade.
That privilege now is not only “exorbitant” but “extortionate”. How long the rest of world will allow the US to exercise this “extortionate privilege” is uncertain.
Winston Churchill famously observed that Americans can be counted on to do the right things but only after all other possibilities have been exhausted.
Unfortunately, it is doubtful that the US debt problem will be resolved by resolute American actions. The deployments of FMD’s seem more likely.
America remains the world’s only military super power and constitutes a quarter of the global economy. This means that what happens in America is unlikely to stay in America.
The world must prepare for the denouement of the US debt crisis. At best, actions by America will usher in a prolonged period of stagnation for the US economy reducing global economy growth. At worst, continuation of a strategy of FMD and maintaining the balance of financial terror will create a volatile and dystopian economic environment.
As a significant amount of US government debt is held outside the country, foreign investors will suffer significant losses, through depreciation of the US dollar. These investment losses will limit the financial flexibility of these countries, limiting their future growth.
The damage may lead to political instability.
In China, the blog-o-sphere has seen fierce criticism of the central government and its management of its reserves.
Foreign lenders may simply give up on the US, write off their existing investments (either explicitly or implicitly) and withhold further investment. This would trigger a major collapse of the US dollar and US government bond prices, triggering a different kind of financial crisis.
A policy of devaluation of the US dollar may trigger trade and currency wars. Many emerging markets have already implemented capital controls. These will be strengthened and supplemented by other measures such as trade sanctions.
There are already accusations of protectionism, currency manipulation and unfair competition. This is reminiscent of the trade wars of the 1930′s and will retard global growth.
US dollar devaluation is also destabilising for emerging markets and commodity prices. Low interest rates and the falling US dollar have encouraged investors to increase investments in emerging markets, offering better returns and higher growth prospects.
These flows have pushed up asset prices and currency values distorting economic activity in these countries.
As most commodities are priced and traded in US dollars, the lower value of the currency causes price rises. Low interest rates have encouraged speculation in, and stockpiling, of commodities.
Higher commodity prices and strong capital flows are fuelling inflation in emerging markets.
Central banks in these emerging countries have been forced to increase interest rates and restrict bank lending to reduce price pressures.
Given that emerging markets have been a key driver of economic growth globally, this risks truncating the recovery.
Any problems with the US dollar and unequivocal acceptance of America’s creditworthiness are amplified by its pre-eminent role in economic activity and financial markets.
There are limited alternatives to the dollar in global trade, especially given the problems of Japan and the Euro-Zone.
US government bonds are traditionally seen as a safe-haven as well as the preferred form of collateral used widely to secure borrowing and other obligations.
If the quality of US government bonds were to fall significantly, then this would affect the solvency of the banking system which has substantial holdings.
US government bonds are used as collateral to raise funding (in the “repo” market) and secure trading in financial instruments.
Falls in the value of US government bonds or a loss of confidence in their value as surety would lead initially to a global “margin call”, as the value of the collateral is marked down setting off a “dash for cash”. In an extreme case, where US governments bonds are not accepted as collateral, it would lead to a contraction of liquidity and financial activity generally.
Many of these problems are not new.
Politicians and policy makers have persistently refused to deal with the role of the US dollar as a reserve currency and large global financial imbalances for many years.
Recent proposals, such the use of Special Deposit Rights (“SDRs”) or introduction of Keynes’ Bancor, are impractical.
No Exit …
The US is in serious, perhaps irretrievable, financial trouble.
Peter Schiff president of Euro Pacific Capital, identified the state of the Union with characteristic bluntness:
“Our government doesn’t have enough spare cash to bail out a lemonade stand. Our standard of living must decline to reflect years of reckless consumption and the disintegration of our industrial base. Only by swallowing this tough medicine now will our sick economy ever recover.”
There is a lack of political or popular will to take the action necessary to even stabilise the position.
The role of US dollars and US government bonds in the financial system mean that the problems are likely to spread rapidly to engulf other nations.
As John Connally, US Treasury Secretary under President Nixon, belligerently observed: “Our dollar, but your problem.”
Minor symptoms, often increasing in frequency and severity, can provide a warning of a life threatening problem in a key organ, such as the heart.
Since 2007, the global financial markets have been providing warnings of an impending serious crisis. Private sector credit problems have spread to sovereign nations. Debt problems of smaller nations have flowed on to larger nations. The problems are gradually working their way to the issue of US debt.
Without rapid and decisive action, which seems to be unlikely, a major organ failure within the global economy is now inevitable.
The magnitude of the problem and its effects are so large, market participants would do well to heed Douglas Adams famous advice in The Hitchhikers Guide to the Galaxy:
Find dark glasses that go black in the case of a crisis and a towel to suck on.
Satyajit Das is the author of Extreme Money: The masters of the Universe and the Cult of Risk (2011) and Traders, Guns & Money: Known’s and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010)
This may very well be another case of wishful thinking. On the other hand – if these experts are right – there may be a light in the end of the tunnel for the people of Greece after all. This analysis is provided by three high-profiled London-professors and syndicated by http://www.eurointelligence.com. They conclude that a new government in Greece may be able to do what Papandreou never managed – create confidence in the nations economic recovery.
” If political forces miss this opportunity, they should be held individually and collectively accountable by the Greek population for the collapse of their financial sector, the destruction of productive forces, and the wealth reduction and re-distribution (from the poor to the rich) that inflation and a return to the Drachma would entail.”
Michael G Jacobides/Richard Portes/Dimitri Vayanos
“Time is running out fast for Greece. This is the last opportunity to use the crisis as an occasion to change the structure of the Greek economy and allow Greece to enter the growth path of which it is capable. A cross-party government should not have a narrow mandate on securing the restructuring deal; rather, it should seek consensus to engage in far-reaching reforms that no party alone would dare to initiate,” the three professors writes.
Well, the quote above is quite obvious…
However, the rest of the article, including arguments, suggestions and proposals, are interesting.
Anyone involved in the current “Greek Tragedy” should read this piece:
The dramatic political developments in Athens have focused international attention on Greece. Papandreou’s ill-fated initiative to hold a referendum was partly an effort to increase popular support for the bailout and reform package. A new interim government with a strong mandate to engage in far-reaching reforms could achieve exactly that.
That the biggest bailout plan in history has become unpopular among its supposed beneficiaries may seem paradoxical. But this is not only the result of a populist stance from the opposition and of lopsided coverage by the media.
It is also because the plan’s implementation, as run by the government and monitored by the Troika (IMF, EC, ECB), has focused disproportionately on fiscal targets, as opposed to structural reforms.
Over the last eighteen months, fiscal discipline has been limited to reducing capital and discretionary expenditure, cutting public-sector wages uniformly with no relationship to productivity, and raising tax rates to unsustainable levels.
We have not seen real progress on tackling tax evasion or on a far-reaching rationalization of the public administration.
While there have been some steps in the right direction, effecting real change has been slow. But deep institutional change is necessary for popular acceptance and hence success of debt relief, to avoid an eventual default and disastrous exit from the euro.
Greece must not waste this opportunity. Structural reforms, including the aggressive pursuit of tax offenders, would reduce the need for unpopular austerity measures.
More important, they would restore faith in the government by reducing the feeling of inequity and cutting waste, corruption and rents held by interest groups, whether in the private or public sector.
Creditors and the IMF should consider whether the proposed debt relief is sufficient for sustainability and growth.
The focus in Greece, however, should now change from fiscal targets and debt restructuring to operational restructuring.
Politically difficult but often economically evident decisions need to be made.
The debt overhang in Greece is the symptom and indeed consequence of the underlying inefficiencies of Greek public administration and of the current economic model. Without addressing the causes, any debt reprieve will surely be temporary.
Three weeks ago, we hosted a meeting at London Business School where former ministers and current MPs of both major parties met with senior policy makers, bankers, regulators and academics from Greece and abroad.
It is sobering to note that this was the first event of its kind, whether inside or outside Greece. Very positively, despite the range and diversity of the participants, a remarkable consensus emerged on the way forward.
We are thus convinced that a set of bold structural reforms can be supported by many parties, if only they take the courageous step of severing their own ties to practices which led to the onset of the problem.
Our report, informed by the meeting, focuses on four key areas: tax evasion, public administration, privatizations, and the financial sector.
Reform in the public administration is essential for the better functioning of the state and hence for the success of all other reforms.
The main directions of reform are to make the public administration more independent from the politicians, while also introducing greater accountability and incentives.
In the area of tax collection, for example, lack of accountability and incentives have generated a highly inefficient and corrupt system, which strongly resists change.
We propose to abolish the current tax collection offices – which would result in minimal loss of tax revenue – and move tax assessment and collection to a new independent authority.
This authority should have an arm’s-length relationship with the Ministry of Finance, and its staff should be hired on limited-term contracts and be evaluated based on Key Performance Indicators (KPIs).Independent Authorities with tight governance and accountability could be useful in other areas as well.
We propose three additional such authorities: one charged with the overall monitoring of structural reforms, one on healthcare procurement (a big expenditure item, where waste is rife), and one on corruption reduction. These authorities may help jump-start the change effort throughout the Greek government and its associated institutions.
All authorities should be staffed by competent technocrats and be accountable to the Parliament as opposed to the government.
An additional measure, which would bring technocratic skills, continuity and accountability, would be to reinstate Permanent Undersecretary of State, appointed for periods longer than a parliamentary term, accountable to Parliament.
We argue that the privatization process has been hastily designed: targets are unrealistic and the mandate does not, as it should, include the increase in value of the assets for ultimate disposal. The resources of the Privatization Fund must increase, and its mandate should be the increase of long-term value of formerly state-owned assets.
We propose that the programme’s focus shift from immediate sales to a scheme supported by a moderate amount of debt financing using the assets as collateral. This would provide an incentive to the government to increase the value of assets to be sold, while also avoiding fire-sales.
We further point to the risk of increased political interference in banks as an unwanted side-effect of their recapitalization process. Such interference has been common in the past, and has harmed the corporate governance and efficiency of the affected banks, as well as their sound supervision.
We suggest ways to promote good corporate governance during the recapitalization process, and we emphasize the need to strengthen financial supervision.
Time is running out fast for Greece. This is the last opportunity to use the crisis as an occasion to change the structure of the Greek economy and allow Greece to enter the growth path of which it is capable.
A cross-party government should not have a narrow mandate on securing the restructuring deal; rather, it should seek consensus to engage in far-reaching reforms that no party alone would dare to initiate.
Anything short of this will quickly lead to Greece being marginalized and expelled from the euro zone.
A caretaker government with a weak mandate, focusing on elections, will send the ultimate wrong message and risks losing the waning creditor and EU partner support.
It is thus critical to launch a concentrated effort now, and not just a caretaker government.
If political forces miss this opportunity, they should be held individually and collectively accountable by the Greek population for the collapse of their financial sector, the destruction of productive forces, and the wealth reduction and re-distribution (from the poor to the rich) that inflation and a return to the Drachma would entail.
0 AD–September 11, 2001: Everything fine September 11, 2001: September 11, 2001 September 12, 2001: A determined George W. Bush responds to the Sept. 11 attacks by swiftly promising two failed wars, a nearly 10-year manhunt for...
The financial crisis is currently well beyond the stage I regarded as a “worst-case-scenario” only two years ago.
The way out of the ‘debt trap’ is the same as the way out of recession: if the private sector won’t invest, the public sector must become investor of the last resort.
