Saturday, July 17, 2010

Fiscal Crisis Ahead?

The Congressional Budget Office is saying that the U.S. debt/GDP ratio will probably exceed 100% by 2012.

The Good News: two of the most popular doomsday scenarios, hyperinflation via the printing press and a national bankruptcy via outright default, are very unlikely.

The Bad News: the austerity measures that will be required to balance the budget, let alone to run fiscal surpluses if we intend to pay the debt down, will be very, very painful unless we enter a prolonged period of remarkably high economic growth. Under some austerity scenarios, many Americans will actually wish that the printing press and national bankruptcy were valid options.

The Worse News: the present value of the government's unfunded entitlement liabilities (Social Security, Medicare, Medicaid) is estimated to be north of $50 trillion. To fund these liabilities without distorting its balance sheet, the government would need to have $50-$70 trillion, today, sitting in a national pension fund getting market returns.

Interest Rates are Key

Here is perhaps the closest thing to a WMD that exists in macroeconomics:

s = (r-y/1+y) * d


s=the primary surplus. This is the fiscal surplus the government must run in order to keep debt/GDP constant

r=interest rate on the debt

y=growth rate of GDP

d=debt/GDP ratio

There are several interesting things that happen when a government has to satisfy this term, but here is one rule of thumb that may be important in coming years: when the debt/ratio exceeds 100%, the interest rates paid on the debt cannot exceed the rate of GDP growth or the country will fall deeper and deeper into debt, even if it runs balanced budgets. The primary surplus must be achieved to offset the debt spiral. If the government cannot or will not do this, the debt dynamics will become unstable.

A very nasty problem arises when deficits, debt/GDP, and interest rates all begin to move together. This is essentially what recently happened to Greece: Greece was running a high debt/GDP (about 115%), was in a period of poor economic growth, and then proceeded to report a larger-than-anticipated deficit. Greek borrowing costs on 2-year bonds had been less than 2% in late 2009, and shot up to almost 20% within six months.

On the other hand, Japan has been able to operate with a debt/GDP ratio of almost 200% (second only to Zimbabwe's, IIRC) without being attacked by bond vigilantes. There are several reasons why Japan has been able to do this, but certainly one has been the deflationary recession that the country has been mired in for two decades. If the Japanese economy were ever to recover and interest rates were to rise, the government would have very serious fiscal problems.

The speed and violence with which the bond market can punish irresponsible governments is what makes high debt/GDP ratios perilous. Once a debt-laden country is confronted with a spike in borrowing costs that takes the interest rate substantially higher than the rate of growth, it must somehow absorb the fiscal shock. The severity of the shock is based on the size of the differential between its current deficit spending situation and the primary surplus that it must now run to keep debt/GDP constant, plus anything that is needed to credibly pay down the debt, and the urgency with which these demands must be met.

For instance, let's use an extreme example and say that a country had a debt/GDP ratio of 150% and suffered an interest rate shock that raised its cost of borrowing to 7%. It has a GDP growth rate of 3%, and was running an 8% structural deficit when it received the shock.

The primary surplus necessary to stabilize debt/GDP is now almost 6% of GDP. In order the achieve this, the government must also cut the structural deficit completely. That's another 8% of GDP. Taking the two together, the government must run fiscal surpluses equal to 14% of GDP. If the market demands that the government also lower its debt/GDP ratio to, say 60% within 10 years, then there is even more pain coming because another large surplus will be necessary to pay the debt down.

This is why it is extremely important for heavily indebted countries to have credible central banks. If it appears that the central bank does not have the will to do what it takes to fight inflation, the market can demand higher nominal interest rates on the debt. As debt/GDP ratios get higher, market participants can look at a country and see that the central bank will have a very hard time raising rates beyond the country's GDP growth because doing so will generate fiscal shocks. Thus, the central bank's inflation-fighting credentials become questionable---there seems to be a ceiling on how far the central bank can go if push comes to shove in the future.

The impact this will have on the targeted country will depend on many factors, including the maturity of the debt: the United States is quite vulnerable to an interest rate shock because we finance much of our borrowing by issuing short-term debt.

The short-term nature of the debt is also why the printing press scenario, wherein the Treasury sells debt indirectly to the Federal Reserve, which buys the debt using printed money, would not work well, at least if attempted on a large scale, for the United States: borrowers would be able to punish the practice by demanding high nominal interest rates to compensate for the high inflation created by the nuclear money printing. The U.S. economy would suffer from high inflation and even higher borrowing costs.

The best scenario for a government that wanted to try to escape its debts by debasing its own currency through the printing press would go something like this:

1) Borrow a huge amount of money upfront, enough to prevent you having to run deficits and go back to the bond markets for many years

2) Have your central bank keep rates very low when you do this, and hope that borrowers are stupid enough to be anchored to these rates

3) Issue bonds that have the longest maturities possible---20 years would be ok, 30 years would be ideal. If possible, go a step beyond and see if the buyers will accept zero-coupon structures, wherein you don't even have to make regular interest payments and can say you will just pay off the entire thing in three decades

Outright default is not an option for the U.S. unless current laws are changed. Legally, our bondholders are at the top of the capital stack and the interest on the national debt will be paid before any other programs, including Social Security and national defense. The result of austerity will be a cutting of programs at the bottom of the stack first, then more difficult decisions as priorities must be made.

1 comment:

  1. That's awesome. You always make me feel so warm and fuzzy inside when you point out these uncomfortable truths!