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News : International Last Updated: Jul 8, 2009 - 7:26:50 AM


America's long-awaited fiscal train wreck is now underway
By Finfacts Team
Jul 7, 2009 - 5:36:49 AM

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US public debt was 41% of GDP at the end of fiscal year 2008, a little above the 40-year average of 36%. The Congressional Budget Office (CBO) projects that in the next few years, deficits will be extraordinarily high by historical standards - - almost 12% of GDP in fiscal year 2009 and almost 8% in fiscal year 2010. As a result, debt will grow to 60% of GDP by the end of fiscal year 2010. After peaking at 113% in 1945, federal debt held by the public declined as a percentage of GDP to its lowest level in the post-World War II era, 24% in 1974. Similarly, when federal debt increased in the 1980s, its rise was followed by declining deficits from 1993 to 1997 and surpluses from 1998 through 2001. The systematic widening of budget shortfalls projected under CBO’s long-term scenarios has never been observed in US history.

America's long-awaited fiscal train wreck is now underway, according to Richard Berner, a Managing Director and Co-Head of Global Economics, at US investment bank Morgan Stanley. He says depending on policy actions taken now and over the next few years, US federal deficits will likely average as much as 6% of GDP through 2019, contributing to a jump in debt held by the public to as high as 82% of GDP by then - a doubling over the next decade.  Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP. Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth. Berner says soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service.  Not only will those factors steadily lower our standard of living, but they will imperil economic and financial stability.

The fiscal impact of the current crisis will result in the debt of the advanced economies growing to at least 114% of GDP (gross domestic product) in 2014, more than triple the 35% of the main emerging economies including China, the International Monetary Fund forecasts.

The IMF said in a June report that the debt won’t be repaid as quickly as after World War II, which ended with debt topping 250% of GDP in the UK, 200% in Japan and 100%t in the US.

In wartime, the IMF said governments exercised “comprehensive control” over the economy and citizens felt a “moral duty” to buy war bonds.

Rich nations’ debt constituted 78% of GDP in 2006, the year before the financial crisis, while emerging- markets debt has fallen from 38%, the IMF says.

America's savings rate fell below zero for a period in 2005, while China with a controlled currency, fed the demands of US consumers and enabled it to build up holdings of US Treasury bonds to about $860 billion, including the holdings of Hong Kong, with Japan second at about $690 billion.

Now China is increasingly using its renminbi for foreign payments.

The New York Times says today that when the renminbi is fully convertible - - more than a few years away, but perhaps less than a few decades - - it will most likely signal a huge shift in global economic power, and a day of reckoning of sorts not just for China but also for the United States, which will no longer be able to run up huge debt without economic consequences.

The Times says that despite the slow, cautious pace at which China is moving, few experts on Chinese monetary policy doubt that the long-term direction of policy is toward strengthening the renminbi as an alternative to industrialized countries’ currencies.

“To many minds here in China the US dollar’s time is almost up,”wrote Stephen Green, an economist in the Shanghai offices of Standard Chartered, in a research note last Thursday. “The euro zone suffers from political paralysis and a too-conservative central bank, while two decades of economic stagnation and a shrinking population do the yen no favors.”

The long-term health of the US economy is crucial for countries like Ireland and longtime warnings of an unsustainable fiscal policy are no longer a niche preserve.

In 1987, Peter Peterson, then chairman of the Blackstone Group finance house, warned in a famous article The Morning After, in the Atlantic Monthly, October 1987 - -  the month when the Dow plunged 22% on the so-called Black Monday, Oct 19, 1987: "The truth is that the most astonishing success of Reaganomics has been the myth of our own invincibility. This myth rests upon an enduring, bipartisan principle of American political life which in the 1980s has become gospel: never admit the possibility of unpleasantness--especially when it appears inevitable.

If you allow for unpleasantness, the mechanics of our trade deficit cease to be confusing. America runs a deficit because it buys more than it produces. By systematically discouraging measures that would boost its anemic net savings rate, the United States has acquired a structural deficit economy, meaning that at no stage of the business cycle can we generate the amount of savings necessary for minimally adequate investment. In 1986, in fact, nearly two thirds of our net investment in housing and in business plant and equipment would not have occurred without dollars saved by foreigners. (This level of investment was, to be sure, very low by historical standards, but without the capital inflows that accompanied our trade deficit in 1986 it would have been at the rock-bottom level of a severe recession year--lower, in fact, than during the recession years of 1980, 1975, 1970, and 1958.)"

Last week, the bipartisan Congressional Budget Office (CBO) set out what Richard Berner terms ever-more depressing fiscal scenarios in its annual Long Term Budget Outlook. 

He says the problem, ironically, is that the day of reckoning hasn't come.  This has seriously undermined doomsayers' credibility and, more importantly, it has made the electorate and elected officials complacent about the threat from unsustainable fiscal policies. Former Vice President Cheney had said that President Reagan showed that "deficits don't matter."

The Morgan Stanley view is that the last five years have brought the ever-distant US fiscal crisis rapidly forward.  Some of the deterioration is obviously cyclical: Courtesy of the financial crisis and recession, aggressive fiscal stimulus, and ongoing military outlays, the federal deficit has ballooned to US$1.8 trillion or 13% of GDP in fiscal 2009.  But the bulk of the threat is structural: MS says the fiscal stimulus package included spending increases with minimal bang for the buck, leaving more debt than growth.  In its FY2010 budget, the administration proposes to extend several tax cuts enacted in 2001 and 2003, provide relief from the alternative minimum tax, and increase both mandatory and discretionary spending compared with current law.  Most important, by 2019 the full force of rising entitlement outlays and debt service will begin to hit the budget.  No rosy growth scenario will provide sufficient resources to meet all the claims on future federal revenue.  And while tax hikes or a broader tax base will likely be part of the solution, the real cure is to curb the growth of entitlement spending.

Against that backdrop, voters and politicians are nervous: Two recent polls suggest that Americans are more worried about deficits than healthcare by a ratio of 2:1. But despite voters' deficit anxiety, near-term action to reduce long-term deficits seems highly unlikely for two reasons.  First, no one wants to endanger a still-fragile economy by raising revenues or cutting spending until they are sure of economic recovery. Second, while there is no shortage of fiscal scolds inside the Beltway (metaphor for Washington DC), the political will to change popular entitlement programs is still absent. 

Healthcare the main culprit:  MS says analysis of those programs makes it easy to see why. The rise in federal healthcare outlays under Medicare and Medicaid is the main long-term factor boosting deficits.  These popular programs create a safety net for the elderly and disadvantaged that has been a band-aid for America's flawed system of financing healthcare. 

The base is already large: In 2010, some 100 million Americans will be enrolled in Medicare, Medicaid and SCHIP (the State Children's Health Insurance Program), and outlays amount to 5% of GDP.  Longer term, Medicare enrollment will rise significantly as the population ages. More importantly, future per capita cost growth for both programs is well in excess of per capita GDP, meaning that outlays for these three programs will double to 10% of GDP by 2035 and nearly double again by 2080. Translated into budget outcomes, according to CBO, these programs will account for virtually all of the likely growth in primary federal spending - total spending less interest on debt held by the public - in relation to GDP, and thus all the likely expansion of the deficit and debt.  In contrast, social security cost increases will play a relatively minor supporting role.

MS's Richard Berner says there is no lack of options to alter the unsustainable path for Medicare and Medicaid outlays.  At the end of 2008, for example, CBO analyzed 115 of them, any handful of which could significantly slow the growth of spending or find the means to pay for it.  To name two: Raising the age of eligibility for Medicare by two years (to 67) starting in 2014 would save US$85 billion by 2019.  Limiting the tax exclusion for employment-based health insurance to amounts below the 75th percentile for such premiums and doing the same for health-insurance deductibles for the self employed would net US$452 billion over 2009-18.  He says the second option would raise additional revenue, but would not address burgeoning entitlement spending.  Yet the prospects for actually adopting any of these measures are dim.  There is no serious discussion in Washington of, or appetite for, curbing eligibility for federal health programs.  Nor, more important, is there the will to rein in the growth of per capita costs. 

Meanwhile, Berner says the current healthcare reform effort aims at the apparently conflicting goals of curbing costs and increasing access and quality.  In the long run, those goals may turn out to be complementary. But in the near term, politics likely dictate that increasing access will take priority over cutting costs.  And increasing access to today's health options will be expensive.  For example, preliminary CBO estimates of Subtitles A through D of Title I of the proposed "Affordable Health Choices Act" indicate that expanding access to health insurance for 39 million Americans by granting subsidies will cost US$1 trillion over the next decade.  Proposals to cut costs may yet emerge to fulfill the president's requirement that any healthcare reform be deficit-neutral. He says political agreement will be hard to come by; witness the storm of opposition to a "public insurance plan" when the outline for any such plan is still vague.  Thus, in the short-to-intermediate term, increasing access first means bigger deficits are likely. Berner says pundits are describing the president's ability to deliver a healthcare reform package that improves Americans' lives and contains costs as a defining moment for his leadership. 

"As I see it, it is also a bellwether for our willingness to tackle our fiscal challenges," Richard Berner says.

Deficit disorder:  Berner says America's now chronically rising deficit will almost surely expand debt beyond the appetite of global investors to hold it without significant concessions in the form of higher interest rates or a big enough decline in the dollar to make it look cheap, or both.  Soaring deficits and debt imply higher real interest rates. That hasn't happened in the current recession, of course, because of the weakness in private credit demands resulting from the collapse of corporate external financing needs and the deleveraging of the American consumer.  But rates likely will rise significantly when recovery begins to lift private credit demands. Standard estimates suggest that a 20-point sustained increase in debt/GDP - what we will experience between 2008 and 2010 - will boost real rates by 70-110 basis points (bp). 

Richard Berner says many question whether rising deficits and debt will have significant longer-term market consequences. Optimists cite the example of Japan, where massive deficits boosted government debt to 160% of GDP with apparently no effect on interest rates.  The comparison is not apt for two reasons.  First, Japan's lost deflationary decade pulled down nominal yields, but there were serious consequences for real yields.  Real 10-year JGB yields averaged 1.7% over that period, much higher than the 30bp of annual real growth experienced in Japan. Morgan Stanley's Robert Feldman points out that this positive gap between real rates and real growth clearly boosted Japan's deficits and debt unsustainably.  Second, Japan's massive current account surplus, which averaged 3% of GDP, means that Japan has no need to rely on foreign saving inflows. 

In contrast, America's budget deficits are worsening the persistent internal and external saving-investment imbalances. The chronic external deficit has shrunk to 2.9% of GDP in recession, but rebounding oil prices and imports suggest it will grow in recovery.  Even a coming sea change in consumer behavior and the incipient rise in our personal saving rate to 7-10% of disposable income (5-8% of GDP) won't be enough to offset federal dissaving.  State and local governments are awash in red ink, now more than 1% of GDP and growing.  Consequently, America will still need sizeable inflows of saving from abroad to finance federal deficits. 

Fiscal credibility deteriorating:  Berner says some are concerned that America's reckless fiscal policy will trigger a downgrade of the US sovereign debt rating, making the financing of burgeoning deficits more difficult. While worries that the US will default on its debt are illogical, global investors and officials are concerned about the credibility and the sustainability of US fiscal policies. 

"They fear that we will adopt policies that will undermine the dollar and the domestic value of dollar-denominated assets through a combination of risk premiums and inflation," Richard Berner concludes. "I worry about that too, although such policies probably would be accidental rather than deliberate.  As a result, interest rates may have to rise significantly to compensate investors, including reserve portfolio managers and sovereign wealth funds, for such dangers.  While the dollar will for now retain its reserve-currency status, such concerns put it at risk," he adds.

The FT's Martin Wolf commented last January that "the Japanese policymakers who told everyone the US was in danger of falling into a prolonged period of economic weakness were right. To understand why this is true, you need to read a brilliant book by Richard Koo of the Nomura Research Institute -  - The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession. In this, he explains how the combination of falling asset prices with high indebtedness forces the private sector to stop borrowing and pay down debt. The government then inevitably emerges as borrower and spender of last resort. Because the Japanese government knew this at least, the country suffered a prolonged recession rather than a slump.

It has long been argued that the US could not suffer like Japan. This is wrong. It is true the US has three advantages over Japan: the destruction of wealth in the collapse of the Japanese bubble was three times gross domestic product, while US losses will surely be far smaller; US non-financial companies do not appear grossly overindebted; and, despite efforts by opponents of marking assets to market, recognition of losses has come far sooner.

In other respects, however, the US is still more vulnerable than Japan, after its recent debt binge. The rest of the world’s economy was big and dynamic enough to sustain Japan’s exports, but the whole world is now in recession; moreover, the US is both a deficit and a debtor country. Mrs Watanabe trusts her government. How far does she trust Uncle Sam? How far, indeed, does Hu Jintao?

Any complacency about US recovery prospects is perilous. Moreover, the fact that the US has a structural current account deficit has bearing on the second point Mr Obama’s advisers must make. Fiscal stimulus is a necessary palliative for a debt-encumbered economy afflicted by falling asset prices. But the likely longevity and scale of the needed fiscal deficits are quite scary."

Martin Wolf said that at the end of the Napoleonic wars, the UK had a ratio of public debt to GDP of 270%. This was brought down over a century: growth, the gold standard and the commitment to balanced budgets did the trick. The question is how much debt the US (or UK) can accumulate now? "My guess is that the US could hope to run large deficits for years if these were used to finance the creation of high-quality assets. But the policy could not safely endure throughout a two-term presidency.

Yet, contrary to widespread belief in the US, a swift return to small fiscal deficits, high employment and rapid growth will not occur spontaneously. It is necessary to make structural changes in the US and world economies first," he added.

SEE: Record debts for the former world's biggest saver; Japan heading for debt level as much as 300% of GDP by 2020

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