Full Faith and Overextended Credit

By Andrew G. BiggsMonday, March 30, 2009

Filed under: Economic Policy, World Watch

The federal government’s long-term budget could bring about a financial crisis that surpasses the current one. Who do you think is more reliable—the full faith and credit of the United States backing up Treasury bonds, or the McDonald’s Corporation, backed only by “billions and billions served”? By some market measures it is the latter, and for good reason. The price of credit defaults swaps guaranteeing payment on 10-year Treasury bonds has risen by 1000 percent since December 2007, with an implied 12 percent probability of default on government debt over the next decade, according to data from Credit Market Analysis. In the view of the markets, this makes U.S. government bonds a more risky proposition than debt issued by McDonald’s. Why? Trillion dollar annual short-term budget deficits due to the recession and financial crisis will soon merge with even larger deficits generated by government entitlement programs like Social Security, Medicare, and Medicaid. While a large short-term deficit to stimulate the economy can be absorbed, large deficits running for decades simply cannot be. Over the next decade, the combined costs of the big three entitlement programs will rise by 2.1 percent of gross domestic product; over the following decade, entitlement costs will increase by an additional 3.1 percent of GDP, with costs continuing to grow thereafter. The quip that the U.S. government will soon be nothing more than a pension plan with an Army has more truth than one would think. And the purchaser of a 30-year Treasury bond would be wise to bear this fact in mind. Without significant retrenching, the federal government’s long-term budget capacity is not simply uncertain. It is certain to fail, bringing about a second financial crisis that could rival or surpass the current one. Credit rating agencies such as Moody’s and Standard & Poor’s have warned that ratings on U.S. sovereign debt could be downgraded if debt continues to rise. If sovereign debt ratings were driven entirely by fiscal balances, as Standard & Poor’s says in the case over the long run, the United States would lose its AAA rating in the year 2017—coincidentally, the year in which Social Security first begins running deficits. Five years later, Treasury bonds would decline to an A rating, around where Greece is today. By the early 2030s Treasury bonds would be speculative grade—junk. It is almost trite to say that these trends are “unsustainable.” But what does that mean—what could actually happen if we continue to do nothing in the face of steeply rising costs of programs for the elderly? If government budget deficits were financed out of domestic saving, the likely outcome would simply be a slow economic decline. Americans’ savings would finance current government consumption rather than future private sector investment, thereby lowering productivity, wages, and economic growth while raising unemployment and interest rates. And yet, this may be a better case scenario than reality. The danger of a hard landing lies in the fact that federal deficits are financed not through domestic saving but by the willingness of foreigners to lend us money. The current account deficit of 4.7 percent of GDP represents the difference between domestic investment and the domestic saving available to finance it. In other words, it is the net amount that, as a nation, we are borrowing from abroad. Should federal deficits rise as projected and saving remain unchanged, a current account deficit double today’s level is easily imaginable. What could trigger a crisis is the fact that almost all this borrowing from abroad is denominated in dollars, a luxury almost unique to the United States as an international reserve currency. The upshot of this is that any devaluation of the dollar is a comparable default on debt to foreign borrowers. To give the scale of things, a 2005 Congressional Research Service study said that a devaluation ranging from 10 to 56 percent would return the current account to sustainable levels, on par with currency declines during the 1997–1998 Asian Financial Crisis. Now, some will argue that markets have actually given a vote of confidence to the United States, with Treasury interest rates at record lows and the dollar rising significantly over the past year. Yet these steps are largely the result of foreign governments and affiliated sovereign wealth funds propping up the dollar, knowing that any devaluation would hit their existing dollar holdings. In other words, foreign lenders are for now doubling down their bets on U.S. government. Yet there is clear evidence that some are getting worried. Just recently, China’s premier Wen Jiabao said, “We have lent a huge amount of money to the U.S., so of course we are concerned about the safety of our assets. Frankly speaking, I do have some worries.” Wen called on the U.S. to “maintain its credibility, honor its commitments and guarantee the security of Chinese assets.” Likely the only thing keeping the Chinese in the game is that they would suffer more than anyone if the dollar depreciated, as they hold over $3 trillion in dollar-denominated securities. But the Chinese are not putting all their eggs in one basket: they’ve also talked in recent days of setting up a new reserve currency managed by the International Monetary Fund as an alternative to the dollar. This should worry Americans, since should any large investor choose to flee the dollar, others may fear being the last one standing when the music stops. But what would happen then? The dollar would drop precipitously, meaning that businesses and consumers would face sharply higher prices for imports. With less foreign capital flowing into the country, interest rates could be expected to increase significantly, raising mortgage rates for homeowners, lowering the stock and bond markets, and reducing investment by businesses. Rising interest rates could trigger defaults on mortgages and other loans, spreading throughout the economy. While a dollar decline would be good for the export sector of the economy, it would also imply large economic dislocations as labor and capital devoted to domestic production shift to export-oriented industries. All told, the costs to the fragile U.S. economy could be large. How likely is this scenario to occur? In the short term, not very. But as University of California economist Sebastian Edwards has shown, the higher the current account deficit the more likely it is for the country to experience a hard landing when that day of reckoning occurs. While short-term deficits are justified if tied to genuinely stimulative fiscal policy, long-term deficits must be put under control. While the preferable way to do so is through spending reductions rather than tax increases, the broader point is that Americans and their elected representatives must come to terms with the mismatch between what they desire from government programs and how much they are willing to pay in taxes to finance those programs. Addressing the U.S. fiscal gap will require significant changes to Americans’ expectations regarding government taxes and services, but the necessary changes—and the chance of an economic crisis—will only grow if action is delayed. http://74.125.153.132/search?q=cache:G27Es4cz4foJ:www.american.com/archive/2009/march -2009/full-faith-and-overextended-credit+full-faith-and-overextended-credit&cd=3&hl=en&ct=clnk&gl=sg