Articles
Debt and Deficits: Let’s Get Real!
Last quarter we investigated the relationship between a country running high deficits or having high levels of debt and subsequent economic growth rates. Fortunately for investors, the link between economic growth and equity returns is a weak one. However, Standard & Poor’s recent lowering of its long-term outlook for the U.S. government’s fiscal health from “stable” to “negative” is a clear sign that the U.S. will need to get its fiscal house in order to maintain its top credit rating. Although the current U.S. deficit and debt levels do not comprise an imminent national threat, many economists believe that these levels are unsustainable in the long run. If not credibly dealt with by the government, they will rise to the level of a national threat over time, with potentially unforeseen economic consequences.
This quarter, we summarize the current state of US fiscal debt while investigating how this problem might play out economically. We also present suggestions for how the White House and Congress might effectively deal with the current deficit run rate and discuss some steps we are considering to better control risk in your portfolio.
The Sheer Size of the Deficit Problem
The following two charts illustrate the country’s deficit for fiscal year 2010 (last year) . The government took in $2.15 trillion but spent $3.46 trillion, leaving a deficit of $1.31 trillion that year. In the current fiscal year, the deficit will likely grow to $1.5 trillion, and President Obama’s proposed budget for 2012 (currently being debated in Congress among other proposed budget frameworks) is expected to be $1.65 trillion.
The size of these numbers is mind boggling. In terms of a percentage of the country’s total output (a more informative way to look at deficit spending), the 2010 deficit was 8.9% of GDP.
For perspective, over the last half century, US deficits have averaged around 2.5% of GDP. Furthermore, the national debt (which is the cumulative net total of all deficits and surpluses run over the years) has skyrocketed from 36% of GDP in 2007 to 62% for fiscal year 2010.
Economists explain that there are two main components to the current US deficit problem. Much of the current high level of deficit spending can be traced to the financial crisis of 2008-2009. Prior to that time, the deficit was just $161 billion (about a tenth of what it is now). During the crisis, tax revenues fell and economic stabilizers such as unemployment insurance kicked in. Combining this with a heavy dose of Keynesian stimulus produced our current massive deficits. The economic recovery appears to be in full swing and tax revenues are expected to rise substantially over the next few years -- reducing the deficit, but not enough to balance the federal budget. However, over the next couple of decades the deficit should increase again because we have a structural problem – primarily due to the rising costs associated with healthcare (Medicare and Medicaid), Social Security and the aging of the baby-boomer generation. Fixing this structural deficit has proven extremely difficult as our political process does not readily address problems before they blossom into a full scale crisis. As a case in point, the recent acrimonious political debate around spending cuts of less than $40 billion was an exercise that was mostly irrelevant to fixing our long-term budgetary problems.
The Possible Face of a Fiscal Crisis
What might our structural deficits lead to? The Congressional Budget Office (CBO) has suggested one set of outcomes in a paper last summer entitled “Federal Debt and the Risk of a Fiscal Crisis” (downloadable at www.cbo.gov). When the US runs a deficit, it simply borrows money by selling treasury bills (debt) to investors (domestic and foreign). China is now the single largest U.S. creditor. Until now, bond investors have given the U.S. the benefit of the doubt, primarily because we are perceived as the biggest economy, the dollar remains the world’s reserve currency, and generally, we are viewed as a safe and politically stable place to put money.
If investors in the bond markets were to conclude that U.S. borrowing was outstripping the county’s ability to repay (and Standard & Poors recent action was a step in this direction), those investors might stop purchasing treasuries. At that point, the government’s only choice would be to raise interest rates to whatever level to bring buyers back into the picture. The rise in interest rates required might be substantial, causing the deficit to balloon and accelerate a negative deficit spiral. If this process were to happen gradually, then political leaders might have enough time to get serious about fixing the problem. However panics, which are based largely on investor psychology, don’t tend to happen gradually. Instead, they tend to happen with sickening speed. We have only to look at the recent financial crisis for an example.
If such a fiscal crisis were to play out, the CBO has indicated that alternatives would be limited and unattractive. They might include high inflation (if the government chose to print more money) or large tax hikes and/or deep cuts in Social Security and Medicare, either of which could force the economy into another serious recession. , Essentially, the government’s credit cards would be maxed out, and there would be no option to spend additional money in response to such a crisis.
The Path to a Real Solution
Fortunately, there is time to address this problem. More importantly, there are now serious budget reform proposals on the table, including a recently released plan by Wisconsin Rep. Paul Ryan, and a plan released last December by the National Commission on Fiscal Responsibility and Reform (chaired by former Republican Sen. Alan Simpson and former White House Chief of Staff Erskine Bowles, a Democrat – a.k.a. the Simpson-Bowles plan). Although imperfect, these plans break ground by recognizing the magnitude of the U.S. structural deficit and suggesting real solutions. This sets the stage for honest political dialogue and invites Congress and the White House to put politics aside and forge a compromise. It will be important for the government to publicly commit to a credible plan. Simply announcing a negotiated settlement should have a positive economic effect by signaling that the U.S. is serious about reducing its debt level over time.
Since politics will be unavoidable, getting to a proper solution will likely include all of the following:
- Multi-dimensional approach:
A credible solution cannot be formed by going after one element because special interests can likely defeat reform. A multi-dimension approach allows political majorities to coalesce around a solution, while also providing political cover to politicians.
- Gradual implementation:
Because of the size of the deficit problem, any credible solution will need to be implemented gradually over time, possible decades.
- Fairness:
A credible solution will need to be seen as a “fair” shared sacrifice by all.
Our political process has never dealt well with long-term problems that develop gradually over time. Although history does not offer strong evidence that current deficits predict future bond or equity returns in a country’s financial markets, our preference would be to not to test this. Although we face serious challenges, it is not unreasonable to cite with some hope, as Winston Churchill observed, that “Americans will always do the right thing – after they have exhausted all the alternatives.”
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*Figures used in this section are based on Congressional Budget Office numbers and are from a series of lecture notes prepared by Joshua Bolten, who served as director of the Office of Management and Budget from 2003 to 2006 as well as White House chief of staff for the last three years of the Bush administration.
