Official Congressional budget estimates understate the peril of rising debt, Fed chair Ben Bernanke told the Budget Committee on Capitol Hill today.Warning that our nations fiscal health has deteriorated appreciably since the onset of the financial crisis and the recession, Bernanke called upon lawmakers to confront the long term fiscal challenges sooner rather than later. If lawmakers dont confront them, theyll find themselves confronted by them.From Bernankes prepared remarks:By definition, the unsustainable trajectories of deficits and debt that the CBO outlines cannot actually happen, because creditors would never be willing to lend to a government with debt, relative to national income, that is rising without limit. One way or the other, fiscal adjustments sufficient to stabilize the federal budget must occur at some point. The question is whether these adjustments will take place through a careful and deliberative process that weighs priorities and gives people adequate time to adjust to changes in government programs or tax policies, or whether the needed fiscal adjustments will come as a rapid and painful response to a looming or actual fiscal crisis.Bernanke explained that the Congressional Budget Offices calculations miss an important reality. As the governments debt and deficits rise, the economy will slow down—an effect not taken into account by the CBO. So, for instance, when the CBO says that federal spending for health-care programs will roughly double as a percentage of GDP in the next 25 years, it is probably being too optimistic. If debt keeps, rising, GDP will be much lower than the CBO estimates—which will mean that health care spending will be a much larger percentage of the overall economy.Heres Bernanke on the effect of rising debt:Sustained high rates of government borrowing would both drain funds away from private investment and increase our debt to foreigners, with adverse long-run effects on U.S. output, incomes, and standards of living. Moreover, diminishing investor confidence that deficits will be brought under control would ultimately lead to sharply rising interest rates on government debt and, potentially, to broader financial turmoil. In a vicious circle, high and rising interest rates would cause debt-service payments on the federal debt to grow even faster, resulting in further increases in the debt-to-GDP ratio and making fiscal adjustment all the more difficult.
Archive for the ‘Articles on Debt’ Category
The conventional wisdom that nearly infinite demand exists for U.S. Treasury debt is flawed and especially dangerous at a time of record U.S. sovereign debt issuance.
The recently released Federal Reserve Flow of Funds report for all of 2011 reveals that Federal Reserve purchases of Treasury debt mask reduced demand for U.S. sovereign obligations. Last year the Fed purchased a stunning 61% of the total net Treasury issuance, up from negligible amounts prior to the 2008 financial crisis. This not only creates the false appearance of limitless demand for U.S. debt but also blunts any sense of urgency to reduce supersized budget deficits.
Still, the outdated notion of never-ending buyers for U.S. debt is perpetuated by many. For instance, in recent testimony before the Senate Budget Committee, former Federal Reserve Board Vice Chairman Alan Blinder said, “If you look at the markets, they’re practically falling over themselves to lend money to the federal government.” Sadly, that’s no longer accurate.
It is true that the U.S. government has never been more dependent on financial markets to pay its bills. The net issuance of Treasury securities is now a whopping 8.6% of gross domestic product (GDP) on average per annum—more than double its pre-crisis historical peak. The net issuance of Treasury securities to cover budget deficits has typically been a mere 0.6% to 3.9% of GDP on average for each decade dating back to the 1950s.
But in recent years foreigners and the U.S. private sector have grown less willing to fund the U.S. government. As the nearby chart shows, foreign purchases of U.S. Treasury debt plunged to 1.9% of GDP in 2011 from nearly 6% of GDP in 2009. Similarly, the U.S. private sector—namely banks, mutual funds, corporations and individuals—have reduced their purchases of U.S. government debt to a scant 0.9% of GDP in 2011 from a peak of more than 6% in 2009.
The Fed is in effect subsidizing U.S. government spending and borrowing via expansion of its balance sheet and massive purchases of Treasury bonds. This keeps Treasury interest rates abnormally low, camouflaging the true size of the budget deficit. Similarly, the Fed is providing preferential credit to the U.S. government and covering a rapidly widening gap between Treasury’s need to borrow and a more limited willingness among market participants to supply Treasury with credit.
“THIS brutal lack of confidence” is how the chief executive of one of Europe’s biggest banks describes the situation facing his firm and its peers. The catalogue of troubles afflicting the institution (call it Bank X, so as not to punish it for its candour) shows how worrying the outlook has become for big banks, and hence for the real economy.
A bank-funding crisis that started on Europe’s periphery with worries over Greek, Irish and Spanish banks has now infected the core of the West’s financial system. The governments of France and Belgium said this week they would stand behind the debts of Dexia, a perennially troubled lender, while also engineering a break-up of the bank. Across the Atlantic shares in American banks whipsawed on worries about a Greek default and rumours of policy breakthroughs.
For Bank X, the most pressing issue is a freezing of funding markets as investors ponder the potential impact of losses that banks may take on their holdings of euro-zone government bonds. American money-market funds have almost completely withdrawn dollar funding from European banks over the past few months. This is forcing them to sell dollar assets. Some of these transactions will do no harm to the sellers: there are buyers at reasonable prices. But Bank X is also cutting traditional banking activities denominated in dollars. Some of these include critical functions such as trade finance.
A bigger worry is a freeze in euro funding. Institutional bondholders such as pension funds and insurers have refused to buy unsecured European bank debt in any meaningful quantities since early summer, and balk entirely at durations longer than two years. “There are a lot of banks that would be willing to give away assets if they could, just so they don’t have to fund them,” says one investment banker. Bank X is trimming euro assets, accelerating plans to cut the size of its balance-sheet. Other lenders are doing the same. That risks driving down asset prices, forcing lots of banks to mark down equivalent assets and erode capital. Deleveraging also means a reduction in lending activity.
Equity investors are running scared. The shares of European banks have fallen by 40% over the past three months.
Financial turmoil in Europe is no longer a problem of small, peripheral economies like Greece. What’s under way right now is a full-scale market run on the much larger economies of Spain and Italy. At this point countries in crisis account for about a third of the euro area’s G.D.P., so the common European currency itself is under existential threat.
And all indications are that European leaders are unwilling even to acknowledge the nature of that threat, let alone deal with it effectively.
Here’s a quick and fascinating breakdown by total amount held and percentage of total U.S. debt, according to Business Insider:
Hong Kong: $121.9 billion (0.9 percent)
Caribbean banking centers: $148.3 (1 percent)
Taiwan: $153.4 billion (1.1 percent)
Brazil: $211.4 billion (1.5 percent)
Oil exporting countries: $229.8 billion (1.6 percent)
Mutual funds: $300.5 billion (2 percent)
Commercial banks: $301.8 billion (2.1 percent)
State, local and federal retirement funds: $320.9 billion (2.2 percent)
Money market mutual funds: $337.7 billion (2.4 percent)
United Kingdom: $346.5 billion (2.4 percent)
Private pension funds: $504.7 billion (3.5 percent)
State and local governments: $506.1 billion (3.5 percent)
Japan: $912.4 billion (6.4 percent)
U.S. households: $959.4 billion (6.6 percent)
China: $1.16 trillion (8 percent)
The U.S. Treasury: $1.63 trillion (11.3 percent)
Social Security trust fund: $2.67 trillion (19 percent)
So America owes foreigners about $4.5 trillion in debt. But America owes America $9.8 trillion.
Thank you, Standard Poor’s.
The rating agency’s warning about the possibility it may downgrade the credit rating of the United States is a welcome wake-up call.
Another one. A few weeks back, Pimco, the world’s biggest bond fund, said it was eliminating its holdings of U.S. government debt.
Then the International Monetary Fund lectured the United States in a tone that sounded more suited to a teetering Third World country than the fund’s largest shareholder. A “credible strategy” to stabilize the U.S. national debt is “urgently needed,” the IMF warned.
Now comes Standard Poor’s to lower its assessment of U.S. Treasury securities from “stable” to “negative” — meaning at least a one-in-three chance the U.S. debt rating could be lowered within two years.
It cited a “material risk” that there could be no agreement on how to deal with medium- and long-term budget issues by 2013. If nothing happens by then, “this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns,” SP said.
In other words, our greatest intangible asset — the fact that the United States is viewed as the world’s safest investment — could evaporate. Pffft. Interest rates would rise. The economy would tank. The higher cost of servicing the debt and the accompanying collapse of tax revenue would make it that much harder to escape this decidedly unvirtuous circle.
Truth is, you don’t have to be in the ratings business to see how difficult it will be for the United States to avoid this fate. The dysfunctionality of the political system is evident to any casual newspaper reader.
Deficits and the Printing Press (Somewhat Wonkish)
Right now, deficits don’t matter — a point borne out by all the evidence. But there’s a school of thought — the modern monetary theory people — who say that deficits never matter, as long as you have your own currency.
I wish I could agree with that view — and it’s not a fight I especially want, since the clear and present policy danger is from the deficit peacocks of the right. But for the record, it’s just not right.
The key thing to remember is that current conditions — lots of excess capacity in the economy, and a liquidity trap in which short-term government debt carries a roughly zero interest rate — won’t always prevail. As long as those conditions DO prevail, it doesn’t matter how much the Fed increases the monetary base, and it therefore doesn’t matter how much of the deficit is monetized. But this too shall pass, and when it does, things will be very different.
So suppose that we eventually go back to a situation in which interest rates are positive, so that monetary base and T-bills are once again imperfect substitutes; also, we’re close enough to full employment that rapid economic expansion will once again lead to inflation. The last time we were in that situation, the monetary base was around $800 billion.
Suppose, now, that we were to find ourselves back in that situation with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.
So then what? The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So?