US fiscal deterioration is very pronounced. Deficits of the current size at the top of the economic cycle are very concerning.
Weak revenues and rising mandatory federal spending are the key reasons for the fiscal squeeze.
A crisis from mounting fiscal red ink has been averted by falling interest rates stopping public debt from spiralling out of control.
The fiscal position is now a clear hostage to economic fortune. A downturn will bring even more borrowing, from the public or from the Federal Reserve, which could easily test markets’ patience.
All in all, anxiety over this fiscal black hole is amply justified.
Continue reading the article below for more information.
Records tumbling – fiscal ones too
This is a time of breaking records, everywhere. Three have recently been broken in the US. This is now the longest US economic expansion seen. We have also just seen the lowest long duration bond yields in the post-war period. And this bull market in stocks has also broken the record on length.
Let us add some breached fiscal landmarks, or which look likely to be. This is the first swollen peace-time budget deficit (4.6% of GDP expected for 2019) at an unemployment rate so low (3.7%)1. Usually, at the top of the economic cycle, budgets are in good shape, but this time is different. Or how about the likelihood that in the not too distant future, the 1946 record of the ratio of Federal debt to GDP (106%) will be broken? And a third: how is it that record deficits and huge treasury bond supply over the past decade ($9 trillion over the past decade) have coincided with such a large rise in their price in the form of falling bond yields? As we see it, these fiscal breaches are storing up trouble ahead. Below, we explain why.
Marked fiscal deterioration
Budget deficits of the type currently being racked up are a ‘first’. They are typically only seen in recessions like the mid 1970’s, early 1980s, early 1990’s and 2008-9, as the chart below shows.
At these times, high deficits come from weaker tax revenues and higher spending levels reflecting higher unemployment. Now, with very low unemployment after a decade-long economic expansion, large deficits show things gone badly awry. On current tax and spending commitments, deficits are likely to remain very high as far as the eye can see (see chart above). This is nothing short of a fiscal black hole.
Of course, rapidly rising public debt, as shown in the chart below, is just the corollary of these large deficits. The numbers as shown in the chart below only cover Federal Debt held by the public (which includes the Federal Reserve). If we widened the definition of government debt to the ‘general government debt’ definition that the IMF uses, US public debt is already above 100% of GDP (Fiscal Monitor, IMF April 2019). With deficits like these, even the CBO’s narrower measure of government debt will rise to exceed GDP. The record to watch is the all-time high in the immediate 2nd World War period of 106% (1946). This is scheduled to be broken by the early 2030s.
Where is the red ink coming from?
There is no mystery over where these deficits are coming from. Tax revenues are lacklustre and growing very slowly. This is not just the result of the Tax Cuts and Jobs Act of 2017 though that is a big part of it. As the Peterson Institute recently pointed out, the current revenue share of GDP at 16.5% is some 2% of GDP below where it has historically been when the economy has been at this level of unemployment.
With revenues this low, the fiscal books would be less challenged if expenditure levels were lower to compensate. This is difficult to achieve because ‘mandatory’ government spending (Social Security, Medicare, Medicaid, et.al) is becoming bigger as the population ages, difficult to do very much about. By contrast, a ‘discretionary’ spending squeeze (defence, education, transport, foreign aid., et.al) is ongoing, explaining those fierce Congressional battles (see chart). Seen this way, the US fiscal black hole very obviously is the result of weak revenues rather than a spendthrift US government.
The saving grace – low interest rates
Though much is made of the burden of interest payments on servicing this growing public debt, low interest payments are one of the key saving graces of this poor fiscal position. This largely reflects the era of low interest rates unleashed by the Federal Reserve in the aftermath of the financial crisis. The average maturity of Federal debt is about six years, so it is sensitive to the part of the Treasury yield curve the Federal Reserve has most sway over, front and intermediate durations.
As the chart shows, thanks to the persistence of low rates and a recent further move lower, average interest servicing costs have been remarkably low and falling in recent years. Even with such rapid accumulation of public debt, it is startling that interest payments on Federal debt are no higher a share of GDP or total government spending today than that seen in the 1970s.
Treasury avalanche but prices keep rising
Here is one of those conundrums of our time. How is it that bond prices keep rising even at such high levels of bond issuance? Why is a threefold increase in bond supply in the past decade not hurting the bond market (see chart)? The answer is obvious: demand has risen even faster. No other explanation works.
We should note that the demand has come from all categories of investors – financial institutions reacting to stronger regulatory requirements, investors in the US and globally who seek yield and safety in a more negative-yielding world globally, not to forget the Federal Reserve, for several years. The US central bank has not been buying since 2017, but this is being offset by a worsening global economy that helps keeps demand strong.
But with public debt scheduled to climb much higher, will yields not be impacted at some later point? Can the ever-larger US fiscal black hole still safely be ignored as we look ahead? Will such a relentless rise in debt not eventually bring a buyers’ strike that dents demand? If so, where and when will the tipping point be reached when bonds might, finally, be affected?
Low rates help avoid the tipping point
There is one key factor here helping the US avoid the tipping point so far. Like the US corporate sector where leverage has moved to quite high levels without too much trouble so far, the government has not struggled to roll debt over and borrow more because interest payments remain very affordable. So long as the interest rate paid on debt is lower than the rate of expansion in the US economy, debt to GDP ratios will only rise slowly2. This allows the government substantial leeway. Deficits can be run, so long as the market believes that such low rates will persist.
US interest rates have remained below inflation rates for many years keeping debt servicing costs low. This ultra-low interest rate policy pursued by the US Federal Reserve has been of huge importance in helping the US government manage its finances (see chart below). With modest deficits, debt ratios to GDP will rise relatively slowly. But US deficits have not been modest, they have been high. Even low rates have not managed to prevent a doubling in the ratio of debt to GDP.
Japan has been getting away with it?
One of the arguments made by those who reject the idea that US debt and deficits are a problem at all, is that Japan has been getting away with high deficits without impacting yields. In the past couple of decades, Japan’s ratio of public debt to GDP has doubled, with debt on a net basis now at well over 150% of GDP (IMF). Through this time, ten-year Japanese government bond yields have plunged from about 2% to current negative levels of -0.25%. The lesson that some take from Japan to the US is that if you are issuing debt in your own currency, so long as interest rates remain very low, rising public debt can be managed. Much like Japan, the US is not an emerging market which needs to finance some of its financing in another currency. So long as interest rates remain low, the argument is that the US can manage to service its debt, still run modest deficits and continue to roll and refinance existing debt.
Why then should we get anxious?
Unfortunately, downplaying the impact of the big rise in US public debt this way brings many hostages to fortune as we look ahead. Here is the reason why. Yes, there is no crisis at present and low interest rates are a vital support. The problem is that these conditions may not continue. If they do not, a continuation of current fiscal trends presents a growing risk to US financial stability. The key problem as we look ahead is what happens when the US economy completes the current business cycle by entering a recession in the 2020/21 period. This is not allowed for in the CBO’s deficit and debt projections, large though those deficits and debt projections look even without this.
Two possibilities exist. We know that any recession conditions would worsen the current fiscal position substantially by weakening revenues and taking some spending categories higher. However, there is more to the fiscal effects of recession now than in previous cycles. This is because scope for the Federal Reserve to stimulate the economy by cutting interest rates is very limited unlike previous cycles. This makes it all but inevitable that the government would need to run even bigger deficits to stimulate the economy to escape recession.
On this scenario, two possibilities arise:
First, the US government could opt to issue even more debt to finance more spending to stimulate the economy. If it did that, the current $1 trillion type US budget deficits could easily double. Though even these massive deficits do not necessarily bring default fears, it is very conceivable that holders of long duration US bonds will begin to believe that repayments are likely to be repaid partly through higher inflation, a way in which the real burden of national debt falls, helping the government. Though this cannot be used indefinitely, it can for a time, as has happened in the past. Even though the time scale for such a change of bond market view is uncertain, as debt levels go higher than GDP, such concern looks very possible, even likely.
What are the implications? Well for one, the disappearance of inflation risk pricing in US long duration bonds could reverse3. Yields would go higher, not during the recession but after it. A key difference with Japan is that the US is not a large savingssurplus economy that can finance rapidly growing public debt internally. It needs to borrow overseas, and in sizable amounts. The fact that it borrows in its own currency is protection to a point only. Concern over rising yields and a weaker dollar may well adversely affect foreign flows that finance the US deficit. In other words, the risk premium on US bonds would rise. This has been seen before but would probably be on a worse scale given the worsening in public finances.
Second, there might be a view that with public finances already in such difficulty, the only way ahead is using direct monetary financing (Federal Reserve money creation) to run higher budget deficits. This rolls quantitative easing and fiscal policy into one policy. It avoids having to issue large amounts of public debt to the market. If there is resistance from the bond market to finance much bigger deficits, this becomes likely, even inevitable. Such a policy is merely a form of transfer from the Federal Reserve to the Federal government. In effect, some of this was happening during the Quantitative Easing years (2008-2017), but this would be on a larger scale and in more direct fashion than at that time.
The problem here is that market thinking could still take us to the same place as in the first scenario, i.e. towards expecting higher inflation. This is because such direct financing of government by the Federal Reserve would all but destroy its independence, and with it, the assurance of preserving low and stable inflation.
Historically, monetary management by governments rather than independent central banks have tended to mean markets assigning a higher probability to inflation going higher. Whether higher inflation happens is not the key issue, it is about the market’s risk assessment. In other words, both forms of fiscal financing in economically challenging times could have similar effects. By taking an already bad set of public finances towards a much worse direction, it brings to a head some of the problems that have been concealed by very low interest rates. To widen this argument out, any development that raises market concerns about returning inflation, or interest rates having to go higher than the current extraordinarily low profile of expected US interest rates out to 10 years and more would bring similar concerns about fiscal sustainability. More protectionist moves in trade, by raising costs and prices, could do this too.
We should outline and clarify the view. This note is not arguing that the anxiety around the US fiscal problem will raise yields imminently or create a wider financial crisis at this stage. On yields, it is more likely than not that yields will likely fall first given the elevated risk of recession in the next year or so – yes, yields have already fallen sharply in the year to date because of economic fears, but they will assuredly fall further if the current economic slowdown worsens into outright recession.
Later, with admittedly uncertain timing on when and how strongly the market reaction takes to unfold, the fiscal issue may start to make itself felt by some upward pressure on yields. This means that the logical tendency to extrapolate very low yields forwards on an indefinite basis could be wrong. Yields could bounce from those lows. The bigger issue is this. If the bond market starts to worry about US fiscal sustainability, there is an obvious danger that it will morph into a wider crisis as financial markets suddenly worry about the build-up of public debt. There would be wider market impact beyond bonds - on the US dollar, with spill-over effects on all financial markets. We would all feel it.
Downplaying the US’s fiscal problems is making us too comfortable with a view that low interest rates will stop US public finance deterioration from turning into a crisis. We are probably underestimating the extent to which the risks are building up.
In terms of actions, it should be obvious where this is taking us. It is that the US needs to act very soon to stop this fiscal deterioration from blowing up into a crisis. Without some countervailing fiscal actions now, quite a lot is at stake. Given that the squeeze on the spending side is already fierce, it needs to be stronger revenue raising efforts that are the focus. We see no signs at present that this is happening. Rather, the talk has recently been about payroll tax cuts. Whichever way you look at it, the US fiscal black hole is ripe for anxiety.
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