SERIOUS MONEY:BOND MARKET vigilantes have stalked the euro zone's sovereign debt markets for more than a year now and, one by one, the monetary union's troubled periphery states, including Greece, Ireland and Portugal, have succumbed to market pressure and requested financial assistance.
The euro periphery has been singled out, but Europe’s weakest links are not the only advanced economies facing untenable fiscal positions, with both Japan and the United States facing herculean tasks in the years ahead. Japan has managed to escape attention due to its high saving rate and large domestic ownership of public debt, while the US has resisted upward pressure in treasury yields due to its position as the world’s reserve currency and safe haven asset of last resort.
This benign state of affairs may change for the US however as recent events including a near-government shutdown, the debate over raising the statutory debt limit, and Standard Poor’s decision to lower the sovereign’s long-term outlook from stable to negative, have brought America’s fiscal position into sharper focus.
A federal government shutdown was avoided two weeks ago following a last-minute compromise between the Republicans and Democrats on a joint draft budget for the remainder of the current fiscal year to end September. The deal has been heralded as the biggest compromise since 1850, but it provides for a less than $40 billion reduction in federal spending during the remainder of the current fiscal year and still leaves the deficit on track to reach a post-second World War high of more than 10 per cent of GDP.
In reality, although a compromise was reached, the US continues to delay necessary adjustment. Its fiscal position has actually deteriorated over the past year due to the stimulus package adopted last December.
The near shutdown had little impact on financial markets, but investors’ focus has since shifted to the statutory debt limit, which is set by congress. Gross federal debt reached $14.2 trillion on March 31st, as compared with the current debt limit of $14.29 trillion, and the treasury department estimates that the ceiling will be reached no later than May 16th. Reaching the limit would have devastating consequences, as the treasury could not raise funds through new debt issuance and may be unable to meet its day-to-day obligations.
Congress has always raised the debt ceiling in the past and has done so on 10 occasions since 2001, but partisanship is at levels not seen in almost 150 years, which complicates the debate. Treasury secretary Timothy Geithner has warned the “consequences of [failure to raise the limit] would be catastrophic for the United States.
“Default by the United States would precipitate a crisis worse than the one we just went through. I think it would make the crisis we just went through look modest in comparison. It would force us to cut payments to the military, cut critical payments to our seniors. It would be a reckless, irresponsible act.”
Amid the uncertainty precipitated by the near shutdown and aggravated by the debt ceiling debate, Standard Poor’s decision to change its long-term outlook on the US from stable to negative added fuel to the fire. The agency believes there is a material risk that policymakers will be unable to agree a fiscal consolidation strategy by 2013 that addresses the sovereign’s medium and long-term budgetary challenges. “This would in our view render the US fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.”
It noted that “there is at least a one-in-three likelihood that we could lower our long-term rating on the US within two years”.
The ratio of net federal debt to GDP has jumped from below 40 per cent in 2007 to close to 65 per cent today and, though the increase in recent years has been alarming, the figure still seems reasonable in the context of manageable sovereign debt burdens.
However, the current debt is dwarfed by the present value of unfunded entitlement obligations, which amount to some $66 trillion or a figure more than seven times greater than the net federal debt.
Medicaid, which provides healthcare for low-income households, and Medicare, which is the healthcare programme for people aged 65 or over, account for almost 90 per cent of unfunded future liabilities. Escalating healthcare costs must be addressed if the US public debt ratio is to be contained at manageable levels in the years ahead.
The growth in healthcare spending per person has exceeded increases in GDP per capita by roughly 1½ percentage points per annum since the mid-1980s and, if no reforms are made, the ratio of net federal debt to GDP is likely to approach 90 per cent within the next decade and the path would become increasingly exponential thereafter.
America’s untenable fiscal position has come into focus in recent weeks but serious efforts at reform are unlikely ahead of an election year. As Winston Churchill once quipped: “Americans can always be counted on to do the right thing . . . after they have exhausted all other possibilities.”
The likelihood of a ratings downgrade draws ever nearer.
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