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Caxton Global Economic Commentary 01

Caxton Global Economic Commentary 01

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Published by: TheBusinessInsider on Apr 28, 2011
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09/13/2011

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Caxton Global Economic Commentary
 Is America the Next Japan?
In late January, Standard & Poor’s reduced its sovereign debt rating on Japanese governmentdebt from AA to AA-. Almost simultaneously, the U.S. Congressional Budget Office reported thatthe U.S. budget deficit in 2011 would be $1.48 trillion or 9.8 percent of GDP, an increase of nearly$300 billion from previous estimates. While the CBO announcement was not a huge surprise, inlight of the substantial additional tax cuts enacted by the Congress in December, it did lead some tosuggest (including the Moody’s debt rating service) that America could be headed for a “lostdecade” that includes crushing budget deficits and an ever-rising debt burden. Concerns over therising U.S. deficits and debt burden were underscored by George Soros at the Davos conclave whenhe pointed specifically to a possible “crowding out” problem for the United States: if the economypicks-up and prices begin to rise, U.S. interest rates will rise so rapidly that they will choke-off therecovery.America’s looming debt/deficit catastrophe has been a perennial feature of the pronouncementof global soothsayers for nearly a decade. It has been conveniently forgotten that many of theanalysts who are credited with having foreseen the financial collapse of 2007-2008 had predictedthat it would arise because of a collapse in U.S. bond markets and a collapse in the dollar related tothe unwillingness of America’s creditors to continue to accumulate U.S. government notes andbonds. The actual crisis, which saw the housing bubble translate into a systemic financial collapse,created the reverse—a panicky rush into the “safety” of the U.S. dollar and Treasuries that, after theLehman crisis and the turmoil that followed, drove yields on Treasury notes down close to 2 percent.The fact that history has not played out as expected, especially with regard to the implicationsfor the dollar and U.S. government debt, should not lead to complacency going forward. Still, it isworth remembering that the experience after Japan’s real estate bubble burst in 1989, not to mentionthe experience of the Great Depression, suggests that the behavior of deficits and government debt,alarming as it may be, is not a reliable guide to the path of interest rates going forward. It isnecessary, after bubbles burst, to keep a close eye on the behavior of inflation and the possibility of deflation. A drift toward deflation, like that occurring in the Great Depression and in Japan after1997, can be more dangerous than a rapid run-up in government debt, especially if the real burden of that debt accumulation is enhanced by deflation. Further, outright deflation usually means a fall innominal GDP growth and an attendant rise in the ratio of government debt-to-GDP.It is also important to keep an eye on the behavior of total debt (government debt and privatesector debt), when evaluating the implications of a sharp run-up in government debt. For example,few have pointed out that at the end of 2010, total U.S. debt was actually lower than it was in 2008.Although the highly visible and much-bemoaned federal budget deficit grew sharply, from $0.458trillion in 2008 to $1.413 trillion in 2009, and to $1.294 trillion in 2010, pushing the debt-to-GDPratio up sharply from just above 40 percent to 62 percent at the end of 2010, private borrowing fellby so much that U.S. total borrowing actually fell during 2009 and 2010.How bad is the U.S. government outlook going forward and how does it compare with Japan’sdebt prospects? Probably the best metric to employ when addressing this question is the ratio of net
 
 
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government debt-to-GDP, which approximates the public’s holdings of government debt exclusiveof debt owned essentially by the government itself either in Japan’s postal savings system or in theUnited States Social Security account. Gross debt measures are more alarming but using net debtmeasures that compare across countries is probably the soundest way to proceed. Few of theconclusions reached using net debt figures would be altered by using gross debt figures save for thefact that the headline numbers would be more alarming for both countries, the United States andJapan.First, take a look at the last six years. Over that period, Japan’s net debt-to-GDP ratio rose atabout 6.5 percent a year…..a pretty alarming pace that means that the debt-to-GDP ratio doubles in just eleven years. In Japan’s case, which started at an 82 percent debt-to-GDP ratio in 2004, thatwould mean a truly alarming 165 percent debt-to-GDP ratio by 2015. That is a frightening numberthat doesn’t represent a very controversial forecast. It isn’t very far from IMF projections of 153percent. Even Greece’s debt-to-GDP ratio is not supposed to rise above 150 percent over the nexthalf decade. Of course the market’s treatment of Greek debt is substantially different from itstreatment of Japanese debt with interest rates on ten-year government bonds in Japan yielding about1.2 percent while interest rates on ten-year Greek debt yield about 10.6 percent. Much of Greek debtis externally held and the Greek government’s credibility regarding its ability to manageexpenditures and collect taxes is low.What about the United States? Its debt-to-GDP ratio rose even faster than Japan’s between2004 and 2010 at an annual rate of about 7.7 percent, implying a doubling of the ratio in just tenyears. Such rapid growth, that accelerated sharply after 2007, probably accounts for the enhanced-relative to that occasioned by Japan-- rise in global concern over US debt and deficits Of course witha debt-to-GDP ratio at about 42 percent in 2004, a doubling of its debt-to-GDP ratio over 6 years—the Japanese pace after 2004-- would take it to 84 percent in 2015. That would leave the U.S. debt-to-GDP ratio just above the debt-to-GDP ratio in Japan in 2004. That measure for Japan engenderedlittle of the hand-wringing that is associated with the current, sharp prospective rise of U.S.government debt relative to GDP, perhaps because steady deterioration of Japan’s fiscal conditionhad been underway for over a decade or perhaps because the growth in Japan’s debt-to-GDP ratiohad been slowing for a decade, prior to 2004. Beyond that, the uncertainties tied to the 2008financial crisis were absent in 2004.An analysis of the proximate determinants of the path of the debt-to-GDP ratio is revealingboth in terms of how to evaluate the significance of prospective changes in that level and how tocompare the experience of the United States and Japan. The percent change in the debt-to-GDP ratiois determined by two components. First, the difference between the interest rate on outstanding debtand the growth of nominal GDP. The larger that difference, the faster the debt-to-GDP ratio rises.The second component of the percent change in the debt-to-GDP ratio is the primary deficit—government spending minus tax revenues divided by the stock of debt. The sum of those twopercent numbers determines the growth rate (positive or negative) in the debt-to-GDP ratio.Japan has been plagued both by larger primary deficits and by episodes of sharply negativenominal GDP growth. Japan experienced very weak (about one percent nominal GDP growth from2004 to 2007) and sharply negative nominal GDP growth thereafter until the start of 2010. NominalGDP growth is the sum of inflation and real output growth and Japan’s persistent deflation hassharply weakened nominal GDP growth and thereby contributed to a persistent increase in its debt-to-GDP ratio. In a sense, Japan’s fiscal failure has been two-fold. The government has failed to cut
 
 
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spending enough to reduce the primary deficit. (Tax cuts would probably be counterproductive asthey would slow nominal GDP growth even further.) Second, the Bank of Japan has failed to moveJapan out of deflation and thereby allowed persistently-negative nominal GDP growth to push up thedebt-to-GDP ratio and thereby push up the burden of debt. The average interest rate on Japan’soutstanding debt (average maturity about 5 years) is only about 50 basis points, but the averagenegative 4 percent growth rate of nominal GDP during 2008 and 2009 contributed mightily to therise in Japan’s debt-to-GDP ratio, boosting it by 2.8 percent in 2008 and by a record (since 1981) 7.2percent in 2009.Japan is in a debt trap because deflation boosts the real burden of debt while pushing up thedebt-to-GDP ratio. That rising burden, in turn, forces the government to continue trying to cutgovernment spending and even flirt with tax increases, both of which are counterproductive becausethey further depress growth. Clearly, Japan’s debt dilemma is one of the reasons behind ChairmanBernanke’s strongly stated determination to avoid a drift from disinflation into deflation in theUnited States. In a real sense, Japan’s fiscal dilemma, which led to the most recent S&P downgrade,is an answer to the question: “why is it important for governments with sharply rising debt burdensto avoid deflation?”In contrast to Japan, much of the sharp 20.8 percent rise in the debt-to-GDP ratio during the2009 fiscal year (which began in October 2008, just after the Lehman crisis) was due to a large risein the primary deficit. While the drop in U.S. nominal GDP growth boosted the debt-to-GDP ratioby 4.5 percent during 2009 (given an estimated 2.5 percent interest rate on outstanding debt), thenominal GDP growth rebound in fiscal 2010 reduced the debt-to-GDP ratio by 0.8 percent. Theoverall 11.4 percent rise in the U.S. debt-to-GDP ratio in 2010 was mitigated by stronger nominalGDP growth, despite the large primary deficit. Japan’s persistently weak nominal GDP growthcontributed to the persistent rise in its debt-to-GDP ratio in 2010.Going forward, while the U.S. debt burden problem is not as serious as Japan’s, whenmeasured by the outlook for the ratio of government debt-to-GDP, it is certainly time to takedecisive action to reduce prospective deficits over the coming five to ten years. The burden of mitigating the rise in the debt-to-GDP ratio, however, should not fall entirely on adjustments to theprimary deficit…that is largely adjustments to reduce government spending while enacting revenue-neutral tax rate reductions financed by a widespread elimination of tax preferences. A highernominal growth rate for the U.S. coupled with stable nominal interest rates would contributemightily to containing the implied rise in the U.S. debt-to-GDP ratio. The CBO’s recent report onU.S. deficits and debt demonstrates the right approach. With a growth rate averaging about 3percent from 2011 to 2016 and an inflation rate rising gradually from the current core inflation rateof 0.6 percent to an average of 1.9 percent in 2013 to 2016, an average nominal growth rateapproaching five percent coupled with spending cuts and stabilization of tax revenues would mean adebt-to-GDP ratio of about 75 percent in 2016. That is only modestly above the 70 percent levelprojected for this year and still well below Japan’s 2004 level of 82 percent.Achieving higher nominal growth and a more modest increase in the debt-to-GDP ratioprovides another benefit—the likelihood of lower nominal interest rates. Substantial empiricalresearch by Thomas Laubach, at the Federal Reserve Board of Governors, demonstrates that a 10percentage-point reduction in the five-year forward debt-to-GDP ratio would, other things equal,reduce the five-year forward yield on Treasury notes by about 50 basis points. That is substantialprogress toward reducing the debt-to-GDP ratio below levels currently expected and would provide

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