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Financial Markets and the Long Term Debt Outlook

Financial Markets and the Long Term Debt Outlook

Ratings: (0)|Views: 825 |Likes:
Published by Forbes
Financial
markets remain concerned about the ability and willingness of the US and Europe to tackle their respective fiscal challenges.
With US federal debt approaching its highest level since the formation of the federal government in 1789 (other than during
WWII and its immediate aftermath), rating agencies are taking a close look at rising US debt and what the legislature does to
contain it. The appetite of foreign central banks to accumulate Treasuries has provided the US with a reprieve; these entities,
plus Federal Reserve holdings, now account for half of all Treasury bonds. But monetary policy in Asia and the Middle East is
subject to change, and we have seen in Europe the suddenness with which sovereign debt can be re-priced by financial markets.
Downgrades, government shutdown rumors and political impasse on deficit reduction have not lost their ability to negatively
affect equity markets, business activity and confidence. This note details 10 reasons why we believe financial markets will take
a close look at what Congress does in the year ahead.
Financial
markets remain concerned about the ability and willingness of the US and Europe to tackle their respective fiscal challenges.
With US federal debt approaching its highest level since the formation of the federal government in 1789 (other than during
WWII and its immediate aftermath), rating agencies are taking a close look at rising US debt and what the legislature does to
contain it. The appetite of foreign central banks to accumulate Treasuries has provided the US with a reprieve; these entities,
plus Federal Reserve holdings, now account for half of all Treasury bonds. But monetary policy in Asia and the Middle East is
subject to change, and we have seen in Europe the suddenness with which sovereign debt can be re-priced by financial markets.
Downgrades, government shutdown rumors and political impasse on deficit reduction have not lost their ability to negatively
affect equity markets, business activity and confidence. This note details 10 reasons why we believe financial markets will take
a close look at what Congress does in the year ahead.

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Categories:Business/Law, Finance
Published by: Forbes on May 04, 2012
Copyright:Attribution Non-commercial

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 Topics: Why financial markets are paying close attention to how Congress addresses the long-term budget outlook
1
April 27, 2012
In August 2011, the United States lost one of its AAA credit ratings, a designation first bestowed around 100 years ago, whichwhen combined with the debt ceiling debate, created one of the sharpest market corrections in post-war US history. Financialmarkets remain concerned about the ability and willingness of the US and Europe to tackle their respective fiscal challenges.With US federal debt approaching its highest level since the formation of the federal government in 1789 (other than duringWWII and its immediate aftermath), rating agencies are taking a close look at rising US debt and what the legislature does tocontain it. The appetite of foreign central banks to accumulate Treasuries has provided the US with a reprieve; these entities,plus Federal Reserve holdings, now account for half of all Treasury bonds. But monetary policy in Asia and the Middle East issubject to change, and we have seen in Europe the suddenness with which sovereign debt can be re-priced by financial markets.Downgrades, government shutdown rumors and political impasse on deficit reduction have not lost their ability to negativelyaffect equity markets, business activity and confidence. This note details 10 reasons why we believe financial markets will takea close look at what Congress does in the year ahead.
[1]
Assuming that sequestration takes place as planned, the
Budget Control Act reduces the trajectory of the debt fromthe CBO’s explosive Alternative Case, but does not yet setfederal debt on a sustainable path.
Even after incorporatingall phases of the BCA and assuming expiration of variousbusiness and household tax relief provisions, future debt ratiosstill rise into the mid-80s as a percentage of US GDP. TheCBO Baseline shows a decline in federal debt since it assumesthe following three policy options: a sunset of all Bush taxcuts, an end to indexation of AMT to inflation, and reductionsto Medicare doctor reimbursements which Congress hasagreed to but never enacted. These three cuts and associatedinterest savings would amount to roughly $6 trillion in deficitreduction over a 10 year period. However, it remains unclearwhat political support there would be to do so.
[2] Financial markets are focused on this issue since large deficits and debt levels can affect growth.
There are plenty of debates in the economic community these days (e.g., why haven’t monetary or fiscal stimulus multipliers behaved the way theirsupporters believed they would). One possible explanation is that fiscal stimulus loses its effectiveness when debt ratios rise toohigh. In the chart below, we summarize Ken Rogoff’s findings that when debt ratios in the US and in other advancedeconomies
 
have
 
exceeded 90%, economic growth suffered notably. With the US federal debt ceiling now over 100% of GDP(on a gross debt basis) and projections of net debt rising above80%, financial markets have reason to be concerned.Supporting Rogoff’s findings is a paper prepared by BISeconomists for the Fed’s 2011 Jackson Hole symposium
1
. In astudy of sovereign, corporate and household debt over the last3 decades, the authors find that at around 85% of GDP,government debt exerts a significant negative drag on growth.Their conclusion:
the immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscalbuffer required to address extraordinary events, governmentsshould keep debt well below the estimated thresholds
.”
 
[3] Hoping for growth might not be the best strategy.
The
 
post-BCA debt ratio of 85% by 2022 includes the CBO growthassumptions shown in the chart below. Growth is assumed to spike to 5% in 2015, and average 2.7% over the decade. Someargue that faster growth may bail out the US from its budget problem, reducing the need for deficit reduction measures. It istrue that the US has experienced growth surges before, and it is always possible another one will occur. In the 1950’s, real
1
The Real Effects of Debt”, Cecchetti, Mohanty and Zampolli, BIS, presented at the Fed’s August 2011 Jackson Hole symposium.
 
-2%-1%0%1%2%3%4%5%Debt/GDP:60-90%Debt/GDP:90%+Debt/GDP:60-90%Debt/GDP:90%+Source: "Growth in a Time of Debt", Carmen Reinhart and Kenneth Rogoff,January 7, 2010, National Bureau of Economic Research.
What fiscal austerity supporters worry about: 90% cliff
GDP growth
Advanced economies(1946-2009)U.S.(1790-2009)
30%40%50%60%70%80%90%100%2004200620082010201220142016201820202022
Source: CBO, J.P. Morgan Private Bank.
US long-term debt scenarios
Net debt to GDP, percent
CBOBaselineCBOAlternative CasePost-BCA case
 
 Topics: Why financial markets are paying close attention to how Congress addresses the long-term budget outlook
2
April 27, 2012
GDP growth averaged 4.3% for the entire decade [see table in Appendix], which resulted in debt ratios declining from 80% to46%. However, the unique economic conditions and productivity gains of the 1950’s (e.g., interstate highway, rebuilding of Europe and Japan) may not be repeated. While we are hopeful that the US economy recovers more quickly, if it doesn’t, debtratios might not decline below the mid 80’s, risking another round of rating agency downgrades.
Other areas of potential budget slippage: projections of military spending declines are not the same as structural deficitreduction.
One item in the President’s budget proposal was an assumed $800 billion in savings from troop withdrawals out of Iraq and Afghanistan (so-called “OCO” spending). While progress has been made on this front, uncontrollable geopoliticalevents could require OCO spending to rise again. In addition, as shown above, the Budget Control Act
already
projects thatnon-OCO military spending as a % of GDP will fall to its lowest level since 1940, barely above the levels now spent by Japanand Germany after decades of demilitarization. As a result, financial markets may not ascribe a high likelihood to deficitreduction achieved through lower estimates of future military spending.
[4]
 
It’s not just rating agencies that are unnerved by polarization of political parties
. Markets are aware of the polarizationin Congress, a trend that can be understood by empirical analysis of Congressional voting patterns. As shown below, thepolarization in the House and the Senate is as high as it has ever been, even higher than after Reconstruction, one of the mostacrimonious periods in the country’s history. A closer look at the Senate in particular (below, right) shows that the number of party non-conformists has plummeted. Without a political middle, there is a greater risk that the ideological divide between theparties cannot be bridged, leading to intermittent government shutdowns (or the threat of them
2
) and market disruptions.
[5] Entitlements: where we are now.
Market participants are increasingly focused on entitlements relative to discretionaryspending. First, some history. When Medicare was introduced in 1960’s, it was described as “brazen socialism” in the Senate.When Truman proposed a national healthcare program in the 1940’s, the plan was called a Communist plot by a Housesubcommittee. And when President Roosevelt introduced Social Security in the 1930’s, he was branded as a Communistsympathizer by Republican Senators from Ohio, Pennsylvania and Minnesota, publisher William Randolph Hearst and Alf 
2
Financial markets are aware that last year’s compromise avoiding a shutdown was mostly a reflection of FEMA discovering that itunderestimated the amount of funds that it had on hand. There wasn’t a compromise, since Congress didn’t need to make one.
1.0%1.5%2.0%2.5%3.0%3.5%4.0%4.5%5.0%20122013201420152016201720182019202020212022Source: Congressional Budget Office.
CBO's real GDP growth assumptions
Percent YoY
Since June 2009
2%4%6%8%10%12%14%19481955196219691976198319901997200420112018Source: CBO, OMB, J.P. Morgan Private Bank.
US military spending since 1940
Percent of GDP
30%40%50%60%70%80%90%100%1879189919191939195919791999
   D   i  s   t  a  n  c  e   b  e   t  w  e  e  n   t   h  e   P  a  r   t   i  e  s
Source: Keith T. Poole, University of California -San Diego, January 2011.
Congressional polarization at an all time high
Degree of partisanship as measured through analysis of allCongressional roll calls, 1879-2010
HouseSenate
05101520253035404585899397101105Source:
The Creation of an Endangered Species: Party Nonconformists of the U.S. Senate,
Richard Fleisher and Jon R. Bond, 2005.
Number of party non-conformists in the Senate 1953-2004
Congressional session number
TotalRepublicansDemocrats
1950's1960's1970's1980's1990's
 
 Topics: Why financial markets are paying close attention to how Congress addresses the long-term budget outlook
3
April 27, 2012
Landon (Roosevelt’s GOP opponent in the 1936 Presidential election). So in 1969, when the US Census found that one quarterof Americans over the age of 65 lived in poverty, politicians showed courage in creating a larger social safety net.
However
,
itmay take even greater courage to examine and adjust what was created.
In the late 1960’s, the government estimated thatMedicare expenses would grow by 7 times by 1990 (unadjusted for inflation); they grew by
61 times
instead.
 
As shown in thetable, healthcare spending has overtaken education spending (a); entitlements have grown sharply compared to growth inpopulation, household income and overall government spending (b); price-sensitive medical spending (paid out-of-pocket) hascollapsed (c); and more “productive” forms of government spending have fallen to an all-time low (d). David Walker, theformer Comptroller of the US, refers to this as the “crowding out” of productive discretionary programs.
[6]
 
Entitlements: where we go from here
. Markets generally look at financial statements which are governed by GAAPaccounting, which requires accrual of future commitments. Countries and states are not bound by accrual accounting, leavingmarkets to wonder (and sometimes panic) when they find out what hasn’t been accrued. The existing federal debt, which isalready at elevated levels, does not include the present value of unfunded future entitlement payments. Government agencieshave estimated this latter number at $36-63 trillion, which is 3-6 times the existing stock of federal debt held by the public.How much would tax rates have to rise to support entitlements growing at 5%-7% per year, if nominal GDP grew at 4%-5%?First, the 2001 tax cuts would have to expire on all brackets, and then tax rates would have to be raised by the same amount oneveryone. At that point, federal debt to GDP would still be well above 2007 levels, but at least it would create some borrowingcapacity to fund entitlement payments. The question is what such a policy would do to growth and employment.
[7]
 
How long will China keep buying?
US Treasury markets have benefitted substantially from the appetite of Chinese andother central banks to accumulate Treasury bonds. As shown below, China’s purchases of $1.5 trillion in Treasuries andAgencies is unprecedented, even when compared to other industrializing countries with managed exchange rates. While Chinahas prospered by doing this (keeping its exchange rate cheap and exporting more), it is a policy that carries substantial risk,primarily in the form of higher Chinese inflation. As a result, it would be risky to expect this pace of reserve accumulation to
Indicative entitlement trends: 1960-2010196019701980199020002009/10
Healthcare spending (% of GDP)1%3%4%5%6%8%Education spending (% of GDP)4%6%5%5%6%6%Entitlement program enrollment (% of population)N/A18%22%25%27%29%Entitlement income (% of avg. pre-tax income)N/A8%11%11%12%15%Social Security spending (% of total federal spending)N/A15%20%20%23%20%Medicare spending (% of total federal spending)N/A3%5%8%11%13%Medicaid spending (% of total federal spending)N/A1%2%3%7%8%Price sensitive out-of-pocket spending (% of healthcare spending)48%33%23%19%14%12%Medicare/Medicaid (% of healthcare spending)N/A18%25%26%32%35%
(d)
"Productive" federal spending (% of total federal spending)N/A68%54%46%36%32%
Includes spending on defense, education, infrastructure and technologySource: Kleiner Perkins Caufield & Byers. 2009/10 reflects latest data point available.
(a)(c)(b)
$0$10$20$30$40$50$60$70Source: US Department of the Treasury, US Social Security Administration,Centers for Medicare and Medicaid Services.
The existing Federal debt is the lesser of 2 problems
Trillions, USD
Present value ofunfundedentitlementobligations,through 2086Existingnet debtPresent value ofunfundedentitlementobligations,over an infinitehorizon

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J Alan Reid added this note
The unwind of the "quality trade" the move to the US Treasury is certainly one of my biggest concerns. The basic response from the US Treasury is, we won't let that happen. I suppose Superman hasn't met kryptonite yet...
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