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In late January, Standard & Poor’s reduced its sovereign debt rating on Japanese government debt from AA to AA-. Almost simultaneously, the U.S. Congressional Budget Office reported that the 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, in light of the substantial additional tax cuts enacted by the Congress in December, it did lead some to suggest (including the Moody’s debt rating service) that America could be headed for a “lost decade” that includes crushing budget deficits and an ever-rising debt burden. Concerns over the rising U.S. deficits and debt burden were underscored by George Soros at the Davos conclave when he pointed specifically to a possible “crowding out” problem for the United States: if the economy picks-up and prices begin to rise, U.S. interest rates will rise so rapidly that they will choke-off the recovery. America’s looming debt/deficit catastrophe has been a perennial feature of the pronouncement of global soothsayers for nearly a decade. It has been conveniently forgotten that many of the analysts who are credited with having foreseen the financial collapse of 2007-2008 had predicted that it would arise because of a collapse in U.S. bond markets and a collapse in the dollar related to the unwillingness of America’s creditors to continue to accumulate U.S. government notes and bonds. 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 the Lehman 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 implications for the dollar and U.S. government debt, should not lead to complacency going forward. Still, it is worth remembering that the experience after Japan’s real estate bubble burst in 1989, not to mention the 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 is necessary, 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 after 1997, 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 in nominal 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 private sector 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 $0.458 trillion in 2008 to $1.413 trillion in 2009, and to $1.294 trillion in 2010, pushing the debt-to-GDP ratio up sharply from just above 40 percent to 62 percent at the end of 2010, private borrowing fell by 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’s debt prospects? Probably the best metric to employ when addressing this question is the ratio of net
government debt-to-GDP, which approximates the public’s holdings of government debt exclusive of debt owned essentially by the government itself either in Japan’s postal savings system or in the United States Social Security account. Gross debt measures are more alarming but using net debt measures that compare across countries is probably the soundest way to proceed. Few of the conclusions reached using net debt figures would be altered by using gross debt figures save for the fact that the headline numbers would be more alarming for both countries, the United States and Japan. First, take a look at the last six years. Over that period, Japan’s net debt-to-GDP ratio rose at about 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, that would mean a truly alarming 165 percent debt-to-GDP ratio by 2015. That is a frightening number that doesn’t represent a very controversial forecast. It isn’t very far from IMF projections of 153 percent. Even Greece’s debt-to-GDP ratio is not supposed to rise above 150 percent over the next half decade. Of course the market’s treatment of Greek debt is substantially different from its treatment of Japanese debt with interest rates on ten-year government bonds in Japan yielding about 1.2 percent while interest rates on ten-year Greek debt yield about 10.6 percent. Much of Greek debt is externally held and the Greek government’s credibility regarding its ability to manage expenditures and collect taxes is low. What about the United States? Its debt-to-GDP ratio rose even faster than Japan’s between 2004 and 2010 at an annual rate of about 7.7 percent, implying a doubling of the ratio in just ten years. Such rapid growth, that accelerated sharply after 2007, probably accounts for the enhancedrelative to that occasioned by Japan-- rise in global concern over US debt and deficits Of course with a 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. debtto-GDP ratio just above the debt-to-GDP ratio in Japan in 2004. That measure for Japan engendered little 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 condition had been underway for over a decade or perhaps because the growth in Japan’s debt-to-GDP ratio had been slowing for a decade, prior to 2004. Beyond that, the uncertainties tied to the 2008 financial crisis were absent in 2004. An analysis of the proximate determinants of the path of the debt-to-GDP ratio is revealing both in terms of how to evaluate the significance of prospective changes in that level and how to compare the experience of the United States and Japan. The percent change in the debt-to-GDP ratio is determined by two components. First, the difference between the interest rate on outstanding debt and 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 two percent 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 negative nominal GDP growth. Japan experienced very weak (about one percent nominal GDP growth from 2004 to 2007) and sharply negative nominal GDP growth thereafter until the start of 2010. Nominal GDP growth is the sum of inflation and real output growth and Japan’s persistent deflation has sharply weakened nominal GDP growth and thereby contributed to a persistent increase in its debtto-GDP ratio. In a sense, Japan’s fiscal failure has been two-fold. The government has failed to cut
spending enough to reduce the primary deficit. (Tax cuts would probably be counterproductive as they would slow nominal GDP growth even further.) Second, the Bank of Japan has failed to move Japan out of deflation and thereby allowed persistently-negative nominal GDP growth to push up the debt-to-GDP ratio and thereby push up the burden of debt. The average interest rate on Japan’s outstanding debt (average maturity about 5 years) is only about 50 basis points, but the average negative 4 percent growth rate of nominal GDP during 2008 and 2009 contributed mightily to the rise in Japan’s debt-to-GDP ratio, boosting it by 2.8 percent in 2008 and by a record (since 1981) 7.2 percent in 2009. Japan is in a debt trap because deflation boosts the real burden of debt while pushing up the debt-to-GDP ratio. That rising burden, in turn, forces the government to continue trying to cut government spending and even flirt with tax increases, both of which are counterproductive because they further depress growth. Clearly, Japan’s debt dilemma is one of the reasons behind Chairman Bernanke’s strongly stated determination to avoid a drift from disinflation into deflation in the United 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 burdens to avoid deflation?” In contrast to Japan, much of the sharp 20.8 percent rise in the debt-to-GDP ratio during the 2009 fiscal year (which began in October 2008, just after the Lehman crisis) was due to a large rise in the primary deficit. While the drop in U.S. nominal GDP growth boosted the debt-to-GDP ratio by 4.5 percent during 2009 (given an estimated 2.5 percent interest rate on outstanding debt), the nominal GDP growth rebound in fiscal 2010 reduced the debt-to-GDP ratio by 0.8 percent. The overall 11.4 percent rise in the U.S. debt-to-GDP ratio in 2010 was mitigated by stronger nominal GDP growth, despite the large primary deficit. Japan’s persistently weak nominal GDP growth contributed 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, when measured by the outlook for the ratio of government debt-to-GDP, it is certainly time to take decisive 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 the primary deficit…that is largely adjustments to reduce government spending while enacting revenueneutral tax rate reductions financed by a widespread elimination of tax preferences. A higher nominal growth rate for the U.S. coupled with stable nominal interest rates would contribute mightily to containing the implied rise in the U.S. debt-to-GDP ratio. The CBO’s recent report on U.S. deficits and debt demonstrates the right approach. With a growth rate averaging about 3 percent from 2011 to 2016 and an inflation rate rising gradually from the current core inflation rate of 0.6 percent to an average of 1.9 percent in 2013 to 2016, an average nominal growth rate approaching five percent coupled with spending cuts and stabilization of tax revenues would mean a debt-to-GDP ratio of about 75 percent in 2016. That is only modestly above the 70 percent level projected 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 ratio provides another benefit—the likelihood of lower nominal interest rates. Substantial empirical research by Thomas Laubach, at the Federal Reserve Board of Governors, demonstrates that a 10 percentage-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 substantial progress toward reducing the debt-to-GDP ratio below levels currently expected and would provide
a double bonus by reducing the nominal interest rate on outstanding Treasury debt and thereby reinforcing a further drop in the debt-to-GDP ratio. The other reason to press for a stabilization of the U.S. debt-to-GDP ratio going forward arises from the extensive research conducted by Carmen Reinhart and Kenneth Rogoff in their widelycited book, “This Time is Different.” They show that a debt-to-GDP ratio above 90 percent sharply increases the chance of a financial crisis associated with a rapid increase in sovereign debt. While not a hard-and-fast rule, this result makes considerable sense. Examining the proximate determinants of the debt-to-GDP ratio, if one allows for a negative impact on nominal GDP growth arising from a reduction in the primary deficit, the higher the debt-to-GDP ratio, the more likely is the paradoxical outcome whereby a reduction in the primary deficits aimed at reducing the debt-toGDP ratio actually boosts it because of a negative impact on nominal GDP growth. This is the situation akin to that being faced by many Southern European countries where highly stringent fiscal measures are so depressing growth that aiming for a smaller primary deficit actually results in a higher debt-to-GDP ratio and thereby a debt trap. Japan too could be vulnerable to this debt trap, given its tendency toward deflation-driven, negative GDP growth. The United States is far from this point, but the extreme undesirability of getting into such a debt trap should help to prompt aggressive and credible deficit reduction measures over the next five years by the Congress. It is not too late for the U.S. to rescue itself from a debt/deficit trap like the one that arguably has encompassed Japan and some distressed sovereign governments in Southern Europe. But it is certainly not too soon to take credible measures to avoid that outcome. The Fed’s job is to avoid deflation and to help sustain nominal GDP growth of around 5 percent while the job of Congress is to reduce federal spending from about the 24.7 percent of GDP projected in 2011 down to 22 percent in 2015. That would help to reduce the rise in the debt-to-GDP ratio, actually reduce interest rates on outstanding debt, and help to make way for the rise in private borrowing that will accompany a sustained U.S. economic recovery. Dr. John H. Makin Chief Economist, Caxton Associates, LP February 7, 2011
The foregoing commentary expresses the views of Dr. John Makin, Caxton Associates LP’s Chief Economist, and may not represent the views of Caxton’s portfolio managers. Therefore, one should not infer from the foregoing commentary what actual trading positions or recommendations may be made by Caxton currently or in the future.
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