A Super Committee Failure: Does It Matter?

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by: James A. Kostohryz

Many have argued that the failure of the congressional Super Committee to produce $1.2 trillion in deficit reduction over a ten year period could lead to major turmoil in financial markets. According to this view, in the face of congressional inaction, rating agencies and/or market participants could decide to officially/unofficially downgrade U.S. debt.

It is my view that the failure of the Super Committee will not be all that important in the medium term. The potential problems posed by the U.S. fiscal situation are still a relatively distant threat at this point in time.

No Imminent Threat Of U.S. Default

People need to understand that the debt situation in the U.S. is fundamentally different from that which is facing various European nations.

First, U.S. debt dynamics are nowhere nearly as bad as they are in the European PIIGS nations facing default. U.S. net public and private debt levels are much lower, and the financing costs of that debt are far lower.

It would take many years for U.S. public and private debt levels to deteriorate to PIIGS levels. And it would take many more years to for those debt levels deteriorate beyond a point where they are unsustainable relative to U.S. GDP potential.

It is important to understand that the U.S. has vastly more favorable GDP growth dynamics relative to PIIGS nations. The long-term growth of the U.S. labor force and superior labor productivity dynamics due to its flexible labor market allow the U.S. to grow its economy at a substantially higher rate than that of European nations. This enables the U.S. to carry a substantially higher debt load than can be supported by a European country such as Italy with horrific labor productivity dynamics and a dismal demographic profile.

Second, if the analysis of private and public debt is refined further to only incorporate foreign debt, the U.S. position looks vastly better than that of any European nation. When private and public debt is considered, 70% of American debt is owed to Americans. This is important because the U.S. is far less dependent on flows of "hot money" to finance its government and businesses.

Finally, the euro zone nations most at risk of default do not have a central bank to back up those nations' issuances of debt. As long as the Fed is backstopping the U.S. Treasury - and it is clear that it is - the U.S. is in no imminent danger of default.

Thus, the comparison of the PIIGS fiscal situation and that of the U.S. is not really apropos.

How Bad Is The U.S. Debt Problem

The sovereign debt problems of nations such as Italy and Greece are problems of fundamental solvency, within the context of their membership in the euro zone. The fact of the matter is that within the context of the euro, these nations simply cannot grow at a rate that is sufficient to allow them to service their debts.

The U.S. problem is nowhere near so dire. The U.S.'s current levels of net public and private debt are simply not a problem - even using relatively pessimistic assumptions regarding U.S. long-term GDP growth and real interest rates.

The problem in the U.S. is a matter of containing fiscal deficits 5, 10, 15 and 20 years from now. If the growth rate of entitlements and other public expenditures in the U.S. are not brought under control relative to its revenue collections, the U.S. could get itself into a situation in which the only alternatives would be default or severe inflation. But that is not an imminent threat.

One might argue that markets are anticipatory mechanisms and that the market might discount future problems in the present. This point is debatable. First it is debatable whether markets effectively discount such long-term risks. Second, the proposition begs the question of what scenario should be anticipated - a scenario in which U.S. leaders eventually act in the medium term to contain deficits, or a scenario in which they do not act effectively within the next few years.

As a point of fact, financial markets have consistently demonstrated that they will give sovereign nations a pass on their fiscal situations until they hit a wall. Given its relatively low level of net debt owed to the public and its low cost of financing debt, the U.S. will not be hitting that wall until quite a few years into the future. Furthermore, the existence of a clear Fed backstop is a fact the importance of which would be difficult to overestimate from the point of view of the sorts of future risks that financial markets might discount.

Indeed, it could be argued that the U.S. is "ahead of the curve" in terms of getting a grip on its fiscal problems. For example, in terms of public debt owed to the public, the U.S. is in better shape than Italy was a decade ago - nay, thirty years ago. And with regards to private debt, the U.S. problem is nowhere near as bad as it is in Spain.

Indeed, if one analyzes U.S. total private and public debt as a percent of GDP and compares that figure to an estimate of the various nations' sustainable long-term growth rates, the U.S. has a combined total public and private debt profile that is second to none amongst developed nations.

Conclusion

Current public and private debt levels in the U.S. are not really an economic problem that threatens the nation's solvency in the short or even medium term. The U.S. debt problem is more of a medium term political challenge with long-term economic consequences.

For this reason, I view the current Super Committee drama as a merely prelude to a longer-term process - not an end in and of itself.

In Part 2 of this article I will explain why I am relatively sanguine in the long-term with respect to a satisfactory resolution of this issue. In particular, I will explain why the U.S. political system exhibits significant advantages relative to the European political system in terms of being able to eventually bring the deficit and debt situations under control before it is too late.

In the short-term, the U.S. equity market and equity market proxies such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ) might experience some volatility associated with a Super Committee failure. In the medium term I do not currently see this issue as a major threat to the U.S. economy or stock market. Therefore, investors with long-term time horizons should not be dissuaded from purchasing attractive equities such as Apple (AAPL), Microsoft (MSFT) and Pepsi (PEP) on this basis. The reasons that I believe that investors should avoid equities at this time relate to the problems in Europe and their likely deleterious effects on the U.S. stock market in the medium term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.