Part 1 of "Global Economy - We Are Now In A Waiting Pattern is here.
Whenever you read articles suggesting that debt does not matter or, more pertinent at present, that governments that print their own currency will never default, I would suggest that you take a pause and then discard the article as not helpful to your understanding of the present economic situation.
There are many examples of countries that have had the option of money printing, but have chosen to default on their debt rather than monetize it. Although technically correct that any country that has access to the printing presses does not need to default on its debt, the reality is that the government and central bank will do what they consider best at the time. This may be monetizing the debt or it may be default. The technical position is irrelevant to any understanding of the decision that is made.
So what does this have to do with the second big decision the world faces. The second big decision the world faces is the resolution of the U.S.'s fiscal position and the repayment of it's long term debt. Many have argued that any resolution will be delayed for several more years to give the U.S. economy time to work off its private debt overhang. I am not of this opinion.
Politically this may be what is desired, but once the next presidential election is over, I find it hard to believe that the U.S. debt market will be happy to finance ongoing deficits of $1.3 trillion, or around 8% of U.S. GDP, at present low rates. I may of course be wrong in the timing; if European woes continue, U.S. debt markets will benefit from the safety flows out of risk assets and this may well allow the U.S. to fund these deficits longer than I presently foresee at affordable rates. It will only become clear nearer to the US presidential election where Europe has progressed to. Europe aside, I am presently of the opinion that the U.S. will either make a voluntary decision to deal with it's debts or have the decision thrust on them by the debt markets some time soon after the presidential election in November 2012, most likely in the Spring of 2013.
I have made one assumption for this article and that is that U.S. GDP is presently growing in the 1.5-2% area where it will remain whilst the fiscal deficit is around 8% of GDP. If growth picks up to the 3-4% range (which I do not expect due to debt and demographics) the fiscal position in the U.S. will improve dramatically. If growth were to strengthen to this level, the U.S. would be able to eliminate it's deficit in 2-3 years, with a freeze on spending. It would then be able to start to reduce it's debt to GDP over a 10 year period to a more reasonable level. If this scenario does unfold, the debt market will continue to fund the U.S. at reasonable rates and the problem of public debt will disappear over time. However this is not my baseline scenario (especially after the latest jobs report) and seems very optimistic. It would be vaguely reminiscent of the present GDP forecasts in Europe.
At present U.S. debt to GDP is 101%. The fiscal deficit has been held at around $1.3 trillion for the last 3 years to ensure that the U.S. does not slip back into recession. This equates to around 8.5% of GDP, which is presently around $15.3 trillion. This does not account for future liabilities, just the present debt.
So how will the U.S. cope with this deficit and debt to GDP level? The options that seem to be unworkable are:
1. Grow out of it - not going to happen in my opinion (see above). Growth of 1.7% with a budget deficit of 8.5% of GDP is the 2011 position. This gives no indication of the likelihood of a sudden and sustained upward move in the U.S. growth rate. Work by Reinhart and Rogoff suggests growth will be sluggish in the present public debt scenario.
2. Default on the debt - not a viable option.
3. Inflate away the debt - At present U.S. inflation is running at a year on year rate around 3% (depending on which measure you are looking at). The budget deficit is at 8.5% of GDP, so inflation will have to go to a level of 8.5% for the real level of debt to be unaltered. This also does not seem either likely or achievable.
Many think that the present money printing will lead to much higher levels of inflation. However we started money printing in 2009 and high inflation has not happened yet. Inflation has grown from under 1% to 3% in 3 years or approximately 0.67% per year. At these rates it will take 8.2 years for inflation to reach 8.5%, even if it were allowed to go to this level. This does not appear to be a solution. However it is likely that inflation will help reduce the burden of debt in the present U.S. position, it will just not be enough on its own.
This leaves us with 2 workable solutions:
1. Monetize the debt - At present the Fed has purchased $2.6 trillion of treasuries or approximately 17% of the total available treasuries. Whatever their intentions, it is clear that the Fed is monetizing U.S. debt. The question is whether they will continue on this path, especially if the amount that they need to buy to keep interest rates stable becomes larger and larger. Will they for instance amass $5 trillion (32% of present debt) or $10 trillion (64%) and what will the unintended consequences of this be? Currency collapse? Hyperinflation?
2. Austerity - Today the US debt clock gives U.S. public debt of $15.6 trillion. What will the new President and Congress do? There is plenty of discussion now regarding the expiration of the Bush tax cuts at the start of 2013. This has now been called a 'fiscal cliff'. The Bush tax cuts expiration will have the following effect:
"The Congressional Budget Office predicts that, under current law, the revenue of the federal government will rise from $2.4 trillion in the current fiscal year, which ends in September, to $2.9 trillion in the following fiscal year."
The following is from Martin Feldstein of Harvard University:
The CBO projection of the increase in revenues of $512 billion is equivalent to 2.9 percent of GDP, bringing federal revenue as a share of GDP from 15.8 percent this year to 18.7 percent next year. The higher revenue would reflect an increase in personal tax rates, higher payroll taxes, as well as higher taxes on dividends, capital gains and corporate incomes. Revenue would continue to rise in future years - as a share of GDP, it would increase to 19.8 percent in 2014 and would stay above 20 percent for the remainder of the decade. A sustained tax increase of that magnitude would push the U.S. into a new and deep recession next year. It is important to recognize that legislation is required to prevent such a tax rise.
Feldstein believes getting that legislation passed will be difficult.
It seems unlikely that the Congress will agree on a package that results in an increase of taxes of $512 billion. Assuming a growth rate of nominal GDP of 3.9% (the same as for 2011), US nominal GDP will be $15,685 billion in 2012. $512 billion will represent 3.26% of 2012 nominal GDP, assuming a dollar for dollar reduction in GDP for each dollar reduction in deficit (Note: I have read figures that vary from 0.8 to 1.2 for each dollar reduction of budget reduction and have chosen the middle figure as I am not qualified to suggest otherwise). It seems highly unlikely that Congress will pass a bill that will result in a recession. In 2011 all attempts at a fiscal agreement failed in Congress. Will the result be any better in 2012, specially as there will only be just over a month between the election of the president and the expiration of the tax cuts at the start of 2013? Growth is clearly paramount to US fiscal success.
Note: the difference between my projection and Feldstein's is the projected increase in U.S. GDP and that he is likely using 2013 GDP for comparison. You are quite welcome to believe either estimate as it does not effect the position materially.
Any discussions of the U.S. debt position will be very influential on the stock market. The debt ceiling seems likely to be reached in the middle of September, which will bring it into the presidential election debate. Will this help or hinder any progress?
It seems clear that the present position cannot carry on indefinitely, so it will not carry on. I will be surprised if some sort of limited austerity is not negotiated by congress before it is forced on the nation by the bond markets (although not the full repeal of the Bush tax cuts).
If market forces push the issue, It would be unlikely that the Fed would buy unlimited treasuries to stave off a crisis without an agreement on the future fiscal path from Congress. In these circumstances Congress would be forced into making a deal on the present budget stalemate to gain Fed bond market support and this may well be how it is achieved. The key question in this scenario is what the Fed does? Will they monetize the debt without any fiscal sanity, if it is required to stave off a crisis or will they require some sort of deal from congress to ride to the rescue.
My thoughts are that they will demand a fiscal deal to protect their position (but would be interested in any comments on the issue). If it comes to this position the Fed is in a very difficult place, if high inflation results they will get the blame. I can't see them on this path unless they have their backs covered. With a fiscal deal they can claim that they were crisis managing the congress. Hopefully the position will not get to this type of impasse, but it has to be considered.
The likely solution to the debt problem will therefore involve both fiscal austerity and monetization by the Fed and will be helped by limited inflation. I am sure that if agreement is reached on a reasonable fiscal policy, the Fed will monetize enough debt to keep interest rates stable. However, this will not be a smooth ride and it is likely that there will be substantial volatility in financial markets. It is therefore clearly possible that this will lead to a crisis with the dollar falling substantially. The risks of the stalemate in congress on fiscal policy are therefore greater than is presently priced into markets. However, in market timing, this is an age away and it is likely that this will not become a market issue until some time in September.
However it would seem likely that this issue will be resolved in the next year. It is probably the most influential decision for financial markets since the decision to allow Lehman Brothers to fail. It is not clear today how it will be resolved. If austerity is involved, it will be negative for the stock market. Don't be fooled into thinking that a fiscal deal will be positive for markets in the medium term, it will not be. A fiscal deal is a necessary step for America's long term success but it will be painful in the medium term. If I am correct and the outcome is a combination of austerity, inflation and monetization, the U.S. will be following the Japanese model, which leads me nicely to my last point.
At some stage Japan is going to be forced to face the results of its past economic policy mistakes. The outcome is unlikely to be pretty. If the timing of this event is before any resolution on the U.S. position, the policy options that are chosen may well be very different and not at all what we are presently expecting. If Mises is right and debt induced asset price bubbles lead to either depressions or hyperinflations, the U.S. may get a front row seat of a resolution to this type of policy in Japan. That may well be enough to change present policies. I have long thought that eventually the U.S. will either choose or be forced into managed austerity (similar to what is being done in the U.K.). I cannot see the Fed printing money of the amounts that will be needed, without some budget restraint by Congress. The Fed is still an independent central bank, despite any comments to the contrary. I will find out in the next year if this is a correct analysis or not. And on that question the long term health of this bull market rests!
Note:- I wrote an article recently here on some likely data points over the next few months. After the non farm payrolls release you may want to have a look!
I am just about to read 'this time is different' by Reinhart and Rogoff. I have never read it in it's entirety and am hoping that it will further my understanding of these difficult times.
Disclaimer - This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.
Additional disclosure: Long RWM, RIMM and gold futures, short EUR/USD,