Sovereign Woes

I'm on vacation this week, so blogging will be light.  GM will have to have its death throes largely without me.

But I do want to point to two articles that point to a growing problem that the Obama administration has failed to address in any serious way:  the exploding deficits, and the resulting need to borrow heavily.  USA Today points out that tax revenues are plummeting at the same time as spending is exploding:

Federal tax revenue plunged $138 billion, or 34%, in April vs. a year ago -- the biggest April drop since 1981, a study released Tuesday by the American Institute for Economic Research says.

When the economy slumps, so does tax revenue, and this recession has been no different, says Kerry Lynch, senior fellow at the AIER and author of the study. "It illustrates how severe the recession has been."

For example, 6 million people lost jobs in the 12 months ended in April -- and that means far fewer dollars from income taxes. Income tax revenue dropped 44% from a year ago.

"These are staggering numbers," Lynch says.

Big revenue losses mean that the U.S. budget deficit may be larger than predicted this year and in future years.

. . .

The White House thinks that tax revenue will increase in 2011, thanks in part to the stimulus package, says the report from AIER, an independent economic research institute. But it warns, "Even if that does happen, the administration also projects that government spending will be so much higher each year that large deficits will continue, and the national debt held by the public will double over the next 10 years."

The government may have a hard time trimming spending to reduce the deficit when the recession ends. The 77 million Baby Boomers-- those born in 1946 through 1964 -- will start tapping their federal retirement benefits soon, which means increased government outlays for Social Security and Medicare.

"It will be doubly difficult for federal government to reduce expenditures and narrow the deficit as rapidly as they did following previous recessions," Lonski says. At the end of the last major recession, in 1981, Boomers were in their 30s. Their incomes were expanding, as was their appetite for goods and services.

Meanwhile, in the FT, John Taylor warns that our national credit rating is in danger:

A government debt burden of that [100 per cent] level, if sustained, would in Standard & Poor's view be incompatible with a triple A rating," as the risk rating agency stated last week.

I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor's considers. The deficit in 2019 is expected by the CBO to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth - probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.

The fact that the Federal Reserve is now buying longer-term Treasuries in an effort to keep Treasury yields low adds credibility to this scary story, because it suggests that the debt will be monetised. That the Fed may have a difficult task reducing its own ballooning balance sheet to prevent inflation increases the risks considerably. And 100 per cent inflation would, of course, mean a 100 per cent depreciation of the dollar. Americans would have to pay $2.80 for a euro; the Japanese could buy a dollar for Y50; and gold would be $2,000 per ounce. This is not a forecast, because policy can change; rather it is an indication of how much systemic risk the government is now creating.

Short term yields firmed up this week on better consumer confidence data, but short-term yields shouldn't be what we worry about.  Eventually the treasury has to roll that debt or pay it off, and if interest rates spike, that can prove catastrophic--just ask Argentina.  The five year, seven year, and especially the thirty year auctions will tell us much more.

If the longer-yield debt again registers weak demand, the administration is going to have to address this problem.  Up until now, most of the debate over the administration's spending plans has focused on the political problem:  will the American public accept higher spending?  But the problem isn't the spending; it's how to pay for it.  If the spending were attached to tax hikes, this would cut into its popularity (though I don't know by how much).  That's one of the reasons that administrations like to fund their new spending with borrowing.  But you can't long do this on a scale that freaks out the bond markets--just ask Argentina.  And these days, the bond markets are easily freaked.