The Global Debt Crisis Risk
Carlos M Pelaez

The most critical issue of the world economy is the threat to the recovery from the global recession by rising long-term interest rates driven by the fiscal imbalances and debt of many advanced countries. US debt is rated AAA because the institution that issues the debt, the US government, issues the currency or legal tender, the dollar, with which the debt is redeemed. The dollar is the reserve currency of most countries in the world, conferring to US debt what Charles Degaulle called “exorbitant privilege,” quoting his finance minister Valéry Giscard D’Estaing (Pierre-Olivier Gourinchas and Hélène Rey cited by Pelaez and Pelaez, The Global Recession Risk, 44, Globalization and the State, Vol. II, 190). The US is like the venture capitalist of the world, borrowing short-term at low rates to invest long-term in equities and direct investment with higher rates of return. The pressure on long-term interest rates eroding the US “exorbitant privilege” by threatening its credit rating originates in the deteriorating fiscal situation and the unwinding of the Fed balance sheet. The Congressional Budget Office (CBO) calculates record fiscal deficits from the President’s budget proposal of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP after $1.4 trillion or 9.9 percent of GDP in 2009 (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml ). Debt held by the public would rise from $7.3 trillion or 53 percent of GDP in 2009 to $20.3 trillion or 90 percent of GDP in 2020. Net interest would quadruple from 1.4 percent of GDP in 2010 to 4.1 percent in 2020. The Fed holds a portfolio of $1.9 trillion of long-term securities that will cause increases in long-term interest rates when it is sold to the public even using appropriate tools in an optimum exit strategy. Issuance of debt to pay for continuing high government deficits and refinancing of maturing debt together with the sale of the Fed’s portfolio will cause upward pressure on long-term interest rates with likely adverse effects on the rate of economic growth and employment. The will to restore fiscal balance by elected officials is replaced by profligacy during election processes in alternate years. Voters will eventually be more committed to fiscal parsimony.
This post provides initially analysis of important developments in bond markets, interest rates and the fiscal situation followed by an analytical narrative of the shocks of interest rates in the economic cycle. The final section focuses on the mixed signals from short-term economic indicators and the increasingly worrisome outlook.
Bond Markets and the World Debt Problem. There are signs of stress in markets of US Treasuries. The sale of $118 billion of Treasuries in the week of Mar 22 as part of expected debt issue of $1.6 trillion this year after $2.1 trillion in 2009 resulted in sharp increase of the yield of the 10-year Treasury note to 3.9 percent while the 30-year mortgage rate jumped from 5.06 to 5.13 percent (http://online.wsj.com/article/SB10001424052748704094104575144244213486742.html?KEYWORDS=Lauricella ). The yield of the 10-year note touched briefly 3.954 percent only in intraday trading on Jun 10-11, 2009 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_bnd_dtabnk&symb=UST10Y&page=bond ). Data and analysis by Bloomberg posted on Mar 22 reveal pressure on the yields of Treasury securities because of record budget deficits and expectations of increases in the ratio of debt to GDP of the US toward 100 percent or more (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=azz5FiyZHvMY ). Composite prices compiled by Bloomberg show that notes of large US private entities yield less than the Treasury equivalent security: Berkshire Hathaway note due in Feb 2012 yield -3.5 basis points (bp), Procter & Gamble’s note due on Aug 2012 yield -6 bp and Johnson & Johnson note due Aug 2012 yield -3 bp. Corporate debt is being priced at a yield or risk lower than government debt. Bloomberg also recalled the warning a week earlier by Moody’s that the US would be the AAA-rated country with second highest ratio of debt payments to government revenue: 7 percent in 2010, increasing to 11 percent in 2013. The US government borrowed $2.1 trillion in 2009 almost twice the issue of debt by investment grade companies of $1.08 trillion. Bloomberg data also show that investors demand 60 bp more in yields of Treasuries than in yields of German bunds of similar maturity while a year ago bunds yielded about 50 bp more than Treasuries. The German government deficit is projected to increase to 5.5 percent of GDP in 2010 or half of the deficit/GDP ratio of the US (http://www.imf.org/external/np/ms/2010/020810.htm ). There is temptation to short US Treasuries while going long on similar bonds of Germany and Canada. This arbitrage position is not speculation but rather a defensive strategy for maintaining wealth that would erode in value if invested in Treasuries. Fiscal profligacy is the actual speculation that excessive spending currently does not have a hard price in the future in foregone economic activity and jobs.
Some of the most prominent participants in world financial markets expressed concern about the fiscal situation. Answering questions during testimony in the House (http://www.federalreserve.gov/newsevents/testimony/bernanke20100325a.htm ), Chairman Bernanke reiterated the need for concerted, credible action moving the path of the US deficit toward a more sustainable path (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aHNI.d7R6uVU ). William H. Gross, Managing Director of PIMCO, warned that Treasuries may not be a good investment even if the US escapes its worsening fiscal situation by issuing debt (http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/Rocking-Horse+Winner+April+2010+IO.htm ). The First Managing Director of the International Monetary Fund (IMF), John Lipsky, revealed the projection that average government debt of advanced countries will increase from 75 percent of GDP at year-end 2007 to 110 percent of GDP at year-end 2014. The IMF expects that with the exception of Canada and Germany all G7 countries including the US will have debt/GDP ratios above 100 percent by 2014 (http://www.imf.org/external/np/speeches/2010/032110.htm ). The fiscal effort required to attain by 2030 the average debt/GDP ratios of 60 percent before the credit crisis would require reversing the average deficit of 4 percent of GDP in 2010 to a surplus of 4 percent of GDP in 2020 and maintaining the surplus at that level for an entire decade. The initial swing from deficit to surplus in the first decades of adjustment amounts to 8 percentage points of GDP. Higher taxes will be a key ingredient in reversing fiscal excesses. There is nonzero probability of a global debt crisis likely centered in the US characterized by a risk premium on government debt.
Wealth Shocks. An analytical narrative of the recent economic cycle can shed light on events and future perspectives by the use of permanent income concepts (A Theory of the Consumption Function by Milton Friedman cited by Pelaez and Pelaez, Regulation of Banks and Finance, 219, Globalization and the State, Vol. II, 200 and cited in Friedman’s Nobel presentation (http://nobelprize.org/nobel_prizes/economics/laureates/1976/presentation-speech.html ). Decisions are made not on the basis of current income but on the expectation of what income will be over a lifetime. The calculation of the all-in costs of a medical education including tuition and foregone income during school years and in hospital residence is close to one million dollars. The student borrows the equivalent of a mortgage on a house with the expectation that the lifetime earnings will permit repayment of the loan principal and interest, providing more comfort than available alternatives. All decisions of consumption and investment by households are made on the basis of expectations of lifetime earnings. Wealth consists of physical assets such as houses, bonds and stocks, pensions and human capital such as education and training. Income, Y, is a flow that is obtained by applying a rate of return, r, to the stock of wealth, W, or Y = rW, which on division of both sides by r becomes Y/r = W. A decrease in interest rates perceived by households to be permanent can induce perceptions of permanent increases in wealth as in forever increasing house values, stocks and retirement funds.
In the first period of recovery from the shallow and short recession of 2001, the Fed lowered the policy rate or fed funds rate to 1 percent with the “forward guidance” that it would remain at low levels for as long as required. There was an additional policy of eliminating the auctions of 30-year Treasury bonds between 2001 and 2005 to lower mortgage rates. The policy of affordable housing consisted of a yearly subsidy of $211 billion per year. Fannie Mae and Freddie Mac increased their combined retained and guaranteed portfolios to $4.9 trillion in 2007 or 41.1 percent of total outstanding mortgages of $12.1 trillion and acquired or guaranteed $1.6 trillion of nonprime mortgage-backed securities (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-8, Regulation of Banks and Finance, 79-80). The combination of these policies increased house prices, stock values, bond prices and retirement funds, raising expectations of higher lifetime earnings or wealth that were eroded when the Fed raised interest rates from 1 percent to 5.25 percent between Jun 2004 and Jun 2006. The credit/dollar crisis and global recession originated in these four almost contemporaneous policies that induced highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).
Expectations of lifetime income are suffering a major setback from the poor prospects of economic recovery during the next three decades because of painful fiscal adjustment by taxation in lowering debt levels to the period before the crisis. A global debt crisis would force the adjustment, resulting in costly and sudden contraction of economic activity and jobs. Expected weak economic conditions during a protracted period in the future do not augur well for returns on past, current and future prospects of investment on education and training. The fiscal effort will consist significantly of tax increases. The huge government debt will maintain high real rates of interest, increasing the burden of interest payments. Limited opportunities for entrepreneurship will restrain innovation that has driven US economic growth. Permanent unemployment or underemployment will afflict segments of the population, creating strains on safety nets.
Economic Indicators and Outlook. The National Association of Realtors (NAR) announced on Mar 23 that existing-home sales declined 0.6 percent in Feb to 5.02 million annual equivalent compared with 5.05 million in Jan but are higher by 7.0 percent over 4.69 million in Feb 2009. The inventory of unsold houses increased 9.5 percent in Feb to 3.59 million annual equivalents, which corresponds to 8.6 months at current sales. Distressed sales represented 35 percent of total sales (http://www.realtor.org/press_room/news_releases/2010/03/ehs_ease ). The housing sector may not recover soon its past dynamism of 7.1 million sales of existing homes in 2005, for decline of 30.3 percent from that peak to current levels, or even 6.2 million in 2003 (NAR cited in Pelaez and Pelaez, The Global Recession Risk, 224). The US Census Bureau announced on Mar 24 that sales of new houses in Feb 2010 stood at the seasonally adjusted annual rate of 308,000 for decline of 2.2 percent relative to Jan and 13 percent below 354,000 in Feb 2009 with the stock of unsold homes equivalent to 9.2 months of current sales (http://www.census.gov/const/newressales.pdf ). New home sales have declined from 1371 thousand in Jul 2005 to 308 thousand in Feb 2010 or by 77.5 percent (http://www.census.gov/const/newressales_200601.pdf ). Recovery of pre-crisis levels would require an increase by 4.4 times from current levels. Many workers developed skills and established small businesses during the construction boom for jobs and opportunities that may not return, illustrating the need for creating new, different jobs. On Mar 24 the US Census Bureau announced that new orders for manufactured durable goods increased by 0.5 percent in Feb for a third consecutive monthly increase, following an increase by 3.9 percent in Jan. Durable goods increased by 10.9 percent in Feb 2010 relative to a year earlier (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). The recovery is driven by manufacturing but dragged by housing. Seasonally adjusted initial jobless claims for the week of Mar 20 were 442,000, decreasing by 14,000 from 456,000 in the previous week and the four-week average declined by 11,000 to 453,700. The number of insured unemployment in the week ending on Mar 13 was 4.6 million, decreasing by 54,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Claims below 350,000 as in 2007 may signal dynamic labor markets that could help to initiate the recovery of employment. The Bureau of Economic Analysis of the Department of Commerce announced on Mar 26 that GDP grew at the annual seasonally-adjusted rate of 5.6 percent in the fourth quarter of 2009 with the following contributions in percentage points (pp): 1.16 personal consumption expenditures, 4.39 gross private domestic investment decomposed in 3.79 from change in private inventories and only 0.61 from fixed investment, 0.27 net exports of goods and services and -0.26 government consumption expenditures and gross investment (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2008&LastYear=2009&Freq=Qtr ). While the rate of growth is high, recovery requires more impulse from segments other than change in inventory. In the recession of the 1980s the quarterly annual percentage rate of growth of GDP was: -7.9 QII80, -0.7 QIII80, 7.6 QIV80, 8.6 QI81, -3.2 QII81, 4.9 QIII81, -4.9 QIV81, -6.4 QI82, 2.2 QII82, -1.5 QIII82 and 0.3 QIV82. During the recovery phase GDP grew at the quarterly annual percentage rate of: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points only in a few quarters: 3.5 QII83, 3.1 QIV83 and 5.1 QI84. Growth was driven by personal consumption expenditures and fixed investment. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to: 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The recovery of full employment depends on sustained high quarterly annual rates of growth of GDP originating in demand and fixed investment. Taxation and high interest rates may flatten dynamism from the private sector.
The Fed holds a portfolio of $709 billion of Treasury notes and bonds, $1073 billion of mortgage-backed securities and $167 billion of federal agency securities for total of $1.9 trillion with excess reserve balances of $1144 billion and $100 billion in the Treasury supplementary financing account in the road to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). On Mar 26, the 30-year bond yielded 4.75 percent, the 10-year Treasury note 3.85 percent, the 5-year note 2.59, the 2-year 1.04 and the 3-month bill 0.13 percent (http://www.bloomberg.com/markets/rates/index.html ). This peculiar yield-curve will shift upward with unpredictable twists because of the combination of budget deficits and rising debt with the Fed’s exit of monetary stimulus. There is still time for avoiding a perverse combination of tight monetary policy with expansive fiscal policy that can restrain growth and job creation.
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