U.S. Debt–to-GDP Situation, When Will the Dominos Align

By: Hans_Wagner

In February 19, 2010 Wall Street Journal, Daniel Henninger included the following chart in his column. Federal spending has grown seven times the real median household income over the last 40 years. At some point, the government will be unable to pay for all the new programs, stimulus, healthcare, rapid expansion in number of government employees, etc. The market will drive up the cost of debt to levels that lead to default. Many say it cannot happen to the U.S.

There is a lot of truth in that claim. After all, the U.S. treasuries have seen substantial buying interest as concern over the Greek credit crisis grew more worrisome, lending credence to those that claim the U.S. remains strong despite the growing deficits. But where is the break point?

Debt-to-GDP Threshold

In a paper by Carmen Reinhart and Ken Rogoff, the authors of This Time Its Different found that when the government debt-to-GDP ratio rises above 90%, it lowers the future potential GDP of that country by more than 1%. It also locks in a slow-growth, high-unemployment economy. The authors point to history that shows that public debt tends to soar after a financial crisis, rising by an average of 86% in real terms. Defaults by sovereign entities often follow.

The current problems of Greece and Europe offer an example of what a country faces when their debt gets out of control.

Several countries, including Greece were allowed into the European Union with an exchange rate that many considered overvalued relative to the currencies of the larger more stable countries. This encouraged the Greek consumer to buy products that had been too expensive. Short term it helped the export driven economies of the larger European countries such as Germany.

After joining, the Greek government continued to spend beyond its means. The current Greek debt is now €254 billion and their GDP is €250.9 billion. The Greek debt to GDP ratio is 101.2%, greater than Reinhart and Rogoff’s threshold. The potential that Greece could fail is real, as they are unlikely to be able to fund this debt and future expenditures.

To receive a bailout, Greece is being asked to cut its budget to 8.7% of its deficit in 2010 and another 3% in each of the next three years. This is the equivalent of a $560 billion budget cut for the U.S. this year followed by further cuts of the same size in each of the following years.

U.S. Debt–to-GDP Situation

To put this into perspective the U.S. debt is $12.6 trillion and the 2009 GDP was $14.4 trillion or an 88% debt to GDP ratio. The Federal Reserve and other intergovernmental agencies such as the Social Security fund own approximately half of the U.S. Treasury debt.

With the U.S. running current budget deficits of $1.4 trillion that are expected to continue for several years, this ratio will rise. To quote the Congressional Budget Office (CBO), The Budget and Economic Outlook: Fiscal Years 2010 to 2020, dated January 2010:

“If the tax cuts were made permanent, the AMT was indexed for inflation, and annual appropriations kept pace with GDP, the deficit in 2020 would be nearly the same, historically large, share of GDP that it is today, and debt held by the public would equal nearly 100 percent of GDP” by 2020. This is only for the portion of debt held by the “public” which is about half of the total debt of the U.S. government.

Assuming GDP expands at a 3% per annum rate and the annual deficit remains at $1.4 trillion, both optimistic assumptions, the U.S Debt-to-GDP ratio will pass the 90% threshold in 2011 and reach 102% by 2016, just six years away. This is for the total debt held by the public and by the Federal Reserve and Intergovernmental Agencies.

To keep annual deficits and total federal debt from reaching levels that would substantially harm the economy, lawmakers would have to increase revenues significantly as a percentage of GDP, decrease projected spending sharply, or enact some combination of the two.

Domino Theory

Certainly, the Greek economy is not the same as the U.S. Greece is a country of 10 million people with over 50% of the GDP is government spending. The country does not have the where withal to fund its debt. Any austerity program will be devastating to the country causing a severe recession.

Why not let Greece go under? A loss in the confidence of sovereign debt can be contagious. As those governments that hold the debt of other countries scramble to extract themselves from the fall out, they make the problem worse. The debt they hold of troubled countries falls in value causing them to face their own debt crisis. Once the ball starts down the hill it gains momentum bring stronger and more secure countries with it.

Some countries might try to reduce their debt load through lower spending and higher taxes. This action will push them into a new recession. As one country tips to recession it will curtail spending that drags other countries down with it.

Paul Krugman, a prominent economist, believes this risk is unfounded. The economic strength of the U.S. provides a source of safety for governments and investors worldwide. Yields remain low, as demand for private capital is weak. He believes that as long as households rebuild their savings and companies hold back from investing, the demand will remain low. Notice that savings must rise and investing needs to remain low to keep rates low.

What if the U.S. consumer returns to their free spending ways and stops saving? The lack of available capital will drive up interest rates, increasing the cost of debt that subtracts from the country’s GDP. The CBO projects that the government’s annual spending on net interest will more than triple between 2010 and 2020 in nominal terms, from $207 billion to $723 billion, and will more than double as a share of GDP, from 1.4 percent to 3.2 percent.

A less robust economy increases the strain to pay for this debt. Governments must reduce their spending and increase taxes to cover existing obligations. People who depend on payments from various entitlement programs will receive lower benefits as the promises are not kept.

Already the Social Security system is taking in less in taxes than it spends on benefits. The government has been borrowing from the social security system for years giving the Trust IOUs in the form of Treasury securities. The interest from these treasury securities helps to cover the cost of benefits. The government pays this same interest to all holders of the securities. When you remove the government interest payments from social security, the surplus turns into a deficit. According to the CBO: “For Social Security as a whole, the estimated surpluses peak at $139 billion in 2015 and decline to $107 billion in 2020. Excluding interest (which accounts for the bulk of the intra-governmental transfer), surpluses for Social Security become deficits of $28 billion in 2010 and $202 billion over the period from 2011 to 2020.” The social security system is cash flow negative.

At some point the U.S. will have to bite the bullet and address its debt situation. We do not know what specific event will cause this change or when it will happen, but the current trend is unsustainable. That is why some investors worry what happens with Greece might be that event. I suspect that Europe will deal with Greece and keep it from becoming a more significant problem.

The Bottom Line

As the safe haven, the U.S. enjoys a unique situation. It is able to sell its debt at very low rates and there is a ready market for these securities. However there are some forces in play that could cause this view to change.

First, the debt of the large rich countries goes beyond the temporary affects of the credit crisis. An ageing population with soaring health and pension costs will cause the U.S.’s debt to continue to climb. So far investors have ignored this deterioation of the balance sheet of the U.S. At some point the piling on of debt will become a problem to big to ignore.

Second, as the economy recovers and expands, investment will increase, spawning demand for credit. Interest rates will rise accordingly. Higher interest rates require higher payments taking money away from other government expenditures. This raises the risk premium on soverign debt. Presently, the average maturity on federal debt is less than five years. With higher rates it becomes much more expensive to roll over this debt, making the debt situation worse. Some analysts expect the 10-year rate to rise to 5% be the end of 2010. It was 3.825% on March 24, 2010.

Third, the emerging economies are changing the global economic structure. In the next few years there will be one billion middle people classfiied as middle class in their countries. Domestic spending in these countries will climb offsetting their savings, which is likely to fall relative to their net worth and incomes. This will encourage the cost of capital to climb, hurting those countries with the most debt. The rapid growth of these countries will cause a shift in the perception of where is a safe place to invest. Countries such as Brazil will be relatively more attractive to investors vs. the U.S.

Fourth, new entitlement programs that cannot be funded will add to the debt burden of the U.S. If the market perceives that these new expenditures are unfunded, it will drive up the risk premium for any new debt. The new health insurance program that become law on March 23, 2010 could fall into this category.

Fifth, as Paul Krugman indicated, if households rebuild their savings, it will provide much of the capital to help fund the debt. On the other hand, if consumers start to spend as before, reducing their savings, the cost of capital will rise. The growth in savings seems to have tapered off as consumers are starting to spend. While a positive for the domestic economy, the consumer discretionary sector and GDP, it is a negative for the capital markets and will drive up interest rates.

Going forward we need to monitor these events to see if any one of them causes a break in the debt markets, as this maybe the first sign the U.S. must face up to its growing debt problem.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2010 Hans Wagner

If you wish to learn more on evaluating the market cycles, I suggest you read:

Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.

Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling.  One of the best, easy-to-read, study of stock market cycles of which I know.

The Disciplined Trader: Developing Winning Attitudes by Mark Douglas.  Controlling ones attitudes and emotions are crucial if you are to be a successful trader.

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