Yet Another ‘Innocent Fraud’ Attack On Social Security And Medicare

The Future of Public Debt

By John Mauldin

For the rest of this letter, and probably next week as well, we are going to look at a paper from the Bank of International Settlements, often thought of as the central bankers’ central bank. This paper was written by Stephen G. Cecchetti, M. S. Mohanty, and Fabrizio Zampolli. ( http://www.bis.org/publ/work300.pdf?noframes=1)

The paper looks at fiscal policy in a number of countries and, when combined with the implications of age-related spending (public pensions and health care), determines where levels of debt in terms of GDP are going. The authors don’t mince words. They write at the beginning:

“Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable.

Solvency is never the issue with non convertible currencies/ floating exchange rates. The risk is entirely inflation, yet I’ve never seen a manuscript critical of deficit spending that seriously looks at the inflation issue apart from solvency concerns.

Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability.”

The negative consequences are always due to the moves presumed necessary to reduce deficits, not deficit spending per se.

Drastic measures is not language you typically see in an economic paper from the BIS. But the picture they paint for the 12 countries they cover is one for which drastic measures is well-warranted.

That would mean a hyper inflation scare, not solvency fear mongering.

I am going to quote extensively from the paper, as I want their words to speak for themselves, and I’ll add some color and explanation as needed. Also, all emphasis is mine.

“The politics of public debt vary by country. In some, seared by unpleasant experience, there is a culture of frugality. In others, however, profligate official spending is commonplace. In recent years, consolidation has been successful on a number of occasions. But fiscal restraint tends to deliver stable debt;

Stable public debt means stable non govt nominal savings with economies that require expanding net financial assets to support expanding credit structures and offset institutional demand leakages.

rarely does it produce substantial reductions. And, most critically, swings from deficits to surpluses have tended to come along with either falling nominal interest rates, rising real growth, or both. Today, interest rates are exceptionally low and the growth outlook for advanced economies is modest at best. This leads us to conclude that the question is when markets will start putting pressure on governments, not if.

Govts with non convertible currency/floating fx are not subject to pressure from markets with regards to funding or interest rates.

“When, in the absence of fiscal actions, will investors start demanding a much higher compensation for the risk of holding the increasingly large amounts of public debt that authorities are going to issue to finance their extravagant ways?

Investors have to take what’s offered, or exit the currency by selling it so someone else. And floating exchange rates continuously express the indifference levels

In some countries, unstable debt dynamics, in which higher debt levels lead to higher interest rates, which then lead to even higher debt levels, are already clearly on the horizon.

Only countries such as the euro zone members who are not the issuer of the euro, but users of the euro. They are analogous to us states in that regard, and are credit sensitive entities.

“It follows that the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely.

Agreed, except fiscal drag needs to be removed to restore private sector output and employment. They have this backwards.

Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk.

Like Japan? Triple the ‘debt’ of the US with a 1.3% 10 year note? And never a hint of missing a payment. And Japan, the US, UK, etc. all have the same institutional structure.

It will also complicate the task of central banks in controlling inflation in the immediate future and might ultimately threaten the credibility of present monetary policy arrangements.

Yes, inflation is the potential risk, which is mainly a political risk. People don’t like inflation and will topple a govt over it. But there is no economic evidence that inflation is a negative for growth and employment.

“While fiscal problems need to be tackled soon, how to do that without seriously jeopardising the incipient economic recovery is the current key challenge for fiscal authorities.”

Yes, exactly. Because they have it wrong. The fiscal problem that has to be tackled soon is that it’s too tight, as evidenced by the high rates of unemployment.

They start by dealing with the growth in fiscal (government) deficits and the growth in debt. The US has exploded from a fiscal deficit of 2.8% to 10.4% today, with only a small 1.3% reduction for 2011 projected. Debt will explode (the correct word!) from 62% of GDP to an estimated 100% of GDP by the end of 2011.

Yes, and not nearly enough, as unemployment is projected to still be over 9%, and core inflation is what is considered to be dangerously low.

Remember that Rogoff and Reinhart show that when the ratio of debt to GDP rises above 90%, there seems to be a reduction of about 1% in GDP. The authors of this paper, and others, suggest that this might come from the cost of the public debt crowding out productive private investment.

Can be true for fixed exchange rate regimes/convertible currency, but not true for today’s non convertible currency and floating fx regimes. And today, deficits generally rise due to slowdowns that drive up transfer payments and cut revenues ‘automatically’ (automatic stabilizers) so it’s no mystery that rising deficits are associated with slowing economies, but the causation is the reverse RR imply.

Think about that for a moment. We are on an almost certain path to a debt level of 100% of GDP in less than two years. If trend growth has been a yearly rise of 3.5% in GDP, then we are reducing that growth to 2.5% at best. And 2.5% trend GDP growth will NOT get us back to full employment. We are locking in high unemployment for a very long time, and just when some one million people will soon be falling off the extended unemployment compensation rolls.

Nothing that a sufficient tax cut won’t cure. There is a screaming shortage of aggregate demand that’s easily restored by a simple fiscal adjustment- tax cut and/or spending increase.

Government transfer payments of some type now make up more than 20% of all household income. That is set up to fall rather significantly over the year ahead unless unemployment payments are extended beyond the current 99 weeks. There seems to be little desire in Congress for such a measure. That will be a significant headwind to consumer spending.

Yes, backwards policy. They need to work to restore demand, not reduce it.

My first proposal is for a full payroll tax (fica) holiday, for example.

Government debt-to-GDP for Britain will double from 47% in 2007 to 94% in 2011 and rise 10% a year unless serious fiscal measures are taken.

Or unless the economy rebounds. In that case the deficit comes down and the danger is they let it fall too far as happens with every cycle.

Greece’s level will swell from 104% to 130%,

Yes, and they are credit sensitive like the US states.
This is ponzi.
Ponzi is when you must borrow to pay maturing debt

The US, UK, Japan, etc. Have no borrowing imperative to pay debt, the way Greece does.
They make all payments the same way- they just mark up numbers on their computers at their own central banks:

(SCOTT PELLEY) Is that tax money that the Fed is spending?
(CHAIRMAN BERNANKE) It’s not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed.

Bernanke didn’t call china to beg for a loan or check with the IRS to see if they could bring in some quick cash. He just changed numbers up with his computer.

so the US and Britain are working hard to catch up to Greece, a dubious race indeed.

Confused!

Spain is set to rise from 42% to 74% and “only” 5% a year thereafter; but their economy is in recession, so GDP is shrinking and unemployment is 20%. Portugal? 71% to 97% in the next two years, and there is almost no way Portugal can grow its way out of its problems.

Yes, they are in Ponzi

Japan will end 2011 with a debt ratio of 204% and growing by 9% a year. They are taking almost all the savings of the country into government bonds, crowding out productive private capital.

Nothing is crowded out with non convertible currency and floating fx. Banks have no shortage of yen lending power. The yen the govt net spends can be thought of as the yen that buy the jgb’s (japan govt bonds)

Reinhart and Rogoff, with whom you should by now be familiar, note that three years after a typical banking crisis the absolute level of public debt is 86% higher, but in many cases of severe crisis the debt could grow by as much as 300%. Ireland has more than tripled its debt in just five years.

Ireland is in Ponzi as they are users of the euro.

The BIS continues:

“We doubt that the current crisis will be typical in its impact on deficits and debt. The reason is that, in many countries, employment and growth are unlikely to return to their pre-crisis levels in the foreseeable future. As a result, unemployment and other benefits will need to be paid for several years, and high levels of public investment might also have to be maintained.

“The permanent loss of potential output caused by the crisis also means that government revenues may have to be permanently lower in many countries. Between 2007 and 2009, the ratio of government revenue to GDP fell by 2-4 percentage points in Ireland, Spain, the United States and the United Kingdom.

Again, failure to recognize the critical differences between issuers and users of the currency.

It is difficult to know how much of this will be reversed as the recovery progresses. Experience tells us that the longer households and firms are unemployed and underemployed, as well as the longer they are cut off from credit markets, the bigger the shadow economy becomes.”

Yes, responsible fiscal policy would not have let demand fall this far. The US should have had a full payroll tax holiday no later than sept 08, and most of the damage to the real economy would have been avoided.

We are going to skip a few sections and jump to the heart of their debt projections. Again, I am going to quote extensively, and my comments will be in brackets [].Note that these graphs are in color and are easier to read in color (but not too difficult if you are printing it out). Also, I usually summarize, but this is important. I want you to get the full impact. Then I will make some closing observations.

The Future Public Debt Trajectory

“We now turn to a set of 30-year projections for the path of the debt/GDP ratio in a dozen major industrial economies (Austria, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, the United Kingdom and the United States). We choose a 30-year horizon with a view to capturing the large unfunded liabilities stemming from future age-related expenditure without making overly strong assumptions about the future path of fiscal policy (which is unlikely to be constant). In our baseline case, we assume that government total revenue and non-age-related primary spending remain a constant percentage of GDP at the 2011 level as projected by the OECD. Using the CBO and European Commission projections for age-related spending, we then proceed to generate a path for total primary government spending and the primary balance over the next 30 years. Throughout the projection period, the real interest rate that determines the cost of funding is assumed to remain constant at its 1998-2007 average, and potential real GDP growth is set to the OECD-estimated post-crisis rate.

[That makes these estimates quite conservative, as growth-rate estimates by the OECD are well on the optimistic side.]

Yes, future liabilities are always quoted in isolation from future demand leakages including growth of reserves in pension funds, insurance companies, corps, foreign govts, etc.

And they are always used to imply solvency issues. No actual calculations are ever done regarding inflation.

Debt Projections

“From this exercise, we are able to come to a number of conclusions. First, in our baseline scenario, conventionally computed deficits will rise precipitously. Unless the stance of fiscal policy changes, or age-related spending is cut, by 2020 the primary deficit/GDP ratio will rise to 13% in Ireland; 8-10% in Japan, Spain, the United Kingdom and the United States; [Wow!] and 3-7% in Austria, Germany, Greece, the Netherlands and Portugal. Only in Italy do these policy settings keep the primary deficits relatively well contained – a consequence of the fact that the country entered the crisis with a nearly balanced budget and did not implement any real stimulus over the past several years.

Yes, this is big trouble for the solvency of the euro zone members, but not the rest.

“But the main point of this exercise is the impact that this will have on debt. The results plotted as the red line in Graph 4 [below] show that, in the baseline scenario, debt/GDP ratios rise rapidly in the next decade, exceeding 300% of GDP in Japan; 200% in the United Kingdom; and 150% in Belgium, France, Ireland, Greece, Italy and the United States. And, as is clear from the slope of the line, without a change in policy, the path is unstable. This is confirmed by the projected interest rate paths, again in our baseline scenario. Graph 5 [below] shows the fraction absorbed by interest payments in each of these countries.From around 5% today, these numbers rise to over 10% in all cases, and as high as 27% in the United Kingdom.

“Seeing that the status quo is untenable, countries are embarking on fiscal consolidation plans. In the United States, the aim is to bring the total federal budget deficit down from 11% to 4% of GDP by 2015. In the United Kingdom, the consolidation plan envisages reducing budget deficits by 1.3 percentage points of GDP each year from 2010 to 2013 (see eg OECD (2009a)).

Why would anyone who understood actual monetary operations want to increase fiscal drag with elevated unemployment and excess capacity .

“To examine the long-run implications of a gradual fiscal adjustment similar to the ones being proposed, we project the debt ratio assuming that the primary balance improves by 1 percentage point of GDP in each year for five years starting in 2012. The results are presented as the green line in Graph 4. Although such an adjustment path would slow the rate of debt accumulation compared with our baseline scenario, it would leave several major industrial economies with substantial debt ratios in the next decade.

“This suggests that consolidations along the lines currently being discussed will not be sufficient to ensure that debt levels remain within reasonable bounds over the next several decades.

“An alternative to traditional spending cuts and revenue increases is to change the promises that are as yet unmet. Here, that means embarking on the politically treacherous task of cutting future age-related liabilities.

Here we go- this is too often the ‘hidden agenda’

It’s all about cutting social security and medicare.

Who would have thought!!!

Yes, the euro zone’s institutional arrangements that make member govt spending revenue constrained have it on the road to collapse, maybe very soon, and for reasons other than long term liabilities.

The rest of the world doesn’t have that issue, as govt spending is not revenue constrained, and the risk to prosperity is acting as if we all have the same revenue constraints as the euro zone.

With this possibility in mind, we construct a third scenario that combines gradual fiscal improvement with a freezing of age-related spending-to-GDP at the projected level for 2011. The blue line in Graph 4 shows the consequences of this draconian policy. Given its severity, the result is no surprise: what was a rising debt/GDP ratio reverses course and starts heading down in Austria, Germany and the Netherlands. In several others, the policy yields a significant slowdown in debt accumulation. Interestingly, in France, Ireland, the United Kingdom and the United States, even this policy is not sufficient to bring rising debt under control.