Standard & Poor’s Tests United States’ Confidence

Is America facing a day of reckoning with debt? Or is this time different? These are perhaps the most critical questions the United States (US) as well as rest of the world face today. The US fiscal deficit is projected to be 10.8 percent of the country’s GDP in 2011 and the accumulated general government net debt is likely to be in excess of 72 percent of its GDP. More worryingly, the politics in Washington remains highly polarized on how the nation should pursue a fiscal consolidation roadmap, reining in the burgeoning fiscal deficits and debt.

This prompted the rating agency Standard & Poor’s (S&P) to cut the US’ debt outlook from ‘stable’ to ‘negative’ for the first time since it started rating the country’s debt 70 years ago. In other word, there is a 33 percent possibility that it could lower the AAA long-term rating of the U.S. within two years. While the US sovereign debt which is widely seen as ‘safe haven’ investment still enjoys a triple A tag, the S&P blow jolted the financial markets, notably the equities, around the world. Gold futures hit an all-time high above $1,500 an ounce as funds seek safe haven.

Though the Obama administration and those who blamed the S&P and other agencies for their lackluster job in rating mortgage-backed securities before the financial crisis questioned the credibility of the agency’s latest pronouncement. Moreover, the US Dollar and nominal interest rate in the country remained unconcerned. Although the inverse nexus between dollar and commodity prices, notably oil, is there.

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Source: usgovernemntspeanding.com and World Economic Outlook database, IMF.

So, what is going on? The world’s largest economy has returned to a growth path following the great recession of 2007-09. However, the unemployment situation in the country remains a major concern: nearly one in nine Americans of working age are still out of work. However, for America there is even a bigger issue to worry about: skyrocketing public debt. This has economic as well as geo-political implications. Indeed, many experts persistently cautioned that the greatest long-term threat to America’s national security is its debt. It is no coincidence that Alexander Hamilton, the first Secretary of the Treasury and one of the founding fathers of America, observed over two centuries ago  that ‘the United States debt, foreign and domestic, was the price of liberty.’

How severe is the US debt problem? Accumulation of public debt following the bust phase of a business cycle is hardly new. But the extent of debt accumulation this time is unprecedented. The US gross public debt as a share of GDP is now higher than at any other time in history except after World War II – including World War I and the Great Depression – and counting. The US federal deficit reached 13 per cent of its GDP in 2009, which was the highest deficit-GDP ratio since WWII. The International Monetary Fund projections show that the US’ debt-to-GDP ratio could reach 84 percent by 2015. Though the US has been living with federal deficits for almost a century, it takes a war to get a deficit as large as the one the nation experienced during and after the recession of 2008–09.

Nevertheless, the high public debt is not America’s problem only. The rising debt, if not contained through GDP growth or various fiscal and austerity measures, inflation could be the most favoured candidate to do the job. If the US stoke inflation and devalue the dollar to partly offset its debt then this could unduly punish Asian savers who invested heavily in the US debt.

Historically, in post-war periods, high economic growth along with inflation reduced the debt liability that accumulated to finance war bills. However, the current debt has been accumulated in a relatively peaceful period (with the Iraq War an exception) and, as a result, the growth of the denominator of debt/GDP ratio may not be high enough to reduce the ratio. Understanding the fact, the Obama administration wants to rely both on GDP growth and tax revenues to consolidate the country’s fiscal book. However, the Republicans are dead against Obama’s tax increase plan for the wealthiest Americans.

Both Democrats and Republicans outlined their respective fiscal consolidation plans with some struck differences but whose plan will eventually prevail is difficult to predict.

While the S&P cautions indicate the mounting problems surrounding the US debt, unlike Greece or what we witnessed earlier in Argentina and other Latin American countries the market is allowing the US authorities ample time to get its fiscal house in order. In other word, the risk of soft default of the world’s largest economy via inflation remains low. Many influential economists in America, however, are in favour of inflation to erode some of the debt.

Are inflation expectations well-anchored in financial market behaviour in the US? Despite historic low interest rates, massive quantitative easing and a huge fiscal stimulus, current inflation and expected future inflation remain quite low which is reflected in bond yields.

Investors generally demand higher yield to compensate for inflation risk. The slopes of the yield curves, i.e., the spread between short- and long-term interest rates, show that markets are assuming normal growth and have not yet factored in inflation as a serious risk. The spread between short-term (three months) T-bills and long-term Treasury bonds (10 years) in the US was 3.39 per cent, even after the S&P warnings, which is not unusual in a historical perspective. In some other debt ridden economics such as Greece and Portugal where markets have less confidence the difference is double digit. This tells a fundamental story: it’s all about creditworthiness and confidence.

If one compares the US treasury yield curves of four different periods of the US business cycle (2005, 2007, 2009 and 2011) except for 2007, immediately before the collapse of the Lehman Brothers’ (that triggered the crisis) the behaviour of short-term and long-term interest rates are broadly aligned with normal yields curves. The quasi-inverted shaped yield curve (long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality) of 2007 was a caution of a potential financial crisis that eventually occurred. Historically, inversions of the yield curve have preceded many of the US recessions. One caveat here is there are many instances when yields lagged behind inflation. This means that bond yield curves do not always hold predictive powers.

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Source: Based on the United States Department of Treasury and the Federal Reserve Bank of St. Louis

The key reason behind the low probability of soft default (through inflation) is none other than the mutual dependence between debtor and creditor nations that has been widely captured in ‘global imbalances’ literature. This is nothing but an economic interdependence between the US and Asia as well as petro-dollar economies. Generally, Asian and petroleum-exporting economies invest a large part of their savings in the US and other treasuries and the latter are the consumers of last resort of the former. For instance, over 60 per cent of China’s foreign exchange reserves are being invested in the US debt market and the latter’s Treasury market is the largest bond market in the world.

Moreover, the ‘safe haven’ status of the US dollar remains unchallenged not merely due to an ample demand for the US treasury securities, no country has yet emerged to replace America’s 10 trillion dollar domestic consumer market or challenge its global leadership. So, it is in everybody’s interest to keep Uncle Sam afloat.

That said, it is highly unlikely that the markets will change fundamentally following the S&P warning, at least in the short-run, but it is a wakeup call for the US that it must restore order in its fiscal house. Debt and deficits will remain the key issue in American politics, especially during the 2012 Presidential elections. . It is very likely that the markets could wait till then to prove if the S&P is right or wrong on the US debt.