04 April 2018

Will the US become the new Greece?

This continues my series of closer looks at the seven areas I think can bring the 103 (now 105?) month economic expansion in the US to an end. The previous articles are here (overview)here (interest rates), and here (Inflation).

When considering "Budget Deficits" we are naturally looking at Government deficits, and not the overall global debt load, a load that in and of itself should scare almost anyone. In addition, government deficits are not a US-only problem, at least not US government debt alone. Governments around the world have spent the past decade amassing an ever growing pile of national debt. This has been an easy way to stimulate economies, placate masses, and generally take advantage of the ability to make new, cheap money, or to access pools of "cheap" money.

What happens when the markets' perception turns, and easy government money is viewed as a liability that will push down economic growth? The answer is Greece, where crushing debt, and without its own flexible, sovereign currency, coupled with no external forgiveness resulted in the destruction of the economy, in a self-reinforcing cycle of negative government policies and economic collapse.

How long can budget deficits continue to grow before the markets decide that US sovereign debt is no longer "risk free", or that there are other options for making a return greater (and at equal or lower risk) than government debt? When will there be a tipping point of belief that deficits and national debt payments actually do matter, with the expectation of a drag on economic growth by allocation of national budgets to interest payments, greater probability of a recession, ultimately resulting is loss of market confidence (and reduced resilience should a recession occur)?

Couple the growth of visible budget deficits with the fiscal gap of promised future expenditure, and the outlook is even worse (though perhaps a subject for a future article).

There is a fine balance between Sovereign debt as a safe-haven, and the returns on sovereign debt being strong enough to shift money from other markets - especially if such strength is due to an increase return (the occasional spikes in Spanish and other European debt as a good example), and therefore the future drain on government coffers to pay the interest. Once those interest payments are perceived as being high enough to impact the economic viability of the rest of the economy, we could see a general loss of faith and an associated flight to any "safe" none-market assets.

It is fairly easy to see the reason for concern. Currently 6% of the Federal budget is required to make payments on the interest on the national debt. This is interest only, at an average rate of 2.32% for January 2018, which on a national (Federal) debt of $21 Trillion. This should represent an annualised total debt servings cost of $481 Billion, with no associated reductions in the outstanding debt. In fact, US Federal debt will continue to grow, and with that growth, an even growing servicing cost.

Currently the Fed 10-Year treasury rate is hovering around 2.8%. This is a .5% increase over the past six months effectively matching the increase in the Fed discount rate.

So what happens if the Fed does deliver 3 rate hikes in 2018 (2 more)? If they increase at the .25% rate, we should see a Fed rate in the 2.75% range from the current 2.25% rate.

All things being equal, we should then see the actual rate of interest paid by the US Government rise by .75% to around 3.1%. This excludes any sovereign debt risk premium should China and Japan stop purchasing US sovereign debt, or if there is another downgrade of US debt.

So if we then look at the total that would be payable on the $20.7 Trillion debt, (but for simplicity staying at the current level even though this debt will rise to closer to 21.5 Trillion by the end of the year). The increase to 3.1% across the $20.7 Trillion debt would result in an annualised cost of $642 Billion, an increase of almost $160 Billion.

Markets will look at that increase, and see a combination of increased government spending to fund that debt, and a compounding level of debt expenditure. If the current debt load on the US budget is at 6%, every increase squeezes the amount of government spending available for non-debt servicing expenditure.

This at a time when economists are predicting that the US will begin running almost perpetual $1 trillion deficits. The interest component of the Federal budget is going to rise quickly. The tipping point will come not when the debt can no longer be serviced, as that realistically is too far in the future to be meaningful in terms of market reactions (years, not months). But it will be the tipping point of lost confidence that such deficits can deliver economic growth. And that point is either very soon, or may already have passed.

In their 2009 book “This Time Is Different” Reinhart and Rogoff state that national debt above 90% of GDP results in falling GDP growth. This number certainly caught the headlines, and for a while was presented as a Great Truth. Of course, there were then numbers of papers downplaying that Truth, and highlighting potential errors in their calculations.

Yet their premise stood up to critics, in as much as the 90% threshold does seem to signal a future decline in GDP growth due to debt servicing headwinds at the national level.

The United States is now well past that level, with the current (Federal) debt load of $21 trillion, and State and Local debt loads adding another $3 trillion, for a combined government debt load of $24 trillion. This against a GDP of approximately $19.5 trillion, the US is already running at well over 105% at the Federal debt level, with an additional 15% debt at the State and Local level.

This entire discussion ignores, though it should not, the fiscal gap, and therefore excludes the future bow wave of additional, already promised expenditure. It was this bow wave of pensions expenditure and social support expenditure that ensured Greece would only dig deeper into debt, regardless of bail-outs. 

Both the US and the UK face such a systemic problem - over promise of future expenditure that is not already considered in existing budget and deficit projections. In addition, these future promised expenditures are not limited to the Federal government budgets, and we already are seeing pressure on state and local level pension and entitlement programs.

At some stage there will be a loss of confidence that the combined debt load is manageable, and that the predicted negative impact on growth either has begun or will be felt in the near term.

When that happens, the “US will be the new Greece”. That will not be a pretty picture.

1 comment:

  1. Thanks Dan. As usual a thought provoking piece. Have you looked at the repayment profile for US or UK debt? An increase in interest rates would presumably only affect repayment costs on new debt. Regards Paul