Advanced Economies: Minutes to Midnight? Part I

MEDFORD: The Bulletin of Atomic Scientists first posted a Doomsday clock on its cover in 1947, a warning as the world moved closer to nuclear holocaust. Since then, the minute hand inches back and forth toward midnight, depending on events such as the Cuban missile crisis or arms reduction talks.

The warning by Standard & Poor’s that US Treasury debt is on a negative watch list – and could be downgraded – is viewed by some as similar notice. Most experts agree that the US has high deficits this year and next due to the recession. With no legislative changes, allowing temporary tax cuts to expire, this short-term problem would correct itself by 2015. However, after 2020, rising Medicare and Social Security expenses would cause the deficit to soar again without increasing tax rates by more than is likely to be possible

The real problem is that longer-term deficits – obligations for retirement payments and health care – are out of control and will overwhelm US creditworthiness unless changes are made. Unlike Japan, which has much higher debt to GDP ratios, double those in the US, but funds its debt with domestic savings, the US relies on foreign buyers for its debt. Once these buyers decide that the US is a potential subprime credit risk, they’ll demand higher interest rates. US interest rates could double to 7 percent, but are unlikely to rise as high as Irish or Portuguese debt because those nations cannot control their monetary or exchange-rate policy. Every percentage point hike in the interest rate adds $150 billion to spending, and the growing interest burden would be hard to manage without inflation – a “soft” default – or outright default. With total federal debt to GDP ratios already 100 percent and rising, growth alone won’t likely solve the problem. In 2011, total revenues will be about $2200 billion and spending will be $3800 billion. Adding up to $500 billion in interest costs would be dangerous.

So, the nation must get a handle on the long-term deficit and reassure credit markets. Already, nervous Treasury investors have reduced the average maturity of Treasury debt from 75 months in 2000 to 57 months last year, protecting them if interest rates go up due to Fed tightening or market reactions to poor fiscal outlook.

Deficits can be cut in one of two ways: Revenues must rise or spending must be cut. To oversimplify, Republicans want to cut spending on entitlements like Medicare, health care for the elderly, by phasing in a fixed payment for private health insurance while cutting tax rates for the wealthy. Democrats want to raise tax rates on the rich and reduce Medicare spending by “bending the cost curve” through evidence-based medicine, paying for what works, and counseling on end-of-life care, in which 30 percent of Medicare expenses are incurred.

Both approaches are likely to be insufficient. Facts do not mesh with the Republican assumption that low marginal tax rates will create enough economic activity that tax revenues will increase. President George W. Bush tried it and ended up with large deficits. Real per capita tax revenues in 2008 were about the same as in 2001. It’s also unlikely that the proposed payments for elderly health insurance would allow many in the bottom half of income earners to get adequate care.

On the other hand, simply taxing the rich will not pay for all of the promises made. Bending the medical cost curve is essential, but uncertain for the US given powerful lobbies of special interests and seniors. Unless a bipartisan group can agree on tough choices that involve raising revenues and cutting entitlements, it’s unlikely that deficits will tame. With Tea Party Republicans clamoring for tax and spending cuts, it’s hard to see compromise. Thus, the S&P warns of a possible future downgrade.

The downgrade of US debt has implications for the rest of the world. Loss of reserve-currency status would weaken the dollar. Put aside what would take its place – a key question that’s not trivial. The downgrade should result in lower US imports as they’d become more expensive and higher exports. This would result in more economic activity, higher employment and lower trade deficits for the US. On the other hand, the US would likely pay higher long-term interest rates, although that would also depend on inflation. If the US Federal Reserve kept inflation low, then the depreciation would be effective and large imbalances in trade and fiscal deficits would diminish, as higher levels of activity reduced deficits. However, much higher interest rates would impose a severe burden on the federal budget; roughly each percentage point of higher interest rates would mean 1 percent of GDP in higher interest charges. It would take time, high taxes and spending restraint – even for the military – to correct the situation. The US role in the world would diminish, as its economic weight fell, military capability diminished and fierce competition for funds depressed spending on research and education.

In general, the world is already learning to function without unsustainable demand from the rich countries. From 2007 to 2010, the US and the euro zone decreased their imports by $228 billion, but global imports rose by more than $750 billion, led by developing nations. As rich households in the world community pay down debt and rebuild savings, demand must come from other quarters.

China, India and Brazil are among the nations ramping up imports. Yet all three have problems with inflation, curtailing credit growth or tightening fiscal policy. Future world growth might depend on how well these giants and others manage to sustain rapid import growth. US adjustment would be easier if foreign import demand stayed high just as the depreciated dollar allowed the US to export about as much as it imports.

Similarly, capital flows will likely flow to other nations. If the US reduces its deficits and saves more, there may be more US investment, but a significant net outward flow of capital could be likely because even with a demand lift from smaller net imports, a smaller government and consumer sector will hamper US growth. This outflow has already happened to some extent and will likely continue unless bubbles develop overseas and investors once more get burned. Aggressive overseas borrowing of some Chinese real-estate companies has already raised alarm bells. Much also depends on better governance in reporting financial data and treating minority investors fairly – issues that have slowed capital flows to Russia.

The world is better off with a healthy US economy, just as the US is better off if the emerging nations continued to grow – though in a more balanced way. Since the US spends a sixth of its income on health care without covering tens of millions of its citizens while Canada covers everyone with private providers for a tenth of its GDP suggests that efficiencies and improvements – the Canadians also live longer – are possible.

With political compromise and leadership, a solution would make long-term deficits tractable – especially if US health care costs were reduced. Most health-care spending is paid for directly in government budgets or indirectly through tax benefits, and taking 7 percent of GDP out of government spending would do wonders for the deficit! Investors question if the US political system is up to it. Stay tuned.