Wednesday, 28 April 2010

A Bit Of Clarity

We have received a number of requests to clarify and expand upon a point made in our last update. In it we said that “the US stock of debt has a half life of just over 4 years and a coupon of just under 6%, which suggests a very pressing issue for the 2016 US Presidential Election”. We have been asked to explain exactly what that means and what chain of events might be triggered out to 2016.

To understand this, we need to start with the nature of public sector debt. Although an individual loan instrument has a fixed term, it would be wrong to think of public sector debt as fixed in nature. Because treasuries around the world issue a number of instruments with varying maturity dates at different times, public sector debt is a lot more fluid than we might think it to be. In many cases, the debt is revolving, which means that new debt is issued to repay old debt as it falls due. This is quite normal. Public sector debt is less like a mortgage – a single loan of fixed term used to purchase a big ticket item – than it is an overdraft – a series of lending and repayment events used to smooth out cash flow fluctuations.

At any one point in time, the US Treasury will be issuing new debt instruments, of varying repayment maturities, and either spending that money on fiscal expenditures or using that money to repay old debt. The balance between debt repayment and making fiscal expenditures is largely determined by the size of the fiscal deficit – the extent to which taxes are insufficient to meet expenditure obligations. As deficits grow there is greater pressure to delay the repayment of debt and to allow the total amount owed to increase.

However, the total amount owed cannot increase without check for two reasons. First, because the total debt is a collection of loans for fixed terms, the time profile may well be very uneven. If so, then there comes a point where the total amount borrowed (i.e. the debt repayment that cannot be avoided plus the size of the fiscal deficit) exceeds the willingness of the bond markets to lend to the government. This brings in the second constraint. As we are currently witnessing for Greece, the willingness of the bond markets to lend to a government is partly determined by it’s credit rating and partly determined by the price at which the government is prepared to borrow. These two reasons are why the time profile of the debt and its coupon (i.e. price) are very important.

We measure the time profile of the debt in terms of its half life. This is the period of time in which 50% of the total amount owed falls due for recycling. A short half life combined with a large fiscal deficit implies that the government has a real problem in its immediate future, which will only be solved by drastic reductions in its fiscal deficit (this means emergency and severe spending cuts followed by steep tax increases, as in the case of Ireland) or by the cost of borrowing rising disproportionately (as has happened with Greece, along with the consequential downgrading of Greek debt by the credit ratings agencies). In both cases, the remedial action is likely to be sufficient to trigger a major political crisis.

Bearing this in mind, it is worth using this framework in the case of the USA. The USA has a very short half life for its debt. At 4 years, it is one of the shortest repayment profiles in the OECD. The American fiscal deficit (both Federal and State deficits combined, if we are to compare like with like) is relatively large (11.1% of GDP in 2010 according to the EIU) compared to other OECD nations. In the absence of a strategy to alter this state of affairs, this would suggest that a refinancing crisis could emerge somewhere towards the middle of this decade. The crisis is likely to occur after the 2012 Presidential Election, but could well become a major factor in the 2016 Presidential Election.

There are two aspects to this problem – the savings glut in the global economy and the savings shortage in the US economy. One solution would be for the US economy to save more. To date, the household sector in America has been reluctant to save. Experience elsewhere in the world suggests that if the household sector will not save, then the public sector must do it for them through higher taxation. There is every expectation that this will become a pressing issue in the 2016 Presidential Election, simply because resolving the question of the fiscal deficit is likely to become very pressing.

Of course, raising taxes is not a popular policy, particularly in America, but then, as we said before, the remedial action is likely to be sufficient to trigger a major political crisis.

© The European Futures Observatory 2010