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U.S. Treasuries Lose 'Risk-Free' Luster
Author: Francis E. Warnock, Adjunct Senior Fellow for International Finance
August 6, 2011
Standard & Poors' downgrading of U.S. debt on August 5 merely confirmed what any observer of Washington has known for a long time: The U.S. government has no credible plan to tackle the unsustainable deficits forecasted for 2015 and beyond. The new information this summer is that a partisan, gridlocked U.S. political system has injected a new level of uncertainty into markets.
A year ago I asked the question, "How dangerous is U.S. government debt?" At that time, the worry was that medium-term debt dynamics were so adverse that U.S. debt would become unsustainable and that investors would fund U.S. government borrowing only at sharply higher interest rates.
After nine years of declining revenues and increasing expenditures, the United States had amassed $11 trillion in debt, an amount equivalent to roughly 75 percent of annual GDP. More worrying were the projections that the debt would increase sharply from that already high level. Why would the debt increase so much? There has been, for roughly the past decade, a simple imbalance between revenue (not enough) and expenditure (too much). And an important part of the future increases in expenditure are hard-wired through entitlement spending, especially the unfunded liabilities related to healthcare and an aging society.
In 2010, the specter of wholesale selling of U.S. Treasury debt was alleviated by the eurozone debt crisis. Large investors were signaling their distaste for U.S. bonds, but they had nowhere else to turn. Had there been a reasonable alternative, one would have expected sustained selling of U.S. bonds by both domestic and foreign investors, which would leave the United States--and not just the government--with sharply higher borrowing costs.
Fast forward to this year. Washington's recent political clash over the debt and (future) deficits problem ended with a deal that decreases budget deficits by an estimated $2.1 trillion over the next ten years. Yet this is unlikely to improve the sustainability of U.S. debt. A fundamental driver of expected increases in expenditure--Medicare and Medicaid spending--was left largely unaddressed. Another cause of the imbalance Washington has had during the past decade--revenue that is far too low--was not addressed at all.
In its failure to address the sustainability of U.S. debt the government has taken a hit. Among the recent troubling signals:
Washington can concoct a crisis about something as mundane as the debt limit.
Washington is willing to raise doubts about its willingness to pay bills on past spending and borrowing--spending and borrowing that Congress itself approved.
The U.S. government is willing to expend enormous effort on all this--at a time of great uncertainty about the economy--and at the same time fail to curb the fundamental drivers of the expected growth in U.S. debt.
Washington gets away with this behavior only because the U.S. Treasury bond market is still the world's pre-eminent market. But the U.S. Treasury market, while still large, homogenous, and liquid--features attractive to investors needing to place a large amount of funds--now has an element of uncertainty. This uncertainty, obvious before Standard & Poors' announcement, has been broadcast loud and clear through the downgrade.
Investors domestically and abroad now wish the world had another "risk-free" asset, one that would reduce investors' reliance on U.S. Treasury bonds.
Investors domestically and abroad now wish the world had another "risk-free" asset, one that would reduce investors' reliance on U.S. Treasury bonds. And the antics of Washington may well prompt other countries to develop just that market. Early in the twentieth century, England's pound sterling lost its dominance in global financial markets in part because of the government's own doing: Massive wartime debts and a wildly volatile currency prompted the search for alternatives. But part of the pound's decline was brought about because other countries saw an opportunity; the U.S. Federal Reserve, in particular, moved to increase the importance of the dollar in the market in trade acceptances.
Today, it would take a multi-step process for the dollar to lose its role as the global reserve currency; it could well be that this summer we have witnessed a few steps in that process. A government that puts the world's risk-free asset at risk to attain, in the end, next to nothing, is not one that inspires confidence. And this loss of confidence will provide incentives to investors to search elsewhere for stores of value and to other borrowers to create them.
The problem with U.S. debt is in the medium term--2015 and beyond--it will be driven by unfunded liabilities that will keep increasing and revenues that will remain insufficient. Washington, by avoiding all of the tough issues, has done nothing to shore up the medium-term prospects for U.S. debt.
A year ago, at least we could say that in the midst of the global financial crisis the U.S. government had acted to avoid a depression. Today all we can say is that the U.S. government can come to an agreement that fails to address the fundamental factors that will lead to a real debt crisis. The difficult discussions about what exactly the U.S. government should fund and how exactly it should raise revenue to match those expenditures will have to wait for another day.
In the meantime, we all can hope that investors here and abroad do not become so worried about the U.S. government's ability to deal with the looming debt crisis that they move out of the Treasury market, sending borrowing costs sharply higher, further wobbling an already weak economy. The dollar would weaken, which might be the only stimulus package Washington can hope for, but one whose impact would be vastly overpowered by the concomitant increase in borrowing costs.
Better would be a strategy to squash the looming debt crisis. Tax and spending policies must be changed so that the budget will be balanced or in surplus in good times, allowing for small deficits in times of slack economic growth. But first lawmakers need to embark on a transparent process to correct the fundamental imbalance in tax and spending. The specific proposals, which could include everything from instituting a Value Added Tax to eliminating mortgage interest deductions on the revenue side, to dramatic reforms to healthcare programs on the spending side, can come out of a conversation that policymakers have with the American public.
The U.S. government should not, as it did this summer, start with an outcome (the amount of debt) and back into temporary solutions. Rather, it must start with tough choices on fundamental drivers of the problem (imbalances in tax and spending policies) to get to an acceptable outcome. Its creditors await action.
Rising Fears of New Global Recession
August 5, 2011
Author: Jonathan Masters, Associate Staff Writer
A trader works at Frankfurt's stock exchange August 5, 2011. World stocks sank for an eighth straight session on Friday, wiping $2.5 trillion off their value. (Ralph Orlowski/Courtesy Reuters)
Fears that the global economy could be moving again toward recession sent global markets plunging Thursday and Friday (WashPost), with economic and financial problems worldwide fueling a cycle of upheaval. The plummet in stocks followed President Barack Obama's signing of the $2.4 trillion debt-limit increase earlier in the week, a process that raised concern about Washington's ability to correct its mounting fiscal problems.
Though the U.S. economy continues to struggle, employers added 117,000 jobs (NYT) in July, the Labor Department reported on Friday. The figure was far more than the 18,000 net new jobs reported in June and the most new jobs added in a month since April. Unemployment dropped slightly to 9.1 percent.
Yet more broadly, a troubling dynamic is taking hold where spreading debt in Europe creates new risks for the United States, and the chance of another U.S. recession worsens the European fiscal crisis. These hurdles come as China and other rising economic powers are trying to slow their economies to combat inflation. Central bank interventions in Europe and Japan (FT) were unable to quell investor fears over slow economic growth and a eurozone debt crisis. The European Central Bank purchased government bonds for the first time since March, as the Bank of Japan stepped into the currency markets to slow the rise of the yen.
Writing for the New York Times, Floyd Norris notes that the U.S. economy could be entering a double-dip recession, a second period of decline where the U.S. government is preoccupied with cutting spending and typical policies aimed at combating economic weakness have been taken off the table. Although most analysts believed the country was making a slow recovery, the recent annual revision of the U.S. GDP indicates the recession seems to have been deeper and the recovery more anemic than previously thought.
In response to the question, “why now?,” Steven Pearlstein in the Washington Post writes that structural problems in the United States and global economies that caused the 2008 crisis were “never really fixed.” Some economists are concerned that slow growth in the U.S. economy may itself be a driving factor in the road to a potential recession. Weak growth could undercut consumer and business confidence, instill a loss of faith in the recovery of stock prices, and prompt fears in the credit market, according to Bloomberg's Peter Coy.
The Economist reports that ”All financial-market signs now point to a return to economic contraction,” including a nearly 10 percent drop in the S&P 500 in the last two weeks and market expectations of rising inflation. However, the Fed seems likely to act, perhaps with a new round of quantitative easing or other forms of intervention.
Selected Analysis
Despite global market fears of a U.S. credit downgrade, U.S. treasuries will remain the safest bet for international investors, says global economics expert Kent Hughes in a CFR interview.
The agreement on raising the debt ceiling falls far short of the deep reforms needed to improve U.S. spending patterns and the country's global standing, writes CFR's Sebastian Mallaby.
“As long as 330 million living Americans require promised entitlements--the $66 trillion that wear shoes are as much of a liability as the $10 trillion on paper,” writes William Gross of Pimco Asset Management about the U.S. debt morass.
Reforming the U.S. tax code is one of President Obama's last chances to “pour growth hormones into a sickly economy and get jobs back before November 2012,” writes Stephen Moore of the Wall Street Journal's editorial board.
Research Topic: Capital Markets
The 2008 financial crisis and worldwide recession halted a three-decade expansion of global capital and banking markets. Today, growth has resumed, fueled by expansion in developing economies but also a $4.4 trillion increase in sovereign debt. The total value of the world’s financial stock, comprising equity market capitalization and outstanding bonds and loans, has increased from $175 trillion in 2008 to $212 trillion at the end of 2010, surpassing the previous 2007 peak. Similarly, cross-border capital flows grew to $4.4 trillion in 2010 after declining for the two previous years.
In its 2011 updated analysis of more than 75 countries on the size of their outstanding equity and debt, cross-border capital flows, and the stocks of foreign investment assets and liabilities, MGI finds that the recovery of financial markets remains uneven across geographies and asset classes and significant risks remain. Emerging markets account for a disproportionate share of growth in capital-raising as mature economies struggle. Debt markets remain fragile in many parts of the world—the growth of government debt and of lending in China accounts for the majority of the increase in credit globally.
Highlights of the report include:
The global stock of debt and equity grew by $11 trillion in 2010. The majority of this growth came from a rebound in global stock market capitalization, reflecting new equity issuance and stronger earnings expectations. Net new equity issuance in 2010 totaled $387 billion, and the majority of that issuance came from emerging market companies. Initial public offerings (IPOs) continued to migrate to emerging markets with 60 percent of IPO deal volume occurring on stock exchanges in China and other emerging markets.
The overall amount of global debt outstanding grew by $5 trillion in 2010, with global debt to GDP increasing from 218 percent in 2000 to 266 percent in 2010. But growth patterns varied. Government bonds outstanding rose by $4 trillion while other forms of debt had mixed growth. Bonds issued by financial institutions and securitized assets both declined, while corporate bonds and bank loans each grew.
On-balance sheet loans of financial institutions rose by $2.6 trillion in 2010 (or 5.9 percent). However, this global total hides key differences between regions. Since 2007, outstanding loan volumes in both Western Europe and the United States have been broadly flat with a decline in 2009 followed by a modest increase in 2010. In Japan, the stock of loans outstanding has been declining since 2000, reflecting deleveraging by the corporate sector. Lending in emerging markets has grown at 16 percent annually since 2000—and by 17.5 percent a year in China. Mainland China has added $1.2 trillion of net new lending in 2010 and other emerging markets $800 billion.
Cross-border capital flows grew in 2010 for the first time since 2007, reaching $4.4 trillion, but remain 60 percent below their 2007 peak. This reflects a dramatic reduction in inter-bank lending as well as less foreign direct investment and fewer purchases of debt securities by foreign investors. Contrary to conventional wisdom, this report finds that capital flows to developed countries—not those to emerging markets—are the most volatile.
The world’s investors and companies continue to diversify their portfolios internationally. The stock of foreign investment assets grew to $96 trillion, hitting a historical high in 2010—a ten-fold increase since 1990. Of this, central banks had accumulated $8.7 trillion in foreign-exchange reserves by the end of 2010, a sizeable share of the world’s financial stock invested in government bonds and other low-risk securities. Foreign direct investment assets reached a new high of $21 trillion, as did the stock of foreign debt securities held by institutional and private investors. Banks have once again expanded their international lending, albeit only by a little, with the stock of cross-border loans returning to its 2007 level at $31 trillion.
Cross-border investment is growing fastest outside the traditional centers of financial wealth. In 1999, the web of cross-border investments centered on the United States, which was partner to 50 percent of all outstanding international financial positions. By 2009, the US share of total cross-border invests had shrunk to 32 percent. This reflected both a surge in cross-border investments within Western Europe following the creation of the euro, and phenomenal growth in the size and complexity of linkages with emerging markets. Prior to the 2008 financial crisis, cross-border investments between Latin America, emerging Asia, and the Middle East were growing at 39 percent annually—roughly twice as fast as these regions’ investments with developed countries.