I would like to speak today about government deficits and the need to finance those government deficits with the sale of Treasuries. The size of the U.S. Treasury deficit has become the 800 Pound Gorilla that has entered the room in the last month or two in a very heavy way. The gorilla is sitting somewhat subdued in the back of the room, but nonetheless, it casts a large shadow over the discussions in the debt markets, the equity markets, the foreign exchange markets, and moreover, in the political discourse in the United States as to whether or not, for example, to adopt a health care bill which would add yet more to the deficit. The deficit is making all factions, economic and financial, highly concerned. The question then becomes, “What is the standard for too large a deficit?” The standard for the deficit has been an evolving measure. In the 1950’s, it was doctrine for probably both Republicans and Democrats to run a balanced budget and have no deficit. In the 1950’s, for example, in the eight years of the Eisenhower administration, for three years we actually had fiscal surpluses. Even the Democrats in the early 1960’s were extremely mindful of not having deficits, the rationale being we do not want to add to government debt to put a burden on our children and grandchildren.
In the 1960’s, however, that changed somewhat because we adopted Keynesian economic theories and thoughts in that every time the economy ran into a recession, the doctrinaire approach was to expand government expenditures. By doing so, it would add to the fiscal deficit which would require the sale of Treasuries. The thought in the 1960’s was that, yes, you are going to use the fiscal system to stimulate the economy when the economy is down, but when the economy revives, we will then run fiscal surpluses and retire the debt that was generated during the recessions. The thought in the 1960’s, or the standard, was to run a balanced budget over the course of the business cycle.
All that changed in the 1980’s when President Reagan came into office. His thoughts were that the level of government spending had risen to unacceptable levels, almost 25% of GDP, and his interest was to reduce the level of government expenditures and to pressure Congress to reduce government expenditures by reducing taxes. Indeed, the measures to reduce taxes were voted in, but it did not work in the sense that the lower taxes were not followed by lower government expenditures, so we had a decade-long series of very large government deficits, certainly by comparison to the 1950’s and the 1960’s. In the Reagan administration, the deficits ran about 6% of the GDP. Then it raised the issue, since we now had an ongoing deficit rather than a cyclical deficit, how much of the deficit can the economy stand? The economists came up with the measure that if we kept our deficit, on average ,to 2% of GDP and if GDP grew at 4% in real terms, the net result of all that would be that the proportion of income necessary to service the debt, i.e. pay interest and principal, would be held as a constant proportion of income. Therefore, we ended up with a justification for having an ongoing deficit year by year, as long as it was contained under 2% and the economy grew at 4%. Now that was a somewhat rosy assumption because the longterm growth rate of the U.S. economy has really only been 3%. Nonetheless, that stuck as a rationale to have an ongoing deficit and eliminated the thought, pressure and need on the part of politicians to raise taxes and lower government expenditures in order to, year after year or over a business cycle or even over a decade, eliminate the deficits. Nonetheless, they were capped out. The capping out was based on the assumption that we could continue to grow at 4% real.
There is a problem with that story in that the allowance for debt growth is based on 4% real growth rate. What we see however is an interaction between the deficit and the level of economic growth. In fact, what happens if we exceed our 2% deficit as a percentage of GDP is we then get into a situation where forces are set in motion to retard the growth rate of GDP. The forces that are set in motion are that interest rates are pushed upward as the Treasury competes for funds with private lenders and interest rates rise. Interest rates rise not only for the government but also private borrowers. This is a phenomenon that has often been called something like “crowding out,” where the private market is crowded out by government financing and ends up having to offer higher rates or more attractive terms to raise capital. This, in turn, raises the cost of capital to business. The cost of capital to business increasing then lowers the level of investment spending in the economy. We then have a negative impact upon growth. It is not only related to the interest rate that gets pressured upward, but we also have other issues. Namely, when the deficit becomes large relative to GDP, we now have more financing costs on the part of government. Therefore, taxes tend to get forced upward in order to have the revenue to service the existing government debt. We now end up with something that has been called in the past, and I presume that terminology is going to come back in the future, it was called fiscal drag. When the tax rates become too high, we then lose income out of our income streams to service past debt, reducing the growth rate of GDP.
We also have another factor. To the extent that the debt is sold to foreigners, we now have to service the debt and pay the foreigners the interest. The servicing of the debt now puts us into a situation where we now have something similar to a net trade deficit, called a “current account” deficit. A current account is broader than trade and takes account of not only trade, but also income flows. If we are selling the debt to foreigners, which in the short term looks like a highly desirable outcome and a solution to the problem, in the long term it creates, again, a fiscal drag because our current income is being spent and being sent as income to foreign holders of the Treasury debt. All these factors and a very large debt end up reducing the growth rate of GDP.
There is another way to try to avoid or dodge this bullet. It is often thought, “Well, how about having the central bank jump into the game and “print” money or some obligation and buy the Treasuries?” But there is a problem with that, as well, as we just recently found out. The result of the 2008 large expansion of the Federal Reserve purchases of financial instruments caused an explosion of their balance sheet and if not currency outstanding, but claims on currency outstanding, and the fears of inflation which led to inflation expectations which caused interest rates to rise last spring. There are limits to how much the Fed can bail out the government without having adverse effects, again, on interest rates and GDP growth. The old standard of 2% deficit relative to GDP as the ceiling, as long as we have a 4% growth rate of GDP, it is all digestible, is really being exceeded today by a very large margin. In fact, where we are today, the deficit is 13% of GDP and the growth rate of GDP is zero. We are well beyond the tolerance of where government deficits do not matter by not being at 2% but going to 13% which, incidentally, is about double the highest post World War II deficit as a percentage of GDP. We are now in a totally different situation where we have violated the yardstick by which we did not have to be concerned about government debt.
This is for one year. This is in the year 2009. At this point, we have financed approximately $1.3 trillion of an expected $1.9 trillion of additional government debt to the base of $11.7 trillion. It is a rather huge leap forward in government debt this year. In fact, it is about a 15% add-on to the cumulative debt of the United States running back to 1790. This year we are going to add about 15% to the debt load as compared to the cumulative debt over the previous 219 years. We are taking a large, large leap this year. The question is, “Is this only this year?” The answer is no, because we have enough baked into the legislation requiring expenditures or requiring the Treasury to go back to the market over the next decade. The Obama administration has estimated that over the coming decade, under the best of terms, with a 4% growth rate of GDP which in turn generates income for the government, that we will have $9 trillion additional U.S. government debt accumulated on the already existing $11 trillion. That really just gets us warmed up, because in the following two decades, we now are deep into the Baby Boomer generation of welfare payments of Social Security, Medicare and Medicaid. The estimates put out by the government and the Congressional Budget Office are that we are looking at $65 trillion of contingent liabilities. Over time, those contingent liabilities will become actual Treasury debt outstanding.
This concern and this issue, as I said, is the 800 lb. gorilla that is currently sitting in the back of the room casting a shadow, and it is not on the front burner, but it does get into the daily discourse of the financial markets. For example, a new variable has come to the forefront where the market is watching. They are watching something called the bid-coverage ratio. The bid-coverage ratio is the bids on the Treasury debt being offered by the week. Very recently, we have actually succeeded in selling the debt with a bid-cover ratio of about 2.5, which means that the bids for the new Treasury debt being offered are 2.5 times the debt being offered, which is fine. That is good, that is a healthy number, except if you look under that, 46% or some number in that area has been foreign central banks helping out dramatically. That is probably a short term phenomenon because foreign central banks have become very conservative in their asset allocations. Their foreign exchange reserves have actually declined, but Treasuries are growing as a percentage, so they are getting close to the end of their ability to step into the market with large purchases of that amount in the future.
The question becomes then, “Can the Fed step up?” The Fed intended to step up and announced plans in the spring to add $1 trillion of additional debt on top of the $1 trillion they added in 2008, but what then happened was there was a very substantial market push back in that it created inflation expectations, inflation fears. The 10-year Treasury rate got over 4% in June on the expectation that the Fed would be creating inflation. The Fed then had to respond with “an exit strategy” to tell the market, “Okay, we thought of going there, but you have made your point that if we do go there and add that much more to the balance sheet of the Fed, you are not going to buy the debt.” So the Fed had to back off and they announced their exit strategy. At this point, Treasury is now looking at the market… to market additional Treasury debt to foreign sovereigns and central banks, foreign individuals and the U.S. consumer. Its major market has been taken out, namely the Fed. The issue will start to get back into the spotlight in the coming months; if not the coming months, certainly in the coming years. The question then becomes, what stops a government that has legislated expenditure policies that require expenditure, and to make those expenditures we must finance it because the expenditures far exceed the tax revenues. What stops it is the bond market. At some point, the bond market says we have had enough. That is why the market is watching the bid-coverage ratio so closely.
Just to give you an example of what indeed does happen, let me give you two recent examples. For one, the UK, which is a AAA rated sovereign debt, in the spring went to the market and the bids on the debt being offered by the UK did not cover what was being offered. The UK could not finance its deficit and could not finance the expenditures and had to pull back its expenditures. Furthermore, what this created in turn was the rating agencies put the UK sovereign debt under negative review. Thusfar, I do not believe the credit rating of the UK has been reduced, but obviously that becomes a question of the future. If, indeed, the rating is reduced, the UK will be lower rated and pay even more for its debt. The other current example that we are seeing unfold is the state of California. Unlike many states like the state of Texas, which has constitutional prohibitions on deficits and debt, California does not. California maxed out its ability to borrow from the market. They still have expenditures on the books, but they cannot finance them any longer, so the state is issuing “IOU’s” to its employees and factors. They are paying a relatively small interest rate; I believe it is about 3.75% which is being promised by the state. These IOU’s are now being traded in the secondary markets at pretty big discounts. What happens is employees are being paid partly in cash and partly in IOU’s and then they go out to the market and sell the IOU’s at some discount. If this continues, the willing buyers will disappear and those IOU’s will become worthless, which basically reins in a government. California is making contingency plans at this time as to exactly what expenditures it is going to have to stop if indeed they cannot finance it; things that would astonish you, for example, things like education and roads, but also reducing the prison population. Very quickly California is going to be up against the wall… will face the market and be rejected.
The question is at what point might it hit the United States? If, indeed, we really do attempt to finance $65 trillion in contingent liabilities which is going to end up reducing our GDP growth rate and then we are going to have a much higher level of debt service relative to our GDP, it just simply cannot be financed. At some point, the market says, “No, we have had enough.” My own feeling is I hope it happens sooner than later because at this point, if we were cut off from the market, we would be able to service our existing debt. If it gets to the point where the faith in the Treasury, which has never up to this point defaulted, is so great that foolish people continue to buy the Treasury, it allows us to get so far over our heads that we will never be able to service the debt. What that then does is put us in a situation where we are going to have a sovereign default. That is typically what occurs. Then the holders of the paper get paid off in pennies on the dollar. Hopefully, if we get cut off by the market sooner than later, we will maintain our status as the reserve currency and retain the status, which is highly valuable, of the U.S. Treasury being the flight to quality asset for world wide wealth owners. That has extremely important value to us, because in this current economic recession and over the previous year of these extreme shocks we have been in, the world gravitated their financial resources in the U.S. Treasury as a flight to quality asset, which means the Treasury has been able to borrow at short term rates of less than 1% to cover our fiscal needs in this crisis. That is an extremely valuable thing to give up and we will, indeed, give it up if we continue trying to finance deficits that well exceed 2% or 3% of GDP.