An urgency to rein in budget deficits seems to be gaining some traction among US lawmakers. If so, it is none too soon. Perceptions of a large US borrowing capacity are misleading.
Despite the surge in federal debt to the public during the past 18 months—to $8.6 trillion from $5.5 trillion—inflation and long-term interest rates, the typical symptoms of fiscal excess, have remained subdued. This is regrettable, because it is fostering a sense of complacency that can have dire consequences.
The roots of the apparent debt market calm are clear enough. The financial crisis, triggered by the unexpected default of Lehman Brothers in September 2008, created a collapse in global demand that engendered a high degree of deflationary slack in the US economy. The very large contraction of private financing demand freed private saving to finance the explosion of federal debt. Although our financial institutions have recovered perceptibly and returned to a degree of solvency, banks, pending a significant increase in capital, remain reluctant to lend.
Beneath the calm, there are market signals that do not bode well for the future. For generations, there had been a large buffer between the borrowing capacity of the US government and the level of its debt to the public. But in the aftermath of the Lehman collapse, that gap began to narrow rapidly. Federal debt to the public rose to 59% of the gross domestic product by mid-June 2010 from 38% in September 2008. How much borrowing leeway at current interest rates remains for US treasury financing is highly uncertain.
The US government can create dollars at will to meet any obligation, and it will doubtless continue to do so. US treasurys are thus free of credit risk. But they are not free of interest rate risk. If treasury net debt issuance were to double overnight, for example, newly issued treasury securities would continue free of credit risk, but the treasury would have to pay much higher interest rates to market its newly issued securities.
In the wake of recent massive budget deficits, the difference between the 10-year swap rate and 10-year treasury note yield (the swap spread) declined to an unprecedented negative 13 basis points (bps) this March from a positive 77 bps in September 2008. This indicated that investors were requiring the US treasury to pay an interest rate higher than rates that prevailed on comparable maturity private swaps. (A private swap rate is the fixed interest rate required of a private bank or corporation to be exchanged for a series of cash flow payments, based on floating interest rates, for a particular length of time.)
At the height of the US budget surplus euphoria, the 10-year swap spread in August 2000 reached a record 130 bps. As the projected surplus disappeared and deficits mounted, the 10-year swap spread progressively declined, turning negative this March, and continued to deteriorate until the unexpected euro zone crisis granted a reprieve.
The 10-year swap spread quickly regained positive territory and by 14 June stood at a plus 12 bps. The 10-year swap spread understandably has emerged as a sensitive proxy of treasury borrowing capacity: a so-called canary in the coal mine.
I grant that low long-term interest rates could continue for months, or even well into next year. But just as easily, long-term rate increases can emerge with suddenness. Between early October 1979 and late February 1980, for example, the yield on the 10-year note rose almost 4 percentage points.
The current federal debt explosion is being driven by an inability to stem new spending initiatives. Having appropriated hundreds of billions of dollars on new programmes in the last year and a half, it is very difficult for the US Congress to deny an additional $1 billion or $2 billion for programmes that significant constituencies perceive as urgent. The federal government is currently saddled with commitments for the next three decades that it will be unable to meet in real terms. This is not new. For at least a quarter century, analysts have been aware of the pending surge in baby boomer retirees.
The US cannot grow out of these fiscal pressures. The modest-sized post-baby-boom labour force will not be able to consistently increase output per hour by more than 3% annually. The product of a slowly growing labour force and limited productivity growth will not provide the real resources necessary to meet existing commitments. Only politically toxic cuts or rationing of medical care, a marked rise in the eligible age for health and retirement benefits, or significant inflation, can close the deficit. I rule out large tax increases that would sap economic growth (and the tax base).
With huge deficits currently having no evident effect on either inflation or long-term interest rates, the budget constraints of the past are missing. It is little comfort that the dollar is still the least worst of the major fiat currencies.
The US, and most of the rest of the developed world, is in need of a tectonic shift in fiscal policy. Incremental change will not be adequate.
I believe the fears of budget contraction inducing a renewed decline of economic activity are misplaced. The current spending momentum is so pressing that it is highly unlikely that any politically feasible fiscal constraint will unleash new deflationary forces. Fortunately, the very severity of the pending crisis and growing analogies to Greece set the stage for a serious response.
Alan Greenspan is former chairman of the US Federal Reserve, president of Greenspan Associates Llc and author of ‘The Age of Turbulence: Adventures in a New World’ (2007)
THE WALL STREET JOURNAL
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