MOUNTAIN OF DEBT
Even as sequestration takes effect, the government’s deficit worries aren’t over. A tipping point could be near
How much is too much? Where is the tipping point?
Debate over federal finances takes center stage again with this month’s scheduled sequestration cuts, which will pare spending in defense and other non-entitlement programs. It’s the latest small step to bring red ink under control, after tax hikes for wealthy Americans and a resumption of full Social Security payroll levies.
“We raised taxes in January, and we’ll cut spending in March,” said Jack Ablin, chief investment officer at BMO Private Bank, during a stop in Phoenix. “It’s not the most elegant solution, but we can recognize that government is moving in the right direction.”
But is it enough? Sequestration by itself won’t put more than a tiny dent in the government’s annual deficits and the accumulated debt totals. KC Mathews, chief investment officer at UMB Bank, says the sequester will slow federal spending by 0.1 percent annually.
The fiscal situation has improved a bit, with the Congressional Budget Office now projecting only an $845 billion deficit in 2013, which would snap four straight years of $1 trillion shortfalls. The trajectory is expected to pick up starting around 2017, as demographic pressures intensify.
Speaking in Phoenix recently, former Wyoming Sen. Alan Simpson, co-chairman of President Barack Obama’s debt-reduction commission, repeated his warning that too much red ink will eventually trigger a nasty market reaction that could result in higher interest rates, rising inflation, slower economic growth and other unpleasant fallout.
Is there a critical debt or deficit number that causes such a backlash?
There probably is. But we haven’t reached it, and nobody knows what it is, especially for
the United States, which occupies a unique economic niche. Despite a tripling of U.S. red ink over roughly the past decade, the financial markets haven’t responded lately with much more than a yawn.
Interest rates across the board remain near historic lows — not something you’d expect if confidence in government bonds were eroding.
The stock market is at or near record highs, depending on which indicator you’re tracking. Even gold prices have stalled.
If so much debt undermines the value of the dollar, then other currencies and assets such as gold should be surging. Gold did enjoy a big run-up over the past decade, in anticipation of rising deficits, but it now sits more than $300 an ounce below its peak.
One commonly cited threshold for possible worry is when a country’s accumulated debt tops 100 percent of annual gross domestic product. The U.S. is getting closer, and countries such as Greece and Italy have already gone over. But we’ve been in this position for the past couple of years, with a mostly muted market reaction.
What about the nation’s credit rating, which got dinged by Standard & Poor’s more than a year ago?
This, too, should have led to an increase in interest rates, signaling the need for bond buyers to be more concerned about the government’s ability to make good on its pledges. Lower credit ratings equate to higher borrowing costs, all else being equal. But that didn’t happen, and Treasuries remain as popular as ever.
As for currencies, the dollar has lost some ground. “The dollar is about 30 percent cheaper to the euro and yen over the last 12 years,” Ablin said. But this has hardly touched off an inflationary firestorm and has proven beneficial to manufacturers and exporters, he said.
That the greenback hasn’t declined more reflects the reality that most other countries have yawning deficits, too. In economics, everything is relative.
What about economic growth and, by implication, employment?
Grunden Financial Advisory of Texas said it compared deficits and output for 67 countries over 17 years and found a modest tendency of slower growth in nations running high deficits. “But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation,” the firm said.
Clearly there are compelling reasons to work toward balancing annual budgets and slowing the relentless accumulation of debt. One relates to federal interest expenses, which the CBO expects will start rising again in coming years. The higher the nation’s debt, the more money will be siphoned off to countries like China.
Simpson rightly warns that high indebtedness puts us more at the mercy of foreign bondholders and market forces generally. On the other hand, foreign holders of billions or trillions of dollars worth of U.S. government bonds have a vested interest in protecting their investments, which means they’re not likely to suddenly stop buying or make other moves that would upset the apple cart.
So is the tipping point near or just a vague warning? Nobody really knows. If the economy continues to grow while tax revenues increase and spending slows a bit, all would be incrementally good. It might not change the overall debt burden much, but it would show progress.
In that sense, the widely criticized sequestration cuts — or more precisely, spending slowdowns — are a step in the right direction. Federal opera- tions won’t grind to a halt from a little belt-tightening, and the economy won’t keel over. Bring them on.