July 17, 2007
America is cruising towards a federal deficit shipwreck
By Kenneth Rogoff
The Bush administration was beside itself with glee earlier this month when it announced that the fiscal year 2007 federal deficit was set to fall to just over $200bn, or 1.5 per cent of US gross domestic product. Although the continuing deficit hardly makes the US a picture of fiscal prudence, the dollar amount is less than half what it was in 2004.
Publicly, some Democrats are still condemning Bush II profligacy and preaching a return to Clinton I fiscal conservatism. Privately, though, many are starting to question why a 2008 Democratic president should bother improving the government’s balance sheet if the end result is just a bigger pot for a future Republican president to lavish on his or her friends. Certainly the 2000s, even as long-term interest rates normalise, seem to have thrown cold water on the notion that sustained US budget deficits will automatically lead to high interest rates and low growth. Or have they?
First, the good news. Explosive financial globalisation has made US federal budget policy far less important as a determinant of global real interest rates. Instead of interest rates going up sharply, low levels of public and private saving in the US have helped sustain a massive current account deficit. Continuing foreign inflows are probably holding down US real interest rates by at least 1.5 per cent and possibly more.
And let us give credit where credit is due. The Bush administration’s decision to borrow massively, over a period where global long-term interest rates fell massively, was not a bad market call.
The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.
Richard Cooper: Ken Rogoff focuses too much on the USA, regreting its budget and currenct
Posted by: Richard Cooper | July 23rd, 2007 at 12:18 pm | Report this commentaccount deficits, which will eventually come home to roost in an ageing
American society. He neglects to tell us, however, that other rich
societies, and even some poor ones, are ageing much more rapidly, that
most of the leading rich countries also run budget deficits, and that many
of them (Spain, Britain, Italy, France) also run current account deficits.
Suppose all, including the United States, were to follow his advice and
save more for old age. There would be a major world recession, leaving
everyone worse off. An uncertain economic disaster in the distant future
would be transformed into a certain economic disaster in the near future. World
interest rates would be lower, but that would stimulate little productive
investment anywhere under conditions of weak global aggregate demand.
Budget deficits might well increase. It is difficult to understand how
this would help ageing Americans or more rapidly ageing Europeans and
Japanese.
We should certainly adopt soon his proposal to raise in future
the age for eligibility for public pensions, to 68 and beyond, to
respond to increasing longevity and later entry into the labor force; but that
would not affect the near-term budget outlook, only the long-term projections of
pension expenditures. And health expenditures are out of control. With
marvellous advances in medical knowledge, death is becoming an option. We
need to have a serious public debate about death, who should pay for
avoiding it, under what circumstances and for how long. This is a debate
no politician will initiate; but it will sooner or later be necessary for
all rich societies.
Kenneth Rogoff: Richard Cooper is indeed correct that the deficit/aging problem is a universal one, as I note. As I point our in the article, the problem is not really one of bean counting, but requires fundamental decisions about what society should regard as a minimum acceptable level of health care in a society where “death is becoming an option” as Dick Cooper puts it.
I dasagree wiht Professor Cooper, however, that a gradual broad-based OECD shift towards greater budget balance would be a catastrophe, particularly in conjucntion with restraining future growth of entitlement spending and simplication of tax systems, Indeed, it might well help (at the margin) deepen and extend the current global expansion.
Posted by: Kenneth Rogoff | July 23rd, 2007 at 3:18 pm | Report this commentLeanne Ussher: Kenneth Rogoff does not give enough credit to the financial world’s portfolio demand for US T-bonds. As a percentage of world GDP the US deficit stands at less than 1%, and below the 20 year average. US outstanding debt has also been fairly steady over the past 20 years, between and 12 and 10% of world GDP and falling. As US GDP is a shrinking percentage of world GDP, it is possible that this statistic will continue to fall rather than grow, despite the expectations of greater US deficits in the future.
Holding US T-bonds is a portfolio allocation decision between different financial assets (e.g. cash, bonds and stocks in different currencies and by different issuers). Contributing to the demand for US government bonds, quite apart from world growth, has been a growing financialization of the global economy. The increase in private financial assets, rather than crowding out the demand for sovereign assets, increases the demand for sovereign assets as balance sheets are diversified and liquidity is not constraining.
Since the USD is the world’s reserve currency, default free US Treasuries have a special place in an international portfolio. As the world economy and US dollar denominated financial assets and international transactions grow, there will be a growing demand for US T-bonds. With the cautiousness of central banks and state investment vehicles, sovereign bonds, and especially those issued by the US, will continue to be desired.
During a boom, as T-bonds are a close substitute for cash, financial institutions may hold a larger percentage of sovereign bonds and less cash. In a recession, “flight to quality” leads to an over weighting of sovereign bonds and cash.
With the US dollar as the reserve currency, the demand for US dollar assets have had significant resiliency, despite the current account deficit, and a weakening US dollar. While China can hedge exchange rate risk in the derivatives market, it hedges default and liquidity risk through the purchase of US government bonds.
If the USD T-bond market did suffer a crisis, there may be period of turmoil in which prices of bonds need to settle to a new level, as portfolios are rebalanced. However it is hard to imagine that the global demand for US T-bonds will simply collapse. It may steepen the yield curve, which would probably be welcomed by the Federal Reserve, perhaps improving their control over domestic monetary policy.
While US private deficits, such as the current account and household deficits, are much larger and greater causes for concern, a government deficit is quite a different scenario. Abba Lerner in 1970s claimed that government debt should be treated as “net wealth,” and the “no-ponzi game” assumption (that bonds must be repaid with taxes) is a false one. Lerner argued that liquid and rising government debt can lead to real productivity gains: benefits in being able to price other bonds, completing markets, and adding risk-free assets that enable diversification and higher risk tolerance. These benefits are enjoyed by domestic and global finance.
Later, Robert Eisner also questioned the meaningfulness of a government deficit. In terms of sustainability, he emphasized that the government debt should not grow relative to the economic capacity for servicing it. Since taxes are levied on national income (or GDP), it makes sense to relate the debt to GDP. If the debt-to-GDP ratio remains stable, there should be little cause for concern about fiscal sustainability. Currently this statistic is inline with a 45 year average of 36%, according to the congressional budget office.
I am not advocating the requirement of large US budget deficits or debt. But I do want to emphasize that there are pluses and minuses to a growing US sovereign debt, which complicates any analysis, and certain tendencies may cancel each other out.
The use and containment of government expenditure is an important policy matter that can dramatically change the distribution and growth of an economy. It deserves debating, however it should not be laced with fears of financial shipwreck, which appear to be overstated.
Posted by: Leanne Ussher | July 25th, 2007 at 3:08 am | Report this commentMartin Wolf: I enjoyed Ken’s piece, but I sympathise with both of his critics.
Right now I cannot see how the US fiscal deficit (as opposed to what it is being spent on) can be a problem. In a world with massive excess savings outside the US, a remarkably cautious business sector almost everywhere and modest interest rates, there is no obvious reason for the US to run a tighter fiscal policy. As Professor Ussher notes, persuasively, trends in US public indebtedness are not a serious issue.
So why might the US public finances be a problem, after all? There seem to be two possible reasons: explosive long-run spending commitments, primarily on health; and the quality of spending. Both are legitimate concerns and both, of course, reflect deep political forces. The government is spending too much on the wrong things. In particular, as is true of many western countries, too much is being spent on the old rather than the young, particularly children.
So I think debates on fiscal policy should shift away from a focus on today’s deficits, which are not a big problem, and concentrate, instead, on the quality of spending, the scale of spending (probably too low in the US and too high in parts of Europe) and the cost of some of the long-run commitments.
Posted by: Martin Wolf | July 30th, 2007 at 5:42 pm | Report this comment