Policymakers’ Risk Fiscal Cliff

The debt ceiling, which refers to how much the U.S. federal government may go into debt, has become a bargaining chip in the final round of debate over how to avoid the fiscal cliff. Republicans have promised not to agree to raise it until President Obama offers deeper spending cuts. In a recent message to Congress, the president told Republicans that there would be no negotiating for raising it later if they allow negotiations about the fiscal cliff to fail now, and many economists feel taking the debt ceiling off the table is a smart move for the White House, if only to ensure that if a recession is to result that it comes now instead of at the end of Obama’s second term. For more on this continue reading the following article from Economist’s View. 

One more from Tim Duy:

The Debt-Ceiling Gamble, by Tim Duy: Ezra Klein reports that the White House is drawing a line in the sand on the debt-ceiling, and they really, really mean it:

The Obama administration is utterly steadfast on this point: They will not suffer a repeat of 2011, when they conducted negotiations over whether the United States should default. If Republicans go over the cliff and try to open up talks for raising the debt ceiling, the White House will not hold a meeting, they will not return a phone call, they will not look at the e-mails.

The Administration is looking to take the debt ceiling off the table forever. This is good policy; that Congress should be able to pass laws authorizing spending but not authorizing the required debt is beyond ridiculous. Also ridiculous - and irresponsible - is the willingness of the Republicans to use the debt ceiling to hold the economy hostage. Ending this travesty should be a priority for the White House.
Klein adds that the White House is ready for the fight now while their strength is up:

Boehner and the Republicans don’t want to give up the leverage of the debt ceiling forever, or for 10 years, or even, as John Engler, head of the Business Roundtable and a former Republican governor suggested, for five years. But the White House isn’t very interested in compromising on this issue, as they figure that if there needs to be a final showdown over the debt ceiling, it’s better to do it now, when they’re at peak strength, then delay it till 2014 or 2015, when their own vantage might have ebbed.

I would add another advantage. Better - from a political point of view - to have a recession at the beginning of President Obama's second term that can be blamed entirely on the Republicans. A recession in the first half of 2013 means that, most likely, the Democratic presidential nominee can run on the back of an improving economy by 2016. Alternatively, they run the risk that this recovery, anemic as it is, gets long in the tooth by 2016. Even worse would be that they agree to let the Republicans once again hold the economy hostage two years from now. Politically, if I had to pick between a recession now or closer to the next election, I would pick now.

 This blog post was republished with permission from Economist's View.

U.S. Credit Rating Downgraded: Economists Comment on S&P Error

It appears Standard & Poor’s credit agency downgraded the U.S. credit rating using an incorrect budget baseline and now analysts are questioning why they, the government or the American people should listen to an agency that is apparently incompetent. The mistake hearkens back to S&P’s failed decision to adjust its outlook or rating when the U.S. entered into the recession, and not giving a fair evaluation to investment products and policies that endangered the economy. The error, which misjudged the baseline for rating by $2 trillion, is seen by most as too big to ignore when evaluating the agency. For more on this continue reading the following article from Economist’s View.

I was asked to comment on S&P's downgrade of long-term US debt:

The Consequences of the S&P Downgrade

As I explain, I don't expect much in the way of market or interest rate reaction to the downgrade. Also, I didn't mention this, but S&P's demonstrated incompetence on matters such as choosing the right baseline is another reason to ignore their pronouncement:

I Heard It Through The Baseline, by Paul Krugman: Oh, my. Treasury has a fact sheet explaining that $2 trillion error by S&P; it may sound technical, but to anyone who follows budget issues, it’s a doozy.

When the Congressional Budget Office “scores” policies, it does so relative to a “baseline”... But S&P initially assumed that the debt deal was subtracting off a quite different baseline.

The point here is not so much the $2 trillion, which makes very little difference to real US fiscal prospects; it’s the fact that S&P stands revealed as not understanding basic analysis of budget estimates. I mean, I don’t think I would have made that mistake; real budget experts, like the people at the Center on Budget and Policy Priorities, certainly wouldn’t have.

So what we just saw was amateur hour. And these people are pronouncing on US credit-worthiness?

Donald Marron:

S&P's 2 Trillion Dollar Error: ...The error is understandable but remarkably sloppy for such an important analysis.

The source of the error is painfully familiar to anyone who deals with U.S. budget projections. S&P’s analysts didn’t use the right measuring stick — i.e., the right budget baseline — when analyzing the effects of the recently-enacted Budget Control Act.

In one sense, it’s easy to see how this error happened. Budget discussions are now hopelessly confused by a profusion of different baseline projections of what spending and revenues will look like in the future. ...

But it’s still remarkably sloppy. Budget experts are well-aware of the problem of multiple baselines. Indeed, we all pepper our conversations and analysis with the question “what baseline are you using?” It’s stunning that S&P didn’t have multiple analysts asking the same question to make sure their original numbers were right.

He adds that:

It’s own revised calculations show net general government debt hitting 85% of gross domestic product in 2021 instead of 93%. That’s a big difference. ... S&P was too dismissive in its clarification.

Experts wouldn't have made this mistake. So why is anyone listening to S&P?

This article was republished with permission from The Economist's View.

Looming Default Reminder of Past Debt Problems

Currency expert Kathy Lien revisits a time in 1979 when the U.S. missed a Treasury bill payment, pointing out that the value of the dollar only dropped 0.6% immediately following the lapse; however, the value plummeted less than one month after the one-time default. Lien notes that it would be a mistake to attribute the drop in value on the actual missed payment, but the real reasons were increased inflation and global concerns over the security of the U.S. dollar. For more on this continue reading the following article from Kathy Lien.

Although the U.S. government has never officially defaulted on its debt, it missed payments on some Treasury Bills in 1979. Then as now, Congress was playing a game of chicken with Republicans and Democrats bumping heads on raising the debt ceiling. The debt limit was a fraction of its current levels and at the time, the dollar only fell briefly. The 0.6 percent drop in the Dollar Index was so small that it was barely left an imprint. However less than a month later, double digit inflation and concerns about the outlook for the U.S. economy along with the security of the U.S. dollar drove the greenback sharply lower. It may be tempting to attribute this decline to the short term default on U.S. debt but the Treasury started making its T-bill payments again after a very short delay.

Here’s a chart of how the dollar behaved when the U.S. government missed its debt payment in 1979:

This blog post was republished with permission from Kathy Lien.

Economist Advocates Expansionary Debt Relief Plan

Rober Shiller is convinced that a plan requiring raising taxes and government spending on a one-for-one basis – a “balanced-budget multiplier” – will help stimulate the economy and reduce the deficit without endangering the possibility of economic recovery. Shiller argues this will help solve real problems like high unemployment without necessarily expanding the size of the government, if spending is focused on infrastructure projects and funding private-sector projects. He also skewers ratings agencies for making the problem worse by promising to downgrade the country’s credit rating if it doesn’t figure out how to trim trillions from the deficit while also avoiding another recession – what many analysts now see as impossible. For more on this continue reading the following article from Economist’s View.

Robert Shiller:

Taxing and Spending, in Balance, by Robert Shiller, Commentary, NY Times: The fight over the debt ceiling has deflected attention from the serious problems of fixing the economy and finding jobs for the 14 million unemployed. Worse, it has created strong negative feelings about fiscal policy, just when other policy measures seem incapable of restoring economic health.

The very term “fiscal stimulus” has become tainted. ... Fiscal stimulus is actually very useful and appropriate in the current circumstances. But rather than despair, we should ... never give up proposing sensible economic policies. ...

In December, I wrote about the concept of the balanced-budget multiplier and of raising taxes and government expenditure by the same amount, dollar for dollar..., such a policy would be one-for-one expansionary...

This is an expansionary change in fiscal policy that won’t require additional increases in the national debt. We should start a dialogue right now about taking such action, before the damage of protracted unemployment worsens. ...

Such a policy needn’t make government substantially bigger. Instead, the government would act as a kind of investment banker specializing in public goods. It wouldn’t need a lot of employees itself. It would seek private-sector proposals for building infrastructure and other useful projects, and bring in private-sector panels to review them. This would be akin to the role government already plays for science with the National Science Foundation. ...

Current trends suggest that we may be dealing with high unemployment for years. We should be prepared to provide balanced support to the economy.

I appreciate the sentiment that "we should ... never give up proposing sensible economic policies." We should certainly do our best to educate people and to fight for better policy. But there's no way a policy that involves a substantial increase in taxes will pass right now.

But do I have something better to offer that might pass? Nope -- "might pass" and "better" are non-intersecting sets, and that won't change before the debt ceiling deadline. My effort right now is directed toward avoiding the stupidity that might lead to a failure to raise the debt ceiling, or almost as bad, a deal that raises it stupidly (I avoid using the word stupid here for the most part so that when I do use it, it will have more force).

In that respect, I am annoyed at the (demonstrably incompetent) ratings agencies, S&P in particular. They are now saying that simply raising the debt ceiling is no longer enough, there must be trillions in deficit reduction -- enough to derail the recovery and potentially send the economy back into recession -- to avoid a ratings downgrade. So S&P is making it more likely that a recovery killing deal will be made, and less likely that there is a last minute deal that "cleanly" raises the debt limit, avoids the recession risk associated with immediate debt reduction, and also avoids the risk of the severe economic problems associated with default. [Update: see here too, and here.]

This blog post was republished with permission from Mark Thoma.

Ross Perot Prophecy Comes True

Economist Tim Iacono reflects on the wisdom of Ross Perot during the 1992 Presidential election. He highlights a video made of a debate between Bush, Clinton and Perot wherein Perot warns of a wage convergence between Mexico and the U.S., and notes how now the country at issue is China as their wages climb while America’s falls. Meanwhile, he notes, everyone is too busy talking about taxing and spending to take note of the problem. For more on this continue reading the following article from Tim Iacono.

Spotted over at Patrick.net this morning, 1992 Presidential candidate Ross Perot’s warning about a steady decline in U.S. wages from almost 20 years ago sounds quite prophetic. All you have to do is substitute “China” for “Mexico” when you hear about wages converging at six dollars an hour – ours going down, theirs going up.

Sadly, no one talks about his much – instead, you get a political debate about taxes and spending. And, of course, monetary policy at the Federal Reserve that is largely based on a consumer price index that doesn’t distinguish between imported goods and goods that are produced domestically only exacerbates the problem.

This blog post was republished with permission from Tim Iacono.

Economists Still Employed, Despite Seeming Incompetence

Tim Iacono asks why so many people still turn to economists for financial forecasts when they clearly missed what so many people with no training in the field could see the housing bubble, the credit bubble and surging wealth on Wall Street as signs of imminent instability. He cites a story in CNN Money survey that pinpoints current economists’ biggest fears, which include the sovereign debt default of Greece and oil price shock, and wonders the experts’ responses would have been if asked the same question in 2008. For more on this continue reading the following article from Tim Iacono.

You have to wonder why, after the disastrous performance by economists in assessing risk just a few years ago when it was clear to many non-economists that the whole housing / credit market bubbles were going to end badly, the mainstream financial media continues to ask the dismal set what they fear most these days. But, they do.

This CNN/Money report indicates European sovereign debt and high oil prices top their list, so, it’s a pretty safe bet that the cause of the next financial crisis will be something else.

U.S. policymakers are racing to reach an agreement before the debt ceiling is breached. But the biggest risks to the U.S. economy are mostly out of their hands.

CNNMoney surveyed 27 economists and asked them to choose from a list of possible threats facing the economy. What scares them most? A sovereign debt default by a European country such as Greece. More than half of those surveyed ranked it as one of their top two concerns, with 10 choosing it as their number one worry.

“A Europe debt default could cause financial crises as large as the 2008 one due to financial system interconnections,” said Bill Watkins, executive director of the Center for Economic Research and Forecasting.

Another oil price shock, which most likely would come from further political turmoil in the Middle East and North Africa, is their next biggest worry.

If there was a similar poll back in the middle of the last decade, it sure would be nice to have a look at what this group was thinking back then as, with only a few exceptions, economists were mostly just marveling at what a wonderful financial world it was where everyone was getting wealthy through rising asset prices and Wall Street was booming.

This article was republished with permission from Tim Iacono.

Debt Ceiling Disagreement Persists

Economist Mark Thoma argues that the disagreement between Republicans and Democrats over whether to increase the debt ceiling is less about reducing the debt and more about controlling the size and role of government by either maintaining or changing the current tax structure. Thoma points out that even conservative supporters are mystified by Republican stubbornness when it comes to arguably helpful ideas about how to steer federal revenue, citing the GOP’s refusal to close the tax loophole on the ownership of corporate jets by way of example. For more on this continue reading the following article from Economist’s View.

If you had any doubt that the fight over the debt ceiling isn't really about the debt:

Paul Ryan Responds To David Brooks: We Won’t Cut Loopholes To Reduce Deficit, Only To Finance More Tax Cuts, ThinkProgress: As the August debt ceiling deadline looms and Republicans continue refusing to consider revenue increases, conservative New York Times columnist David Brooks excoriated the GOP for its intransigence. Writing yesterday that it “may no longer be a normal party” but rather a movement of “fanatic[s]” with a “sacred fixation” on tax cuts, Brooks slammed the GOP for rejecting a “no-brainer” compromise with Democrats, which would include closing tax loopholes for things like corporate jet ownership...

But Brook’s plea for sanity was lost on House Budget Committee Chairman Paul Ryan (R-WI), who responded to the column on conservative radio host Laura Ingraham’s show this morning. Ryan said that if Republicans gave up the loopholes now without securing a deal to lower marginal tax rates overall, they would lose an opportunity to demand new tax cuts in the future:

RYAN: What happens if you do what he’s saying, is then you can’t lower tax rates. So it does affect marginal tax rates. In order to lower marginal tax rates, you have to take away those loopholes so you can lower those tax rates. If you want to do what we call being revenue neutral … If you take a deal like that, you’re necessarily requiring tax rates to be higher for everybody. You need lower tax rates by going after tax loopholes. If you take away the tax loopholes without lowering tax rates, then you deny Congress the ability to lower everybody’s tax rates and you keep people’s tax rates high.

...Ryan is arguing that raising taxes on corporate jet owners and others is only acceptable if the money raised is plowed back into new tax cuts, not to paying down the deficit. He is clearly more interested in cutting taxes than dealing with the deficit, and is willing to let these egregious loopholes stay in the tax code until he can best exploit their removal to lower taxes...

With Republicans nitpicking at spending programs and eliminating their favorite targets, even small ones that don't generate much revenue, I appreciated this:

Ironically, just moments earlier in the interview, Ryan attacked President Obama for wanting to close the loopholes, saying doing so would generate an insignificant about of revenue to pay down the deficit. But when it comes to tax cuts, closing those same loopholes would apparently generate plenty of revenue.

The GOP argues that we must eliminate all wasteful spending no matter how small the expenditure (where wasteful means it does not agree with Republican ideology), deficit reduction demands it! Or so they argue. But closing tax loopholes would generate too little revenue to be bothered with?

But it's the "we're open to tax increases so long as they don't increase taxes," i.e. the insistence that all tax changes be "revenue neutral" that gives away the real game. This is about the size and role of government, it has very little, if anything, to do with the debt.

This article was republished with permission from The Economist's View.

Parties Differ On U.S. Economic Policy

Opinions about how to repair the economy in the United States vary from one party to the next, but broadly trend either toward reducing debt or spending more to in an effort to stimulate the financial infrastructure. The vast majority of conservative Republicans and a majority of Independents advocate reducing debt, while Conservative and Liberal Democrats favor more spending. For more on this continue reading the following article from Tim Iacono.

There’s nothing really surprising about the results of a new Pew Research poll in which one party favors deficit reduction to boost the economic recovery while the other party favors more spending, but, it is kind of interesting to see the data all in one graphic.

Following the departure of another Republican from the debt ceiling/deficit reduction negotiations, President Obama has injected himself directly into the talks in the hope that some kind of a deal can be struck prior to the debt ceiling deadline on August 2nd. Somehow, the fat tail of a U.S. debt default seems to have grown just a bit fatter.

This post was republished with permission from Tim Iacono.

Children Paying The Highest Price Of Excessive Government Debt

With record deficits at both the Federal and State level, the burden for repayment is being pushed to our children in more ways than one. Texas is a prime example of a state that is setting its children up for failure. Economics professor Mark Thoma looks at a recent article by Paul Krugman on the topic in his blog post below.

Budget hawks are confused by the meaning of "putting children first":

Leaving Children Behind, by Paul Krugman, Commentary, NY Times: Will 2011 be the year of fiscal austerity? At the federal level, it’s still not clear: Republicans are demanding draconian spending cuts, but we don’t yet know how far they’re willing to go in a showdown with President Obama. At the state and local level, however, there’s no doubt about it: big spending cuts are coming.

And who will bear the brunt of these cuts? America’s children. ... Consider, as a case in point, what’s happening in Texas, which more and more seems to be where America’s political future happens first.

Texas likes to portray itself as a model of small government, and indeed it is. Taxes are low, at least if you’re in the upper part of the income distribution (taxes on the bottom 40 percent ... are actually above the national average). Government spending is also low. ...

But here’s the thing: While low spending may sound good in the abstract, what it amounts to in practice is low spending on children, who account directly or indirectly for a large part of government outlays at the state and local level.

And in low-tax, low-spending Texas, the kids are not all right. The high school graduation rate, at just 61.3 percent, puts Texas 43rd out of 50 in state rankings. Nationally, the state ranks fifth in child poverty; it leads in the percentage of children without health insurance. And only 78 percent of Texas children are in excellent or very good health, significantly below the national average. ...

It’s not a pretty picture; compassion aside,... how the state can prosper in the long run with a future work force blighted by childhood poverty, poor health and lack of education.
But things are about to get much worse. ... For months, Gov. Rick Perry had boasted that his “tough conservative decisions” had kept the budget in surplus while allowing the state to weather the recession unscathed. But after Mr. Perry’s re-election, reality intruded — funny how that happens — and the state is now scrambling to close a huge budget gap. (...achieved with an overwhelmingly nonunion work force.)

So how will that gap be closed? Given the already dire condition of Texas children, you might have expected ... high-income Texans, who pay much less in state and local taxes than the national average, to be asked to bear at least some of the burden.

But you’d be wrong. Tax increases have been ruled out...; the gap will be closed solely through spending cuts. Medicaid, a program that is crucial to many of the state’s children, will take the biggest hit, with the Legislature proposing a funding cut of no less than 29 percent... And education will also face steep cuts, with school administrators talking about as many as 100,000 layoffs.

The really striking thing about all this isn’t the cruelty — at this point you expect that — but the shortsightedness. What’s supposed to happen when today’s neglected children become tomorrow’s work force?

Anyway, the next time some self-proclaimed deficit hawk tells you how much he worries about the debt we’re leaving our children, remember what’s happening in Texas, a state whose slogan right now might as well be “Lose the future.”

This post was republished with permission from The Economist's View.

Government Debt Approaches "Point Of No Return"

Tim Iacono points out that governments must start facing the fact that the growing debt will need to be dealt with in ways that will likely be very painful. The alternative is to keep ignoring the problem which will inevitably lead to a dangerous "point of no return" in which no one believes that the debt can be serviced or paid back. See the following post from The Mess That Greenspan Made.

Recent developments in the euro zone that increasingly look like they will lead to the restructuring (if not the collapse) of one of the world’s major currencies and the potential for this “contagion” to move first north to the U.K. and then west to the U.S. have many people wondering what’s gone wrong with the global monetary system.

How could advanced Western economies have run into such trouble?

With trillions of dollars in debt now transferred from private sector balance sheets onto those of governments (where very different rules apply), could the problems seen in mainland Europe today spread to the British Isles and then to the U.S. where fiscal and economic conditions are, arguably, even worse?

Despite all the talk about slashing budgets in the former and upward revisions to economic growth forecasts in the latter, it seems clear that these two Anglo Saxon nations are not yet clear of danger and, if that danger comes, we may see something that rhymes not-so-nicely with the events of late-2008 as history is not prone to repeating exactly.

How did it come to this point of staring into the abyss and, perhaps, falling in?

In a word, the problem is “debt”.

Too much of it.

There are those who say that, like many things in life, a little debt is a good thing and this is very true.

Credit markets connect investors and entrepreneurs, both of whom presumably understand the risk that is involved, and when a good idea gets a little money behind it, wonderful things can happen – economic growth, job creation, and rising standards of living to name just a few.

And borrowing by governments is not necessarily a bad thing.

We all like new roads and bridges and, just like when a family buys a house, it’s difficult to make such big outlays with cash. Governments borrow to pay for costly infrastructure work just as households finance the purchase of new homes costing two or three times their annual income (at least that’s the way it used to be).
New Debt Not the Same as the Old Debt

Unfortunately, the borrowing and spending that has gone on over the last few decades in most of the Western world (not coincidentally, since the entire global monetary system lost its last tether to anything resembling a system of sound money) seems far removed from any of these “a little debt goes a long way” examples that, by and large, benefit society.

Over the last 30 years, a rapid expansion of credit and debt has been one of the major reasons why economies have grown at such an impressive pace and why asset prices have risen so high, but all the new debt hasn’t gone to build bridges and buy modest homes.

Up until recently, no one really seemed to notice the difference.

Having gone on for so long, it’s no wonder that most economists, analysts, and investors so quickly extrapolate these prior decade’s results into the future. But, a judgment like that assumes the system as we’ve come to it know since the days of the “Reagan Revolution” is sustainable and, after the events of the last few years, it should be clear that this is now at least a question that should be asked.

Sadly, too few are asking that question.

Now, just a year or so removed from the worst financial crisis since the Great Depression, we seem to be quickly approaching some sort of debt threshold – a “point of no return” that may have already been reached in parts of Europe – where no one believes that the massive amount of debt can still be serviced, let alone paid back.

Of course, unlike companies and individuals, sovereign governments with their own currencies have the option of paying back their debt with a currency that they can depreciate – by printing up more of it.

That certainly seems to be the explanation for why the “wolf pack” – those CDS, FOREX, and bond traders who insist on making ever larger bets against whichever country they deem the weakest – have left the U.K. and the U.S. alone.

At least, so far.

Anyone looking solely at deficits as a percent of GDP or debt-to-GDP ratios would surely have concluded that it’s not the eurozone (as a whole) that has a debt problem, it’s the U.K. and the U.S., both of whom seem happy to continue whistling past the graveyard.

Yes, there’s Japan too, but, as should be clear by now, being able to finance government deficits from domestic savings makes a big difference in when your “point of no return” starts to cause big problems.

Many claim that, under the stewardship of Ben Bernanke, we’ve avoided another Great Depression in the U.S. and that the borrowing and creation of trillions of dollars in order to do so is simply “the cost of doing business”.

Some say, “Hey, financial market panics happen every so often, and this one will just cost a little more to clean up than the previous ones.”

For today’s policymakers, the fact that trillions of dollars in debt have been transferred from the private sector to the public sector seems to be but a footnote to the history that is now being written and, while there is mounting concern about who’s going to bail out the central banks who bailed out the governments who bailed out the private sector, there’s far too little serious consideration of the possibility that all this amounts to simply rearranging the deck chairs on the Titanic.
A World of Debt Addicts

There is far too little admission of the basic problem here.

The entire West has become a group of debt addicts – governments, corporations, and individuals – and, instead of trying to have an intervention, we’re just giving lip service to the idea that we’ve spent too much money that we didn’t have and that we can’t continue to do so.

Like a true addict in desperate need of an intervention, current thinking is that, after being nursed back to health from what was a very nasty hangover – the worst yet – we’ll kick this habit for good, but, doing so now would just be too much to bear.

Unfortunately, we’ve heard that all before when the hangovers were far less extreme and, at this point in the discussion, perhaps the loss of brain cells due to excess consumption of alcohol is a more appropriate metaphor…

The current path is clearly unsustainable.

Why doesn’t someone just stand up and say, “Let’s just have a miserable next five years and clean up this mess rather than relegating the entire developed world to a lost decade … or two?”

Why?

Because the path back to a more reasonable lifestyle – where income better matches up with outlays and printing presses need not be run so often – is believed to be too hard.

Politicians have made promises that they can’t keep but they keep getting reelected because a lot of people in the world really believe that there is such a thing as a free lunch.

Now, that may be changing and one need look no further than in the U.S. where a growing percentage of the citizenry seem to like the idea of getting less from their government before the fact.

How they react when the cuts begin to affect them is a discussion for another day.

But, when you think about it, why should wealthy individuals collect social security when they don’t need it and why should public employees be so handsomely compensated when the government must borrow money to do so?

We’ve come to a crossroads where an unsustainable system of expanding credit and debt seems to have reached its upper bound and there are no pain-free ways to make the system sustainable again.

The problem is too much debt and the solution involves pain.

It’s time that we all got used to that idea.

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Industrialized Countries' Debt Is Approaching 100% Of GDP

A recent report issued by the Bank for International Settlements echoes ongoing concerns about the high level of government debt throughout the industrialized world. It points out that although the debt has been easy to finance, with governments moving into a period of higher spending to support aging populations coupled with growing risks of inflation and high interest rates, the debts could become problematic very quickly. See the following article from The Capital Spectator for more on this.

It's all about debt from here on out, and probably will be for many years. That's old news, of course, but it's still relevant, as we've been discussing, including here and here. A new research paper from the Bank for International Settlements is the latest contribution to the literature that rings the warning bells.

"The future of public debt: prospects and implications" (published last month) lays out the basic challenge, explaining:

The financial crisis that erupted in mid-2008 led to an explosion of public debt in many advanced economies. Governments were forced to recapitalize banks, take over a large part of the debts of failing financial institutions, and introduce large stimulus programs to revive demand. According to the OECD, total industrialized country public sector debt is now expected to exceed 100% of GDP in 2011 – something that has never happened before in peacetime.

Is this reason for concern? So far, the paper's authors report, bond markets have shown a high tolerance for future liabilities in the new age of red ink. But the fixed-income market is "notoriously short-sighted," they warn. "We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point." In other words, "the question is when markets will start putting pressure on governments, not if."

The central issue, according to the paper:

…the fiscal problems currently faced by industrial countries need to be tackled relatively soon and resolutely. Failure to do so will raise the chance of an unexpected and abrupt rise in government bond yields at medium and long maturities, which would put the nascent economic recovery at risk. It will also complicate the task of central banks in controlling inflation in the immediate.

The rise in government debt is, by itself, reason for concern. But the problem is compounded by expectations that we're facing an era of higher spending related to aging populations. The study explains:

…the current expansionary fiscal policy has coincided with rising, and largely unfunded, age-related spending (pension and health care costs). Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply. Interestingly, this rise is concentrated in countries such as Japan, Spain, Italy and Greece, which are already laden with relatively high debts

In addition, the full hazards have been muted in recent years thanks to low interest rates and low inflation. Under those conditions, the burden is considerably eased for financing and refinancing debts. But the times they are a changing. In particular, real (inflation-adjusted) interest rates have been rising lately, as the chart from the study below shows.



"Real borrowing rates rose through 2009, and are poised to continue increasing with the reversal of the current zero interest rate policy," the authors predict. "It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far," they write. "In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly."

This post has been republished from James Picerno's blog, The Capital Spectator.

Falling Tax Revenues: A Bad Sign For Economic Recovery

As federal and local governments increase spending to stimulate the economy, their revenues through taxes continue to fall. According to the Wall Street Journal state and local tax revenues are falling due to lower consumer spending while property taxes are sure to decline as property assessments catch up to the depressed home values. See the following discussion from Moses Kim at Expected Returns.

I'm becoming increasingly wary of news of a nascent economic recovery, especially with news from the WSJ that state and local tax revenues declined 7%. Declining tax receipts evidence the weakness in both the labor market and consumer demand. All signs point to this weakness to persist as credit continues to contract for consumers who are deemed by banks to be less and less creditworthy.

State and local tax revenues fell 7% in the third quarter of 2009 from a year ago, the Census Bureau said in a report underscoring how the economic downturn is stressing government collections.

Sales taxes declined 9% to $70 billion in the third quarter compared with the year-ago period, the Census Bureau said. Income taxes plunged 12% to about $58 billion. Together, sales and income taxes make up roughly half of state and local tax revenue.

"We expect continued weakness well into 2010 if not further," said Lucy Dadayan, an analyst at the Rockefeller Institute of Government at the State University of New York.

What more objective indicator is there of economic conditions than sales tax receipts? The consumer is conspicuously not participating in this "economic recovery". There is hardly room to spin this glaring hole in the recovery thesis, but that probably won't stop permabulls from trying.

Property Tax Receipts Rise...For Now

Property taxes increased 3.6% in the third quarter compared with a year ago. But as property assessments catch up with falling residential and commercial real-estate values, property-tax revenues are expected to be weak. That will have a particularly severe impact on local governments, which fund much of their operations from property taxes.

Property taxes were the only bright spot in this report, but don't expect that trend to last. Housing assessments, which determine property tax receipts, haven't fully accounted for the decline in housing prices yet.

Keep an eye on the real estate market. The latest Case-Shiller report shows that housing is flatlining, and suggests further downside risks. The government, through its homebuyer tax credits, has effectively crushed future demand, which should weigh on housing in the months ahead. Of course the government has the option of repeatedly extending tax credits to artificially inflate prices and cause the next major housing crisis, but they can't be that stupid, can they?

States in Crisis Mode

State and local tax revenues tend to lag behind the downturns as well as the upturns in the economy because of the time it takes for collections to catch up with depressed store sales and diminished incomes. The third quarter was the fourth consecutive quarter in which tax collections were below year-ago levels.

Through the first three quarters of 2009 state and local tax revenues totaled $875 billion, nearly 8% below the $951 billion collected in the first three quarters of 2008. In the same period, federal receipts were down nearly 19%.

While the recession appears to have ended during the summer, government revenues are expected to continue to be weak. State and local governments employ 15% of American workers outside of agriculture.

States are about to face some tough choices. Declining tax revenues, which are at depression levels, will force states to cut services and layoff more employees. We are facing a huge fiscal crisis at the state and federal level that is being patently ignored. 2010 should bring these key issues to the fore as deteriorating balance sheets of governments become too much to ignore.

This post has been republished from Moses Kim's blog, Expected Returns.