Obama has promised to halve the the US deficit by 2013, but nobody seems to know how he’ll manage it
The finances of the world’s biggest economy are showing increasing signs of distress. At the end of June, US borrowings stood at a record $14 trillion: more than the total for the eurozone as a whole. Is America bust?
Its debt burden is still a smaller proportion of its economy than many European countries (just under two thirds of GDP, as opposed to 115 per cent of GDP in crisis-stricken Greece, and over 70 per cent in Germany and France). But the US deficit is nowhere near its peak: the IMF estimates that, on present policies, debt will reach 95 per cent of GDP by 2020 and, as its ageing population needs more spending on health and social security, it could hit 135 per cent by 2030 and continue to rise thereafter.
President Obama is promising to halve the budget deficit by 2013 and stabilise it at just over 70 per cent of GDP by 2015. But the first date is just three years away and no one knows quite how that will be achieved. While countries across Europe are announcing austerity packages—Spain is cutting €15bn, Germany €80bn—the US administration’s instinct is to spend its way out of recession. Obama failed to persuade the rest of the G20 about the benefits of increasing spending in the face of the global crisis, yet he is also having little success in persuading people at home of the need for austerity. A key test will come at the end of the year when the tax cuts of the Bush era expire. Obama wants to keep them for all but the rich; the doves think they should be continued for everyone and the hawks say they should not only be abandoned but accompanied by swingeing tax rises.
For the moment, a bit of profligacy is no bad thing. As one of the few western countries that still has the wherewithal to keep spending, the US has been a big component of the global recovery. The IMF pays tribute to the “strong and effective macroeconomic response” of the US authorities, which means “the recovery has proved stronger than we had expected.”
Its assessment may have been premature. Recent data from the US has been relentlessly disappointing: in July, American businesses cut their employees by 131,000, the second monthly fall in a row. And the US Federal Reserve spooked the markets with its warning that the pace of recovery had slowed and was likely to remain modest, and pledging to maintain its $2 trillion support package.
That may make investors start to question their sanguine attitude to the ballooning deficit. While government bonds in countries like Greece and Spain have plunged in value, sending yields (investor-speak for the interest rate divided by the price at which the bonds trade) soaring to more than 12 per cent in Greece, the US is still seen as a safe haven: its treasury bonds have actually risen in value, pushing yields down to around 1 per cent, despite the ballooning deficit.
Can it continue? Ken Rogoff, the Harvard professor whose book This Time it is Different is the definitive analysis of the history of financial crises, accuses the US of storing up trouble for itself by using a trick called “playing the yield curve”: taking advantage of the fact that the rates for short-term borrowing are lower than for longer-term debt. About half of US debt matures in the next three years, a far higher proportion of short-term debt than it has had at any time in the past, and a far shorter maturity profile than other economies: the average for Britain, for example, is 14 years. And it’s worth remembering that the Greek crisis was triggered by the need to refinance short-term borrowings, forcing the country into its crisis €110bn bailout and €35bn cuts package.
No one expects the US to need such a bailout, but the huge amount of debt which will need to be refinanced in the next three years means it is vulnerable to a “buyers strike” should investors decide there are better opportunities elsewhere, or to demand higher yields for the increased risks of the rising deficit. Much depends on the attitude of the Chinese, who currently hold around half of all US debt. So far, they have shown no inclination to stop buying it, but the risks that the appetite could wane are already evident. China is moving gradually to a free float of its currency, ending the dollar peg, which could eventually cut the supply of dollars to its export earners.
It also means the US is missing the opportunity to lock into long-term rates which, while higher than short-term ones, are still very low by historical standards. As this stand, a small rise in interest rates could have a big impact. Jim Leaviss, heads of retail fixed interest at fund managers M&G points out that a 2 per cent rise in interest rates across all maturity levels could push the US interest bill from the current, “troubling” 17 per cent of revenues to around 33 per cent. That, says Leaviss “could put economic recovery at risk.”
Such a hike in rates looks unlikely in the near future. Even the most hawkish of economists think that interest rates will stay low for at least another year to keep the recovery going. That recovery, and the tax revenues it will generate, is vital to keep the faith that the US will be able to deal with its deficit. But Rogoff points out that, judging by historical standards, the higher the budget deficit, the lower economic growth tends to be: his rule of thumb is that, at a deficit of 30 per cent of GDP, growth will average 3.7 per cent; at more than 90 per cent—which the US will reach this year—it falls to 1.7 per cent.
With Europe still in turmoil and doubts about the sustainability of the recovery in Asia, America’s status as a safe haven may not change any time soon. Analysts at Barclays Capital argue that the dollar’s status as a reserve currency means it can run far bigger deficits than other countries. Without that status, the US’s credit rating would already been downgraded from AAA to AA, the same as Spain. But as long as its currency remains more than half the world’s reserves—currently it is 60 per cent —a downgrade looks unlikely.
Yet the more it increases spending and delays tax rises, the bigger the problems being stored up for the future. Sooner or later, financial markets will want to see some evidence that the US is not only aware of its deficit problem, but has the will and wherewithal to deal with it.