Abheek Barua & Shivom Chakravarti: Can we ignore the US fisc?

The outlook is just as bad as that of some of the peripheral euro-zone states

One thing that the European sovereign debt crisis has certainly achieved is diverting our attention from the US’ fiscal woes. Unfortunately, this is unlikely to last long. With the US gross government debt to GDP ratio breaching the 100 per cent mark in 2011, investor attention will at some point have to turn to the fiscal mess in America. A recent report by Capital Economics titled “Are America’s fiscal prospect even worse than Europe’s?” examines the fiscal situation in the US and the options left for its policymakers to try and bring it under control.

The bottom-line of the report is that the US’ fiscal prospects are just as bad as that of some of the peripheral euro-zone states. The US fiscal deficit is actually bigger relative to the size of the economy (that is as a percentage of GDP) than the deficits being run by Spain, Portugal or Italy and is roughly the same size as the deficits in Greece and the UK. Things will only get worse in the long term. The prospect of an ageing population and increasing health care costs could place significant pressure on the fiscal. Even after including the fiscal consolidation of around $2.2 trillion over the next decade that has been agreed so far by the US House of Congress, the fiscal deficit is likely to remain at levels of four per cent to six per cent of GDP for the next few years before it begins to widen further and inch closer to the eight per cent mark in the next decade. The net result is that the total debt burden could spin out of control and reach unsustainable levels in the longer term.

 

However, the US isn’t Greece or Spain and a fiscal crisis in the immediate future à la Europe seems unlikely. The US government still enjoys a number of advantages that could give it some breathing space in the near term. The cost of servicing debt is still fairly low and estimated to be one per cent of GDP, that is, about a third of what it was between 1985 and 1995. This is the result of low interest rates and the fact that there is a natural appetite for the US dollar as the dominant global reserve currency. This reserve currency demand and the fact that the US bond market remains the deepest and most liquid in the world creates a natural bid for US treasury bills and bonds and helps it to fund its deficit at a relatively low cost. Again, unlike the peripheral economies in Europe that have delegated monetary decisions to the European Central Bank, the US’ own central bank controls the supply of dollars and it can tweak this to ensure that yields that fiscal funding costs remain in check.

However, while this can provide short-term respite, the US will have to catch the bull by its horns and make a serious bid to lower both the deficit and the level of sovereign debt over the medium term. What policy measures are open to it? Textbook solutions might not be feasible. Pushing up economic growth to boost tax revenues, for one, doesn’t seem like a viable option, given the deep funk in which the economy finds itself. Weaker global growth prospects will make an export-led growth strategy that much more difficult, while deleveraging or debt reduction by households will continue to constrain domestic demand. The next best solution would be a strong dose of fiscal austerity measures. However, the challenge there is to reach a political agreement across the party aisle on which specific expenditures get the chop. Republicans will insist that some of the Democrats’ pet initiatives like health care get short shrift, while the Democrats will defend them. Even if a political consensus can be reached, there is very little guarantee that austerity will be the answer. The recent experience of most euro-zone nations shows that fiscal austerity leads to even slower growth that implies that the overall improvement in deficit is nowhere close to initial expectations.

The last and most dangerous option would be to inflate their way out of the problem. Higher inflation could prove a useful strategy that would boost nominal tax revenues and reduce the real value of debt. This would, of course, require the help of the Fed that would need to keep monetary policy loose even if inflationary pressures begin to surface. However, the risks are enormous. Inflation has a nasty habit of spinning out of control and this attempt to use inflation to reduce the fiscal drag could turn out to be a botched experiment that will take another recession to correct. Besides at the first whiff of rising inflation, the bond-vigilantes will take over and start pushing bond yields up. Thus, there could be a quick transition in the US from a low interest to a high interest regime. This will destabilise the US economy, raise fiscal funding costs and rock the global economic boat. The US Treasury and the Fed will, thus, have to resist the temptation of using the inflation option to sort its fiscal problems. It might seem like the easiest solution now but is likely to work purely in the short term. In the slightly longer term, it could sow the seeds of another crisis. Beware!

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The authors are with HDFC Bank. These views are personal