dailyreckoning.com.au / By Satyajit Das / November 19th, 2012
The world is focused on the ‘fiscal cliff’, a term referring to the scheduled reductions in the US budget deficit, by way of expiring tax cuts and mandatory spending cuts.
The fiscal cliff may ironically improve public finances, reducing the deficit and slowing the increase in debt levels -America’s debt mountain. But going over the fiscal cliff will not of itself solve America’s fundamental financial problems.
Successive US administrations have avoided dealing with the US debt problem. Policy makers have adopted the rulebook of rapper Tupac Shakur: ‘Reality is wrong. Dreams are for real’.
There are also additional current and contingent commitments not explicitly included in the debt figures, such as US government support for Freddie Mac and Fannie Mae (known as government sponsored enterprises (GSEs)) of over US$5 trillion and unfunded obligations of over US$65 trillion for programs such as Medicare, Medicaid and Social Security. US State governments and municipalities have additional debt of around US$3 trillion.
US public finances deteriorated significantly over recent years. In 2001, the Congressional Budget Office (CBO) forecast average annual surpluses of approximately US$850 billion from 2009-2012, allowing Washington to pay off everything it owed.
The surpluses never emerged as the US government has run large budget deficits of around US$1 trillion per annum in recent years. The major drivers of this turnaround include: tax revenue declines due to recessions (28%); tax cuts (21%); increased defence spending (15%); non-defence spending (12%); higher interest costs (11%); and the 2009 stimulus package (6%).
Despite growing concern about the sustainability of its debt levels, demand for US Treasury securities from investors and other governments remains strong.
‘Innovative’ monetary policy from the US Federal Reserve has allowed the government to increase its debt levels. Around 60-70% of US government bonds have been purchased by the Federal Reserve as part of successive rounds of quantitative Easing (QE).
Federal Reserve action has been a key factor in keeping rates low, allowing the US to keep its interest bill manageable despite increases in debt levels. The government’s average interest rate on new borrowing is around 1%, with one-month Treasury bills paying less than 0.10% per annum and 10 year bonds around 1.80% per annum.
But the current position is not sustainable.