Why our debt-to-GDP ratios are right on

In the second of a two-part post, Roosevelt Institute Braintruster Marshall Auerback explains why the focus on China, reserve currency, and external imbalances is a red herring for our real fiscal problem.

By the end of the first quarter of 2009, it was clear that US nominal GDP had fallen. Incomes started to fall. That indicates the private sector is trying to net save more than is feasible given the shrinkage of the trade deficit and the expansion of the fiscal deficit, largely through so called automatic stabilizers, to date.  This is also reflected in a private household savings rate of almost 7 percent, the highest since 1993 (which, interestingly enough, was also the last time the US government engaged in significant deficit expenditures). 

Now, one could argue that from a US-only perspective, ideally all of the increase in the private sector net saving position would come from a reversal of the trade deficit, but this isn’t going to happen.  China earns about 10 times as much on its external sector than the domestic market, so its decision to become an export juggernaut, taken in isolation, was perfectly understandable. But in a world where global trade is collapsing, in part because export dependent economies have just had the rug pulled out from underneath them as US consumers (and others) try to save, it is a fantasy to think the adjustment process can be done entirely through trade.

The only way to avoid a debt deflation outcome, as long as the private sector is trying to increase its net saving, is through an expanding fiscal deficit. And the reality is that we don’t need a G20 summit to accomplish this.  The US can do this on its own.  As the government spends more than it earns in tax revenue, private sector incomes are boosted, and the private sector can earn more than it spends. They are two sides of the same coin. In fact, this is what is happening today. In that sense, if you agree that private sector deleveraging is a necessary part of the adjustment process, or at least important, it comes at the price of public sector releveraging, barring a heroic reversal in the US trade deficit (which would throw our trading partners into an even more severe recession unless they also pursued domestic demand-led polices, a la China).

To illustrate this, the current account deficit has already gone from about 6 percent of GDP to roughly 3 percent of GDP as of the end of Q1 2009. Let’s say further consumer and inventory contraction gets us to 2 percent of GDP by year end. The CBO suggests the federal fiscal deficit will be out to 12 percent of GDP.  I think that’s a bit high, as it incorporates TARP.  But even assuming a trailing deficit of 8 percent (which is roughly what we’ve got now in the US), the private sector can net save around 7-8 percent of GDP without nominal incomes falling in the economy. At the depths of the 1973-5 recession, private sector net saving hit a post WWII high of nearly 9 percent of GDP. Maybe it needs to go higher this time because of the larger shock to household balance sheets with home and equity price deflation. But at least we can say the fiscal deficit is now programmed to scale up fast enough to reduce or contain the risks of US income deflation, and hence a runaway debt deflation process. To me this is crucial to contain the worst of the credit crisis. 

So can the foreign trade and US household spending imbalances be adjusted? Yes, they can. Can that adjustment process create further challenges? Yes it can, to the extent massive fiscal deficit spending is required to allow the private sector to accomplish its net saving objective without cratering private incomes and setting off a debt deflation spiral.

Then the question really boils down to, can the massive Treasury bond issuance be placed, especially if a smaller US trade deficit means foreign investors have fewer dollars to reinvest in US assets?

Treasury bonds were once over 20 percent of commercial bank balance sheets. They were below 5 percent until recently. Default free securities might look attractive to banks these days, especially with a positively sloped yield curve (and there is no question of national solvency when one has a fiat currency system, as opposed to a gold standard). The Fed used to hold 70-80 percent of its assets in Treasuries, now down to 20 percent. The Fed will want to have plenty of Treasuries to sell into the market once the eventual recovery comes and private investor liquidity preferences fall.. Remember, the Fed has no budget constraint.

Does this imply an increase in liquid assets in the economy? Yes it can, but we are also undergoing a large financial sector deleveraging, and we have begun a household sector deleveraging as well for the first time in the post-WWII period. As loans are paid backed, deposits are cancelled out, shrinking conventional measures of the money supply. Much of the credit in the shadow banking system has been obliterated and will not be coming back soon.

Is there nevertheless a risk of a flight from the dollar to the extent the US is willing to be the first mover, and an aggressive one at that, down these paths of quantitative easing? Yes there is. Is there a risk investors seeing the more central banks pursing the quantitative easing path will take flight into precious metals and other real assets as prospective inflation hedges, even if product price deflation is showing up in more countries? Yes there is. Could that complicate the policy exit strategy to the extent some of these commodities, like oil, are inputs to production, and so higher commodity prices could lead to an adverse shift in supply curves (to the left in price/quantity space, as in stagflationary periods)? Yes it could. 

But I think the alternative of focusing first on the external imbalances between China and the US is the wrong way to go about it. Look at what happened to budget deficits during World War II:  at its peak, the US budget deficit as a percentage of GDP went to 30.3 percent in 1943. Yet by the end of the war, US households and the private sector were once again in a position of massive savings surplus.  This is the financial correlative to those huge government deficits on the side of the ledger.

The whole discussion about China and a new reserve currency, then, is a bit of a red herring in the current circumstances.  As economist James Galbraith has noted:

“[A] stable ratio of debt to GDP is not a normal feature of modern history.  Gradual drift in one direction or the other is normal.  There seems no great reason to fear drift in one direction or the other, so long as it is appropriate to the underlying economic conditions. 
 
“History has a second lesson. In a crisis, the ratio of public debt to GDP must rise.  Why?  Because a crisis – and this really is by definition – is a national emergency, and national emergencies demand government action.  That was true of the Great Depression, true of war, and true of the Great Crisis we’re now in.  Moreover, we’ve designed the system to do much of this work automatically. As income falls and unemployment rises, we have an automatic system of progressive taxation and relief, which generates large budget deficits and rising deficits.  Hooray!  This is precisely what puts dollars in the pockets of households and private businesses, and stabilizes the economy.  Then, when the private economy recovers, the same mechanisms go to work in the opposite direction.  
 
For this reason, a sharp rise in the ratio of debt to GDP, reflecting the strong fiscal response to the crisis, was necessary, desirable, and a good thing.  It is not a hidden evil. It is not a secret shame, or even an embarrassment.  It does not need to be reversed in the near or even the medium term.  If and as the private economy recovers, the ratio will begin again to drift down.”

And if the private economy does not recover, we will have much bigger problems to worry about, than whether we ought to have a new reserve currency. 

To quote Galbraith again:

“The only thing the scary foreign creditors can do, if they really do not like the returns available from the US, is sell their dollar assets for some other currency.  This will cause a decline in the dollar, some rise in US inflation, and an improvement in our exports.  (It will also cause shrieks of pain from European exporters, who will urge their central bank to buy the dollars that the foreigners choose to sell.)   The rise in inflation will bring up nominal GDP relative to the debt, and lower the debt-to-GDP ratio.  Thus, the crowding-out scenario Bob sketches will not occur.  

 ”I’m not particularly in favor of this outcome.  But unlike Bob Reischauer’s scenario, this one could possibly occur. If it did, it would lower real living standards across the board.  This is unpleasant, but it would be much fairer than focusing preemptive cuts on the low-income and vulnerable elderly, as those who keep talking about Social Security and Medicare would do.”

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.