Deficits, the Dollar and Exit Strategies

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
June 15, 2009

During the past 25 years, the private sector in the United States pushed the limits on debt, and when this experiment in debt-fueled consumption came to its crescendo, it sent shock waves throughout the global economy. Now it appears that the U.S. government is trying to push those same limits.

As you can see in the table below, during the 1950s it took $1.36 of debt to generate $1.00 of gross domestic product. However, that ratio has crept up over time, and in the current decade, it’s thus far taken $5.81 of debt to generate that same $1.00 of GDP. And now it’s apparently the government’s turn to ramp up debt.

Debt Through the Decades
Date Range	Decade Change in Debt ($, billions)	Decade Change in GDP ($, billions)	Ratio of Debt to GDP
12/31/1949-12/31/1959	337.6	248.0	1.36
12/31/1959-12/31/1969	752.1	491.4	1.53
12/31/1969-12/31/1979	2,785.2	1,655.9	1.68
12/31/1979-12/31/1989	8,563.7	2,923.8	2.93
12/31/1989-12/31/1999	12,566.2	3,935.2	3.19
12/31/1999-12/31/2008*	27,186.5	4,680.8	5.81

Source: Ned Davis Research, Inc. *Most recent data availabe.

The Obama administration projects total U.S. debt to increase by $1.8 trillion in 2009 and another $1.4 trillion in 2010, driven by the public sector as the private sector continues to unwind debt. On top of that, the Congressional Budget Office (CBO) projects almost $10 trillion in additional debt from 2010 through 2019. As you can see in the chart below, this reflects a doubling in public sector debt as a percentage of GDP through the next decade. We should be concerned about these estimates for obvious reasons, but also because of the optimism of the underlying numbers upon which they’re based: The CBO assumes a robust economic recovery in 2010 and 2011, with GDP growth of 3.8% and 4.5%, respectively.

If these numbers sound lofty, consider the fact that the CBO’s unemployment rate estimate is 8.8% for 2009 and 9% for next year—yet the current rate is 9.4%, as of the latest employment report. To top it off, these staggering numbers also ignore the massive unfunded liabilities of Social Security and Medicare.

And there’s another problem: The average maturity for all U.S. Treasury securities outstanding is 4.7 years, the lowest in 25 years. In comparison, the average maturity for public debt is 14 years in the United Kingdom, with maturities in most other European nations averaging around 10 years. The United States has to continue to roll over this debt as it comes due, meaning it’s not just the ongoing deficit that has to be financed, but all existing Treasuries as well. This leaves us vulnerable to having to fund debt much more expensively if the yields investors demand continue to climb.

Just as we saw on the private sector side, you can’t run deficits higher than nominal GDP without the system faltering at some point, even if we can bump along for a few years (as Japan did during the 1990s). We also can’t run deficits in perpetuity if other nations are doing the same. We’ve been the global consumption engine for a long time, which has allowed money to be recycled back into our debt. But that tide is heading out.

The market can and often will play a role in disallowing debt spikes by pushing interest rates higher and slowing economic growth in the process. As debt and deficits expand, the Treasury has to borrow even more to finance that debt, which pushes interest rates up. Wider deficits also stir inflation fears, which add to the upward pressure on rates, as investors demand more yield to help offset the higher expected inflation.

We’re presently witnessing this firsthand as bond market "vigilantes" have pushed the 10-year Treasury yield from 2.1% to 3.8% (as of June 12). Debate is currently raging among academics, historians and economists as to whether this spike in yields reflects worries about debt, the dollar and inflation—or whether it reflects an improving economy in which investors are becoming less risk-averse. For what it’s worth, I think it’s a bit of both.

What’s the Fed to do?
Federal Reserve Chairman Ben Bernanke recently warned Congress: “Even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance.” He went on to say: "Unless we demonstrate a strong commitment to fiscal sustainability in the longer run, we will have neither financial stability nor healthy economic growth." Hear, hear.

Deficit concerns are starting to offset the Fed’s efforts to restore economic growth, and there are calls from economists, business leaders and political leaders every day for the Fed to share its "exit strategy." On June 2, German Chancellor Angela Merkel publicly rebuked the Fed and the European Central Bank for their loose monetary policies. Usually when politicians put pressure on central banks, it’s to ease—not tighten—policy!

With the next Fed meeting on tap for June 23–24, there’s potential for additional purchases of Treasuries by the Fed to try to combat the rise in yields. But that may not happen, for several reasons:

The rise in actual borrowing costs has been more modest than the rise in long-term Treasury yields.
The Fed has already noted that the yield rebound at least partly reflects the improvement to financial and economic conditions, which has made investors willing to sell Treasuries and take on a bit more risk within their fixed income or equity allocations.
The Fed is cognizant of the need to sop up excess liquidity when the economic recovery gains traction, and moving aggressively now to push yields lower would make that process more difficult when the time comes.
Finally, if a portion of the yield rebound reflects deficit concerns, the Fed has made it clear it doesn’t intend to “monetize” that deficit by incessantly printing money.

More recently, the yield rebound has moved to the shorter end of the yield curve, and as of this writing, the futures market is starting to price in hikes in the fed funds rate later this year. We beg to differ with the market’s current view.

There’s a lot more unconventional “tightening” the Fed can do by soaking up reserves—some of which were created by the Fed’s loans to banks, commercial paper issuers and others to unfreeze the credit markets. Those liquidity facilities charge borrowers a penalty rate, making the Fed’s loans less attractive as private credit revives. This is now happening, and as such, liquidity facilities are beginning to shrink.

Inflation to the rescue?
Inflation builds partly from fear. Consumers and investors need to believe that the extraordinarily bold monetary and fiscal policies unleashed during this crisis will be reversed. If they don’t believe this, inflation expectations will soar—as will interest rates—and policymakers will be in a real bind.

But would a little inflation be a good thing? Can we simply inflate away the debt by printing money? It would have short-term political benefits, but rising bond yields in the long term are not palatable for either the economy or the dollar. The good news is that, to date, most of the rise in bond yields has been in the real (non-inflation) component; long-term inflation expectations are up much less.

China and the dollar
Not only are investors eager to glean the Fed’s next move, but they’re also sweating over China’s role as a financier of our debt and the impact on the dollar should China diversify away from dollar-denominated securities. According to Treasury Secretary Timothy Geithner, there is a “very sophisticated understanding” in China about why the United States needs to run large budget deficits in the short term.

However, this is the same man who heard laughter among University of Peking students when he said that "Chinese financial assets are very safe." It harkens back to earlier this year, when Chinese Premier Wen and People’s Bank of China Governor Zhou questioned U.S. creditworthiness and the dollar’s reserve currency status.

Quite simply, though, we don’t believe China would risk torpedoing its own economy by a massive dumping of our Treasuries. Indeed, China is increasing its natural resource and gold purchases (pushing up commodity prices), calling for an expanded role for the International Monetary Fund’s Special Drawing Rights, and trading more in non-dollar currencies. But there’s still no viable alternative to the dollar in sufficient quantities for China’s reserves (the Financial Times has called it China’s "dollar trap").

The dollar’s not going anywhere ...
... and China knows it, too. "In the short term I don’t think we can find another currency to replace the U.S. dollar," said Guo Shuqing, chairman of China Construction Bank and former head of China’s foreign exchange administrator. "The U.S. dollar is the main currency because their economy is number one in terms of competitiveness, in terms of innovation." Although the financial crisis may be accelerating the balance of power shift toward China, this change will likely remain gradual.

Oh, and China is still buying. China increased its Treasury holdings by $272 billion in the second half of 2008 and continued to buy U.S. Treasuries throughout the first quarter (although more recently at the short end of the yield curve). The last month China was a net seller was February 2008. And it’s not just China. Foreign central banks (FCBs) continue to buy U.S. Treasuries and are absorbing some of the increased supply. In fact, FCBs have purchased more Treasuries ($215 billion this year through May) than the Fed.

This supports the view that U.S. debt is unlikely to get downgraded anytime soon, a worry that developed after Standard & Poor’s revised its outlook on the United Kingdom’s sovereign debt rating from "stable" to "negative." The dollar remains the world’s reserve currency, accounting for 64% of global foreign exchange reserves (versus the euro’s 26%). Also, imagine any private company maintaining an AAA rating when the dominant global reserve country has a lower rating? It’s simply not practical.

What about China’s yuan? Asks our former Schwab colleague Sheldon Engler in his Global Risk Monitor: "Can a non-convertible currency in a country where an authoritarian government fixes interest rates and where capital markets are infantile really be considered a serious contender to the dollar?" Good question.

The fix ... it’s the economy, stupid
Most reasonable folks will concede that in the longer term, we won’t get ourselves out of our debt crisis through spending and taxation. The only way to solve the problem is to grow GDP faster than debt and to adopt vigorous fiscal discipline. So, will aggressive monetary and fiscal policy be sufficient to restore economic growth and the vitality of the financial sector?

Let me play "angel’s advocate" to the consensus bearish view: There is a non-calamitous way out of our present mess. Let’s start with the premise that we’re not the first country to get into a financial pickle and run up large deficits in order to bail itself out. In fact, many countries have run disturbingly high debt-to-GDP ratios but have seen them come back down over time and without calamity.

We even have our own example: The U.S. total debt-to-GDP ratio was 125% after World War II, but had come down to 25% by 1980. Another example would be Japan, which has maintained a high ratio of 150%–180% for the past decade (not that I’m suggesting theirs is a model for us to follow).

The only way to manage our debt is to concentrate on both components of the equation—keep spending in check and maximize economic growth, which in turn reduces the debt ratio by increasing tax revenues. In other words, rising economic growth helps both numerator (debt) and denominator (GDP). We also believe that the private sector’s deleveraging is a longer-term story, meaning savers’ demand for Treasuries will remain high.

Don’t stifle trade or innovation
In Characteristics of Economic Recovery, I wrote about what we thought the economic recovery’s characteristics would be, with an emphasis on emerging economies’ demand and on global trade. On this note, politicians and businesses must continue to resist the temptation to become overly protectionist, given that the United States shepherds other countries’ savings. We need "them" and "they" need us—healthy trade between nations not only brings economic prosperity, but discourages war and strife.

We also need to encourage and incentivize innovation. One sign of hope is the burgeoning war chests that have been re-amassed by private equity and venture capital funds—assuming innovation doesn’t get stifled. Let’s never forget the transition from “rust bowl” despair in the late 1970s to the stunning period of innovation in the late 1990s—innovations spurred by venture capital and private equity investments.

Even on my most pessimistic days during the past two years, I refused to abandon faith in the spirit of innovation that this country has always mastered. And I believe we can pull through again.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. Any investments and strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All views and expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past performance is no guarantee of future results, and the opinions presented cannot be viewed as an indicator of future performance.

Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

(0609-9396)

Return to Top

November Market Snapshot
With Liz Ann Sonders

What's around the corner?

Watch now

Want Liz Ann Sonders e-mail updates?

Clients can sign up for the Market Insight Alert