THE BLOG
01/02/2013 11:18 am ET Updated Mar 04, 2013

The Fiscal White Elephant Is in Danger of Outgrowing the Room

Whilst the last two years of political wrangling has culminated in a deal that generally placates both sides of the isle -- it is hardly a eureka moment. The so-called fiscal cliff is a label that has been applied to a convergence of maturing economic austerity measures that would have generated around $500 billion a year in taxes across the board, and initiated $110 billion a year in automatic spending cuts, split equally between defense and non-defense spending (including Medicare providers and insurance plans, as well as other large programs such as support for farm prices). The draconian measures were never meant to be an intelligent application of policy to address the country's financial matters but more a catalyst that forced Congress to take constructive and meaningful legislative action in tackling America's spiraling debt predicament -- the entire saga has been about as effective as an ash tray on a motorbike.

Twenty-four months of fiscal prevarication delivered an agreement last night that will generate about $620 billion a year in taxes without completely zapping the consumer spending power of America's middle class, as well as saving around $15 billion a year in targeted government spending cuts. In essence, a similar amount of money has been found but from a different source, that doesn't plunge the U.S. economy back into recession, send unemployment soaring or render America unable to fight her next aggressor. Such glimpses of progress will facilitate growth at a time of global economic fragility; support foreign policy in a period of instability in the Middle East; and allows America to still enjoy a bowl of cereal in the morning without requiring a mortgage for the milk. The reality, however, is that progress is a fallacy if Congress doesn't confront head-on, the rather large white elephant in the room, otherwise known as the U.S.'s spiraling debt problem.

Last week the Treasury Secretary, Tim Geithner, made it clear that under extant tax breaks, interest payments and government spending, the U.S. will "hit its statutory debt ceiling" by Dec. 31, 2012, and that to avoid a default "extraordinary measures" will have to be taken -- extraordinary measures are now being taken and they deliver monetary headroom until February 2012. Sound familiar? On May 16, 2011, the U.S. reached the "legal borrowing limit" of $14.3 trillion and for almost three months had to take the very same "extraordinary measures" to prevent the U.S. from a default due to political impasse in Washington.

The conclusion of last summer's debacle culminated in a raise of the debt ceiling from $14.3 trillion to $16.4 trillion, predicated on the implementation of a Budget Control Act. Only the repayment of $917 billion over 10 years could be agreed in August 2011, so the BCA formed and tasked a Joint Committee on Deficit Reduction to find an additional $1.2 trillion by Thanksgiving of the same year. Global markets, as expected, reacted negatively to the political gridlock in Washington, the S&P 500 index fell 10.8 percent in 10 straight trading days, and Standard and Poor's, the U.S. ratings agency, stripped the U.S. of its coveted AAA rating for the first time in America's history. Ignoring market turmoil, in November 2011, the Joint Committee's co-chairs announced that they could not reach an agreement on repaying the rest of the additional overdraft. Given that market confidence can move quicker than fiscal policy can react, the absence of a November agreement was akin to playing a game of political Russian roulette -- at some point the gun is highly likely to go bang.

Failing to learn from the impact of last year's political congestion on global markets, implementing embarrassingly inadequate legislation that is unfit for purpose, and presiding over an unsustainable fiscal policy that allows America to continually spend more than it earns, should be an offense punishable by public humiliation using stocks and pillory. Since 2008, the U.S. has spent around $6.4 trillion more than it has earned -- or a yearly overspend of $1.6 trillion. The current proposal by Congress generates $635 billion a year and according to the CBO will add yet another $4 trillion to federal deficits over a decade. Stymieing the spiraling overdraft problem has to involve greater commitments by lawmakers to cuts and increases in revenue -- significantly more than what is currently being proposed. The cost of servicing the debt, however, is driven by an entirely different set of forces.

Post the U.S.'s downgrade last year, and trending in the opposite direction to many economists predictions, U.S. 10-year treasury yields decreased from 3.5 percent to its current rate of 1.75 percent, hitting a historical low of 1.44 percent on June 1, 2012. Paradoxically, investor and market confidence in the U.S. appears to have strengthened pushing America's interest payments to an all time low -- yet it continues to overspend to the tune of $1.6 trillion a year. Some economists warn that the effects of the downgrade have been masked by flight of capital out of Europe, a global slowdown and the Fed's Operation Twist program that replaces short-term debt with long-term securities; the dollar as the world's reserve currency is benefiting from international economic instability. If, however, as IMF baseline projections assume in 2013, financial conditions in the euro area periphery (Greece and Spain) gradually ease, and, steps by some major emerging markets to stimulate growth gain traction, many foreign investors could look back east for opportunities, reducing demand for U.S. treasuries and rendering U.S. debt far more expensive to service. The U.S.'s interest bill in 2012 was around $360 billion, $100 billion less than in 2011.

Another key factor in helping to keep interest rates suppressed is the demand created by America's own Federal Reserve through monetary easing policy. As the U.S. economy improves and demand for monetary easing subsides, downward pressure on yields can be expected to lessen. Combined with an increase in long-term inflation expectations that will place upward pressure on interest rates -- America would be wise to take advantage of current ultra-low rates -- not to take on more debt -- but to start paying it off.

As yields demonstrated after the U.S.'s downgrade -- market confidence can be unpredictable -- as can the trigger mechanisms. Hitherto, the consequences have fortunately resulted in a favorable outcome for America; Italy, Spain, Greece and Ireland have not been so lucky. In November 2011, turmoil in Greece's political system caused Italian yields to spike to 6.4 percent. Fiscal space, a concept introduced by the IMF, measures the difference between a nation's sovereign debt-to-GDP ratio, and the limit beyond which a nation will default unless extraordinary fiscal steps are taken. A so-called "survival interest rate" can be calculated, with a view that a nation's debt load will spiral out of control if the cost of servicing its debt increases more quickly than GDP -- in December 2011, Italy's survival interest rate was calculated at 4.3 percent and the U.S.'s 8.7 percent. The eurozone is clearly a very different fiscal entity to the U.S. but vulnerability to volatile market and investor confidence still applies.

The squandering of this latest opportunity for Congress to confront the bulging deficit-ridden white elephant, that sits in the room at over 101 percent debt to GDP, is the third in 18 months. Confidence in the U.S. political system to resolve its formidable debt burden will be waning. Given the essential requirement to maintain growth, Congress will have no other option but to authorize yet another increase in the debt ceiling this coming February -- just eight weeks away. Lawmakers in Washington would be wise not to push the boundaries of patience with world markets, ratings agencies and investors -- defaulting is not an option and should not be considered as one. Similarly, taking bold steps to reduce its debt burden should come a close second. The economic landscape is subtly different from 18 months ago and is now trending in a direction that could drive up U.S. debt costs -- both from a lack of foreign investor demand but also internally as the Fed reduces monetary easing. There are many that won't entertain the U.S. being vulnerable to a mass sell-off in U.S. treasuries but then I doubt that four years ago, Berlusconi, Papandreou, Socrates, Cowen and Kiviniemi would have signed up to that notion either.

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