Research US The outlook for US government debt

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1 Investment Research General Market Conditions 3 September Research US The outlook for US government debt US net debt has risen fast during the recent recession, to more than from 36% in 7. Compared with other OECD countries however, this level is not alarming. Rather, it is the outlook for US debt over the next decade and beyond that is worrying. Under the President s current budget proposal the budget will be in continuing deficit throughout the next decade. This will push net debt to by. Additional fiscal tightening is thus needed to stabilise debt. The scope for additional fiscal tightening is limited in the short term and largest beyond. A broadly growth-neutral fiscal policy from onwards would be enough to bring net debt to by. Fiscal sustainability not mission impossible US publicly held debt has been rising at a rapid pace since the onset of the financial crisis and is heading above in. This is not in and of itself a problematic level and is relatively modest compared with other major OECD countries. This also means that the burden from net interest payments on government debt is currently relatively low. What is worrying is the path for US debt over the decades to come. Fortunately although there are definitely challenges ahead to ensure fiscal sustainability in the US the task is not impossible. That said it will take significantly more fiscal restraint than is embedded in the current budget to stabilise the debt level even at a high share of GDP over the next ten years. Projections for US gross and net debt under the President s budget 3 CBO debt projections based on the President's budget Gross debt Debt held by the public Senior Analyst Signe Roed-Frederiksen + 89 sroe@danskebank.dk

2 Under the current budget proposal (The President s Budget), the Congressional Budget Office (CBO) estimates that debt held by the public will rise steadily toward over the coming years and gross debt to. The reason is straightforward a continued budget deficit throughout the next years and rising interest rate costs. Net government debt, end 9 Net interest payments, end 9 Net debt as Net interest payments Greece Ireland Germany Spain Portugal France Japan Italy US Source: OECD Source: OECD In this paper we assess how much extra fiscal tightening would be needed to stabilise debt. Furthermore, we examine the sensitivity of debt and the budget deficit, to GDP growth and the level of interest rates. Interaction between GDP growth, interest rates and deficits Given the recent intensified worries about the US economic outlook, we believe it is worth examining the sensitivity of US debt and fiscal sustainability under different growth assumptions. Furthermore, a confidence crisis like the one hitting the PIIGS countries in the Euro area could be a risk. We have therefore examined how a spike in interest rates would affect debt-to-gdp and the budget. The Office of Management and Budget (OMB) provides a set of rules of thumb which we use to assess the impact on the budget of different GDP growth paths. The rules of thumb are based on a fixed budget policy, assuming that even though economic conditions change, the fiscal policy will stay the same. OMB rules of thumb of budget impact of lower GDP growth and higher interest rates Effects on budget deficit of percent lower real GDP growth, for calendar year only, with real GDP recovery in -, USD bn percentage point higher interest rate, sustained during -, USD bn Source: US Office of Management and Budget It is assumed that the unemployment rate will be. percentage point higher for each one percent shortfall in the level of real GDP, compared with the baseline, but other economic variables are held constant. Lower GDP growth will affect the budget and debt mainly through a reduction in taxable income growth, but also through increased spending as unemployment rises. Furthermore, growing interest costs associated with larger budget deficits will add to the negative budget effects. Gross debt is defined as total outstanding amount of federal debt. Debt held by the public is defined as debt held by investors outside of the Federal Government, both domestic and foreign, including US State and local governments and foreign governments. It also includes Federal debt. 3 September

3 We also use OMB s rules of thumb to assess the impact of a change in funding costs to the US budget deficit. According to the OMB, a sustained increase in interest rates of percentage point would raise the deficit by USDbn in years. The rise in interest payments is larger than this net figure, but the increase in revenues from government accounts holding of securities offset almost USDbn of the outlays. We have calculated the increase in net debt-to-gdp both with and without this offsetting factor (see section on confidence crisis below). The main results are presented in the table below, while the following sections go into more detail with the different scenarios. Budget surplus and debt under different scenarios Real GDP growth % y/y Funding rate % Budget surplus in % of GDP Net debt in % of GDP Gross debt in 3 CBO's estimate Recession scenario Slump scenario Confidence crisis CBO's estimate Recession scenario Slump scenario Confidence crisis CBO's estimate of Presidents budget Recession scenario Slump scenario Confidence crisis CBO's estimate of Presidents budget Recession scenario Slump scenario Confidence crisis CBO's estimate of Presidents budget Recession scenario Slump scenario Confidence crisis Source: CBO, OMB and Danske markets Risks from deterioration in the economic outlook In our first scenario, the US economy falls back into recession but recovers in the following years and returns to the baseline GDP growth rate. In this scenario, the main effect on the budget will be felt in the first couple of years. GDP growth in the baseline, recession and slump scenario 6 % y/y Real GDP projections % y/y CBO baseline 3 Slump scenario Recession scenario Developments in the primary budget and net interest payments in a recession scenario, 3,,, Net interest payments CBO Primary budget Recession September

4 Interest rate costs will increase but not dramatically and by net debt to GDP will be only marginally higher at 9% compared with CBO s estimate of % under its baseline growth assumptions. This only holds, of course, as long as the government does not implement new fiscal stimulus measures to counter the recession. A more severe deterioration in the US fiscal situation would occur in a long-term slump scenario in which economic growth gets stuck below or close to trend for the next three years before recovering to above trend. This will increase both the primary deficit and interest payments considerably compared with the CBO s baseline economic assumptions. By US net debt to GDP will have reached 97% with a primary budget deficit of 3. and gross debt at. US gross debt in baseline, recession and slump scenario 3 Slump scenario CBO projection Recession scenario 9 3 A long term slump would increase both the budget deficit and interest payments, 3,,, Net interest payments Prolonged slump CBO Primary budget 8 6 8, 3,,, This is without taking into account that in the latter scenario doubt about the fiscal sustainability in the US could increase and cause interest rates to rise above the assumed moderate path. Below we take a closer look at the risks to fiscal sustainability from an increase in funding costs. Risks from a drop in investor confidence So far the demand for US treasuries has been large despite the increase in the US budget deficit and deteriorating debt outlook as treasuries are benefitting from their safe haven status. Nevertheless, a turn in investor confidence could send treasury yields and thereby funding costs markedly higher. CBO assumes that funding rates will gradually increase over the next years to reach % in. If interest rates are pp higher than the CBO s assumptions this would take debt held by the public to 9 compared with %. In a confidence crisis the rise in interest rates are likely to be more significant though. We simulate a shock to interest rates that sends funding rates to a peak of 8.% over the next three years after which they stabilise just below 8%. Using the OMB rules of thumb, this would send debt-to-gdp to 9% by compared with % in the baseline scenario. This seems like a modest increase and reflects the relatively low starting point for net debt. If we adjust for the increase in revenue from the government account s security holdings we get an increase in debt to 9. If we look at gross debt instead of net debt the increase in debt-to-gdp is more significant to 6 in compared to the baseline estimate of %. Alternative paths for interest rates 9 % Funding rate, % 8 confidence loss Funding rate 7 6 -year treasury yield 3 Funding rate, 3 CBO 9 -year yield, CBO September

5 Net debt path following a loss in investor confidence Gross debt projections under different interest rates US debt held by the public Scenario excl interest revenue CBO projections of the President's budget Scenario incl interest revenue High interest rate scenario CBO projection What s needed to ensure fiscal sustainability? Despite the already significant short-term fiscal tightening imbedded in the President s current budget, there is a continuous deficit on the primary budget over the coming ten years, which is likely to push debt-to-gdp constantly higher. If the administration should want to stabilise gross debt-to-gdp at its current level in, it would take an additional tightening of the primary budget of.7pp each year over the next five years starting in. The fiscal tightening under the current budget proposal entails a drag on GDP growth of on average.-pp each year in, and 3. Assume that half of the additional tightening is done through tax increases and the other half via reductions in government spending. Using the standard multipliers from the OECD s interlink model this would imply an additional drag on GDP growth of on average.pp each year for the five-year period. The net result would be a drag on GDP growth of around -.pp a year in the coming three years. Effect on GDP growth from fiscal tightening Gross and net debt scenarios,,, %-point, q/q Effect on GDP growth from discretionary fiscal tightening %-point, q/q,,, Gross debt at % in -, -, -, -, -, -,, The President's budget Debt back to current share of GDP in Gross debt at in 3 -, -, -, -,, 3 CBO gross debt CBO debt held by the public Net debt back to current share of GDP in Source: OMB, CBO, OECD, Danske Markets Source: OMB, CBO, Danske Markets Alternatively if the US government had to comply with the debt limit in the stability and growth pact of the EMU, gross debt had to comply with a ceiling of. Assuming that this target had to be met in, the budget deficit had to be reduced by 3 September

6 .pp a year over the next five years. The drag on GDP growth would then average.- 3pp each year from to 3. Given the fragility of the current economic recovery, the scope for more fiscal tightening than embedded in the current budget proposal is probably limited in the short term. The room for austerity measures is, however, larger beyond when fiscal policy turns net positive for growth under the current budget proposal. This might seem odd since the primary budget deficit is basically constant from 3 to. The reason is that what matters for growth is the cyclically adjusted primary deficit as this captures discretionary outlays not driven by cyclical factors. According to the OMB s estimates, the cyclically adjusted primary deficit decreases until but from thereon starts to increase again. If we assume that the primary budget deficit develops as scheduled in the President s budget until 3, to get net debt back to the current level of in the primary budget should be tightened by an additional.9pp of GDP each year from to. Adding this to the positive growth impact embedded in the current budget proposal, it implies only a marginal net drag on GDP growth of.pp a year on average from until. Hence, if the administration could credibly promise to implement a broadly growth-neutral fiscal policy from onwards, this would be the preferred way to ensure fiscal sustainability. The long-term outlook could the US default on its debt? As explained above, the fiscal situation in the US over the next decade is not as worrying as one might have feared. As we see it, the greater risk to the outlook lies beyond. As highlighted in the CBO s long-term budget outlook, there is a need for structural reforms to avoid a surge in longer-term debt to GDP. According to the CBO, under a set of assumptions that tries to replicate the recent years trend in US fiscal policy, US net debt will enter an exponentially increasing path from and beyond. Under these assumptions, net debt to GDP will reach 8% in 3 an unsustainably high level. CBO s estimate of US debt held by the public in the long-term under a set of assumptions Cyclically adjusted primary deficit Structural budget deficit Source: OMB Based on the President's budget until, after on a set of alternative assumptions Debt held by the public 3 Source: CBO, Ecowin and Danske Markets Medicare s payments to physicians are allowed to increase and that policymakers will not allow various restraints on growth of Medicare costs and health insurance subsidies to have their full effect in the decade after. Further, federal spending on other than the interest payments and major mandatory programmes will maintain the same size in percentage of GDP as in recent years. On the revenue side it is assumed that the Bush tax cuts of & 3 are extended and that the AMT is indexed with inflation. Beyond it is assumed that revenues will stay at a level just above 9, which is about a percentage point above the average of the past years. 6 3 September

7 The main culprits are the rising costs to Medicare and Medicaid. CBO estimates that healthcare costs will increase from. in to.9 in 3. Both aging of the population and the rapid growth of per capita healthcare costs are responsible for the rise in federal spending. Furthermore, the rapid rise in the debt level implies that interest spending will grow rapidly from 3.8 in to 8.7 in 3. In fact, the CBO s projections likely understate the severity of the long-term budget problem as they do not incorporate the significant negative effects that accumulating substantial amounts of additional federal debt would have on the economy. A high level of government debt would tend to crowd out private investment in productive capital as a larger share of private savings will flow into government securities. Another downside is that high and growing debt reduces lawmakers ability to respond to economic downturns and other challenges as there is limited room to manoeuvre for fiscal policy. Over time, higher debt would also increase the probability that investors would lose confidence in the government s ability to manage its budget and require a higher premium to fund the government deficit. A natural question is then whether the US could default on its debt if nothing is done to control the long-term path for debt. We believe that if debt should spiral out of control, which is not our main scenario, the risk of rising inflation and depreciation of the US dollar is more likely than a US default or debt restructuring. All US debt is denominated is US dollars, meaning that the Federal Reserve would be able to print money to finance the budget deficit. This is one major difference between the PIIGS of Europe and the US. 7 3 September

8 Disclosure This research report has been prepared by Danske Research, which is part of Danske Markets, a division of Danske Bank. Danske Bank is under supervision by the Danish Financial Supervisory Authority. The author of this report is Signe Roed-Frederiksen, Senior Analyst. Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high quality research based on research objectivity and independence. These procedures are documented in the Danske Bank Research Policy. Employees within the Danske Bank Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and to the Compliance Officer. Danske Bank Research departments are organised independently from and do not report to other Danske Bank business areas. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Danske Bank research reports are prepared in accordance with the Danish Society of Investment Professionals Ethical rules and the Recommendations of the Danish Securities Dealers Association. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors upon request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. First date of publication Please see the front page of this research report for the first date of publication. Price-related data is calculated using the closing price from the day before publication. Disclaimer This publication has been prepared by Danske Markets for information purposes only. It has been prepared independently, solely from publicly available information and does not take into account the views of Danske Bank s internal credit department. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. The Equity and Corporate Bonds analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for retail customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S. Danske Bank A/S is authorized by the Danish Financial Supervisory Authority and is subject to provisions of relevant regulators in all other jurisdictions where Danske Bank A/S conducts operations. Moreover Danske Bank A/S is subject to limited regulation by the Financial Services Authority (UK). Details on the extent of our regulation by the Financial Services Authority are available from us on request. Copyright (C) Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission. 8 3 September