US Economics. Crunch Time. For important disclosures, refer to the Disclosures Section, located at the end of this report.

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1 NORTH AMERICA Crunch Time Morgan Stanley & Co. LLC Recent Reports Vincent Reinhart David Greenlaw Ted Wieseman Dane M Vrabac Dane.Vrabac@morganstanley.com John Abraham John.A.Abraham@morganstanley.com Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates, which in turn make debt burdens more severe. The result will then be higher budget deficits and debt levels, possibly leading to a fiscal crunch a tipping point in which government bond rates shoot up and a funding crisis ensues. Title Date Beyond the Cliff Dec 20, 2012 David Greenlaw US Forecast Update: Still in Holding Pattern Nov 20, 2012 In the U.S., high debt levels could eventually lead to higher interest rates, thereby raising future budget deficits and debt levels well beyond official baseline projections, which in turn could raise interest rates still further. A greatly expanded Fed balance sheet carries some risks. For example, Federal Reserve remittances to the Treasury could evaporate if interest rates rise, exposing the central bank to a political attack. The combination of a massively expanded central bank balance sheet and an unsustainable public debt trajectory is a mix that has the potential to substantially reduce the flexibility of monetary policy. For important disclosures, refer to the Disclosures Section, located at the end of this report.

2 Crunch Time 1 David Greenlaw and John Abraham (New York) An analysis of sovereign debt dynamics reveals that countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates, which in turn make the debt problems more severe. To see this, suppose that a country s current primary surplus is less than that level needed to stabilize the level of debt-to-gdp. The government then has four options: 1) cut spending or increase revenues to increase the primary surplus; 2) do nothing so that the debt-to-gdp ratio grows even larger; 3) use unanticipated inflation to bring the debt-to-gdp ratio back down; or 4) default on the debt. If lenders doubt the feasibility of the first alternative, they will demand a higher interest rate, thereby increasing interest payments on the debt. The result will then be higher budget deficits and debt levels, possibly leading to a fiscal crunch a tipping point in which government bond rates shoot up and a funding crisis ensues. Exhibit 1 shows data for our sample of 20 advanced economies. Based on the mechanics of debt accumulation and economic growth, we calculate the level of the primary government surplus that would be required to stabilize the debt-to-gdp ratio at 2011 levels. These values are shown in the last column. If the so-called necessary surplus is sufficiently far from a country s historical experience and politically plausible levels, the government may well begin to pay a premium to international lenders as compensation for default or inflation risk. We next conducted a statistical analysis of the recent experience of these twenty advanced economies asking what factors in the prior year help predict the average yield on ten-year debt. We find that gross debt is a little more important than net debt, while the current-account deficit also matters. Importantly, as is illustrated in Exhibit 2, we also find that there is an interaction between the impact of the level of debt and the current account, as well as tipping-point nonlinearities in which the higher the debt levels and current account deficits, the greater the rise in interest rates. For example, a 1% increase in 1 This note is based on a report presented at the 2013 U.S. Monetary Policy Forum that was co-authored by David Greenlaw, James Hamilton of the University of California at San Diego, Peter Hooper of Deutsche Bank Securities and Frederic Mishkin of Columbia University. The full report, as well as comments by Boston Fed President Eric Rosengren and Federal Reserve Board Governor Jerome Powell, is available at: netaryforum.aspx debt-to-gdp when the current account deficit is 2.5% and debt-to-gdp is 100% (the current value for the U.S.) is associated with a 6 basis point (0.06 percentage point) increase in the ten-year bond rate. By comparison, when both the current account deficit and debt-to-gdp ratio are at zero, a 1% increase in debt-to-gdp is associated with only a 1 basis point increase in the ten-year rate. Exhibit 1 Key Fiscal Indicators for 20 Advanced Economies year yield (%) 2011 debt/gdp (%) 2011 net debt/gdp (%) current acct/gdp (%) Nominal GDP growth (%) 2011 surplus (%GDP) Necessary surplus (%GDP) Country Australia Austria Belgium Canada Denmark Finland France Germany Greece Ireland Italy Japan Netherlands Norway Portugal Spain Sweden Switzerland U.K U.S Source: Haver Analytics, IMF, authors calculations Exhibit 2 Response of Sovereign Yields to Debt Ratios Under Alternative Current Account Balances 16% 14% 12% 10% 8% 6% 4% (Sovereign Yield, Percent) CA = 0.0% CA = -2.5% CA = -5.0% 2% (Debt to GDP, Percent) 0% Note: CA is current account balance as % of GDP. Horizontal axis: gross debt as a percent of GDP in year t - 1. Vertical axis: amount by which a country s interest rate in year t would be predicted to be higher (measured in annual percentage points) compared to what the interest rate would be if debt in year t - 1 were equal to 0 for indicated levels of the current-account balance. Source: Authors calculations 2

3 Case studies illustrate the problems encountered historically by countries with debt above 80% of GDP and persistent current-account deficits. These countries proved to be vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics. Interest rate surges occur either because there is news that budget deficits and future debt levels are much higher than previously suspected or because a decline in economic growth leads to higher projected debt-to-gdp. The need for time-consistent budget projections makes incorporating such feedback loops difficult, and they are left out of current, official long-term U.S. budget projections (see Exhibit 3). If materialized however, it could be much more difficult for the U.S. to maintain a sustainable budget course. 2 The most recent projection from the Congressional Budget Office assumes that the yield on ten-year Treasury notes rises to a level of 5.2% as the economy recovers, and remains there, as is shown in Exhibit 4. Under current spending and tax policy, the CBO forecast calls for U.S. gross debt/gdp to rise to 107% by 2014 and decline modestly for the next several years before resuming a gradual upward ascent, reaching a level of 150% in twenty-five years (see Exhibit 5). Exhibit 3 CBO Assumptions for Federal Government Revenues and Expenditures Percent of GDP 33% 31% 29% 27% 25% 23% 21% 19% 17% Net Interest Expenditures Revenues 15% Exhibit 4 Ten-Year Bond Yields Under CBO Assumptions and Baseline Simulation Assumes Baseline Economic Conditions 10-Year U.S. Treasury Yield (Percent) 15% 12% 9% 6% 3% Simulation I CBO Projections Actual 0% However, our statistical analysis shows that higher debt levels would likely lead to higher interest rates, thereby raising budget deficits and debt levels, which in turn would raise interest rates further. Simulation I in Exhibits 4 and 5 allows for this feedback effect, resulting in substantially higher interest rates and debt-to-gdp than the CBO projections. However, this simulation uses the same primary deficit baseline and economic projections as the CBO. We rerun the simulation using an alternative economic scenario (specifically, the unemployment rate falls to a long-run level of 6% rather than 5 ¼% as assumed by the CBO) and assume that the looming budget sequester is cancelled. As shown by Simulation II in Exhibits 5 and 6, the result is a rather dire situation with debt-to-gdp rising to 300% in twenty-five years and with 10-year bond yields as high as 25%. These simulations should not be taken as our predictions for what will happen to bond yields and debt levels because we surely would expect modifications in government spending and taxes, but it does illustrate the dangers if nothing is done to put U.S. fiscal policy on a sustainable path. 2 The estimates shown use the latest CBO baseline estimates through 2023, with modest adjustments to account for the treatment of the Doc fix, tax extenders and Hurricane Sandy relief. For years, 2024 through 2037, we rely on the same assumptions used in the CBO s latest Long Term Budget Outlook. 3

4 Exhibit 5 Gross Debt as Percent of GDP Under CBO Projections and Baseline Simulation Assumes Baseline Economic Conditions Gross Debt to GDP (Percent) Exhibit 7 Gross Debt as Percent of GDP Under CBO Projections and Alternative Economic Simulation Assumes Budget Sequester Cancelled and Higher Unemployment Gross Debt to GDP (Percent) 180% Simulation I 350% Simulation II 160% CBO Projections 300% CBO Projections 140% 250% 200% 120% 150% 100% 100% 80% Exhibit 6 Ten-year Bond Yields Under CBO and Alternative Economic Simulation Assumes Budget Sequester Cancelled and Higher Unemployment 10-Year U.S. Treasury Yield (Percent) 25% 20% 15% 10% 5% Simulation II CBO Projections Actual 0% % The preceding analysis raises several issues for the conduct of monetary policy. First, if fiscal policy is shifting in a desirable direction, from an unsustainable path to a sustainable one, easier monetary policy can play an important role in ensuring a successful outcome. Second, given a still polarized political system in the U.S., we also need to consider the implications for monetary policy of a fiscal policy that remains unsustainable. A fiscal crunch not only hurts economic growth because interest rates could rise to unprecedented levels but also because it could make it difficult for the Federal Reserve to control inflation. Unsustainable fiscal policy can force a central bank to pursue inflationary policies, which is known as fiscal dominance. If the central bank does not monetize the government debt, then interest rates will rise sharply, causing the economy to contract. Indeed, without monetization, fiscal dominance may result in the government defaulting on its debt, which would lead to a significant financial disruption, producing an even more severe economic contraction. Hence the central bank will in effect have little choice and will be forced to purchase the government debt by printing money, eventually leading to a surge in inflation. 4

5 Given the Federal Reserve s greatly expanded balance sheet, there is an additional channel through which a fiscal crunch can impinge on monetary policy and exacerbate inflation expectations the heretofore little-noted Fed remittances to the U.S. Treasury. In a fiscal crunch scenario occurring within the next five years, interest rates on the Fed s holdings of government debt would climb to much higher levels, and could lead to substantial losses. Exhibit 8 illustrates the impact these losses could have on the payments to the U.S. Treasury (note that, in practice, once the Fed s income drops below zero, remittances to the Treasury cease and the losses accrue in a deferred asset account). The black baseline takes into account the net interest income that the Fed earns from its balance sheet, as well as realized losses if the Fed sells assets along the lines of the exit strategy principles outlined in the June 2011 FOMC minutes. The black and dashed baseline plus 1% pt higher interest rates beginning in 2016 takes into account the larger losses on asset sales resulting from higher interest rates and suggests that the Fed would be unable to make payments to the Treasury for a number of years. While a broad assessment of the costs and benefits associated with the Fed s policy actions in recent years can certainly be used to justify an eventual downturn in remittances to the Treasury, the central bank could still find itself subject to political attacks. One way to avoid this is illustrated in the grey-dashed no asset sales line, which shows that by putting off asset sales, the Fed would only have a short period of not being able to provide remittances to the U.S. Treasury. It may be no coincidence that, over the course of recent weeks, Fed officials appear to be starting to signal a preference for the no asset sale scenario. Exhibit 8 Federal Reserve Income $Billions Baseline QE through 2014 at Current Pace Baseline plus 1% higher interest rates beg 2016 No Asset Sales Source: FRB, authors calculations In brief, the combination of a massively expanded central bank balance sheet and an unsustainable public debt trajectory is a mix that has the potential to substantially reduce the flexibility of monetary policy. This mix could induce a bias toward slower exit or easier policy, and be seen as the first step toward fiscal dominance. It could thereby cause both longer-term inflation expectations and the risk of overall inflation to rise. 5

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