Folks are getting concerned about the fiscal trajectory in the U.S., and rightfully so.
The plunge into late-cycle fiscal stimulus is largely unprecedented and the rhetoric from Donald Trump and his surrogates suggests they’re either blissfully unaware of the inherent dangers in procyclical, deficit-funded stimulus this late in an expansion, or else simply don’t care.
The President seems hell-bent on overheating the U.S. economy in the interest of delivering on his campaign promise to usher in an economic renaissance regardless of the long-term consequences. That’s populism at its worst – myopia run wild.
On Thursday, Treasury said the U.S. budget deficit ballooned to $898 billion in the eleven months through August. That means the U.S. is now $94 billion ahead of the CBO’s full-year estimate and in this case, “ahead” is a bad thing. The $898 billion figure compares to $673.7 billion during the same period in FY2017.
The latest read on the U.S. fiscal situation underscored the IMF’s warning that the U.S. is on a path to becoming Italy by 2023.
Analyst after analyst, economist after economist, pundit after pundit has cautioned that the gains from Trump’s stimulus will likely prove ephemeral, while the damage from ballooning the deficit will be lasting.
Ironically, there are rumors that the Trump administration has offered to help Italy finance its own fiscal profligacy by buying BTPs next year. That’s fitting for a number of reasons.
Given the above, it comes as no surprise that Goldman’s latest “Top Of Mind” piece is called “Fiscal Folly.”
As a reminder, these are basically expansive takes on whatever the market topic du jour happens to be. They combine interviews with Goldman’s own employees and also with outside sources in an effort to provide a balanced and comprehensive assessment on whatever seems to be the most important question on market participants’ minds (hence “Top of Mind”).
“The fiscal picture in both Italy and the US looks poised to go from bad to worse— yet the market reactions to each couldn’t be more different”, the bank’s Allison Nathan writes, in the introduction.
The piece includes an interview with Carmen Reinhart (obviously a big name) and as Nathan notes, summarizing, she argues that while “the risk of a US debt crisis is low, there are still reasons to worry, and not only in the distant future.”
Below, find the interview which in addition to sounding the alarm on troubling fiscal dynamics in the U.S., also includes a prediction that Italy’s officially-held public sector debt will have to be restructured.
Allison Nathan: Are markets underestimating the risk from fiscal imbalances in developed markets (DMs) today?
Carmen Reinhart: In many instances, yes. This is evidenced by the persistence of unusually low interest rates, which reflect—among other things—perceptions of risk. What exactly these low rates represent depends on the country. In Japan, low rates likely reflect investors’ views that inflation will remain low for the foreseeable future and policy will remain accommodative. But given the BOJ’s objectives, it’s certainly possible that inflation rises down the road, even if it has disappointed for some time. In the cases of, say, Greece and Italy, where recovery has proven elusive and public debt loads remain high, relatively low interest rates probably reflect the backstop of bailout guarantees. And in the case of the US, low rates seem to assume unending demand for US Treasuries given the US dollar’s role as the global reserve currency. Granted, no currency comes close to the dollar today, and its position as the reserve currency has actually strengthened since the 1980s. That gives the US a bit of rope to take on fiscal risk without threatening a crisis. But whatever the case may be, investors are clearly extrapolating from the low-rate environment that we’ve experienced over the past decade. And that has led to some complacency that higher debt loads can be handled without a problem; so if fiscal imbalances are bigger, so be it.
Allison Nathan: But economists generally agree that in most DMs, there is little reason to expect a debt crisis anytime soon. So without the threat of a crisis, is higher public debt really a concern?
Carmen Reinhart: Yes, because over the longer term high debt levels are associated with lower growth. Look at Japan, which went from having sustained average annual growth of above 4% to very muted growth in the decades following its debt buildup in the 1980s and crisis in the 1990s. But Japan is by no means the only case. Vincent Reinhart, Ken Rogoff and I have illustrated numerous examples since the 1800s of sustained high debt levels—on the order of roughly 90% of GDP or higher for developed economies—being associated with lower growth rates. This is in part because high debt levels constrain governments’ ability to respond to adverse shocks. So even in a country like the US, where I don’t expect a crisis, history suggests there are reasons to be concerned.
Allison Nathan: How close to a crisis are DMs like Italy and Greece?
Carmen Reinhart: For Italy and Greece, it’s not so much a matter of new debt crises but lingering ones that have yet to be resolved. When the Global Financial Crisis (GFC) hit, they were the only two advanced economies with public debt levels that already exceeded 90% of GDP. And of the 11 advanced economies that experienced a systemic crisis during that time, they are the only two countries where per capita income remains below its pre-crisis level. So both countries have continuously grappled with the consequences of exceptionally high debt loads; it’s just the level of concern around them that seems to occasionally flare and then subside. I should mention that Italian and Greek public debt is even higher than the most widely reported figures suggest, because most measures do not take into account Target2 balances, or the balance of the national central bank vis-à-vis the ECB and other national central banks. These are an IOU from the public sector. And in the case of Italy, they add roughly 30% to the commonly cited debt-to-GDP figure of around 130%.
Allison Nathan: Clearly, concern over Italy is flaring right now. How likely is it that Italy defaults?
Carmen Reinhart: Should Italy ever exit the Euro area—a prospect that was raised earlier this year by the incoming government—I don’t think it could avoid default. But even barring this extreme scenario, default is possible. Remember, the credit rating agencies define default as anything that changes the terms of the debt in a manner less favorable to the creditor, including any restructuring of the debt by lengthening maturities, trimming interest rates, and so forth. And restructuring is a real possibility because Italy has limited pathways to debt reduction; it has been unable to achieve sustained growth, and it cannot print its own currency or set its own interest policy. That said, the most likely scenario in my view is a restructuring of Italy’s official debt, i.e., the public debt held by other governments or multilateral organizations, rather than the debt held by the private sector. Of course, much of the EU membership would have little appetite for this course of action. But I think a haircut on that official debt is the first step in dealing with the current situation.
Allison Nathan: How would the market react to this type of haircut?
Carmen Reinhart: I don’t think the market would treat it the same way as it would a restructuring of privately held debt. Historically, the credit rating agencies, and thus investors, have focused on debt held by the private sector. Take the European sovereign debt crisis: in 2011, markets were watching Greece so closely not just because it undertook the largest sovereign debt restructuring in history, but because the debt was privately held. Subsequently, Ireland and Portugal restructured some of their officially held debt, and markets took that in stride. I am not sure how many people are even aware that both Ireland and Portugal went through this process. And going back further in history, few seem to remember that advanced economies have a history of restructuring and outright default on official debt; it just isn’t something that’s been on rating agencies’ radar.
Allison Nathan: Emerging markets (EMs) are taking a large hit from investors right now. You’ve held a relatively pessimistic view of EMs for some time. What underlies this, and how do fiscal dynamics factor in?
Carmen Reinhart: Let me first say that EM is a very broad asset class with a lot of heterogeneity. Nevertheless, I am concerned about EMs as a group. They simply do not have the same internal and external buffers that they once did. After the GFC—and in contrast to the aftermath of the 1930s—EMs showed exceptional resilience. This is because they went into the GFC lean and mean: they had significantly reduced their reliance on external debt, and in many cases had lowered their internal debt. They also had relatively competitive currencies. At the same time, they benefitted from exceptionally favorable external factors in the decade of 2003-2013 including one of the strongest commodity bull markets in the last 200-plus years, sustained double-digit growth in China, and exceptionally low interest rates for much of that period.
Since then, these external factors have either reversed or are in the process of reversing. And those lean and mean EMs have taken on more leverage, whether it is government, corporate, or household debt. In fact, the leverage in EMs is higher today than it has been in a long time, in some instances, since the 1990s. And what I, Ken Rogoff, and Miguel Savastano have found is that it doesn’t take much debt for EMs to end up in a precarious position, largely because external debt is often in foreign currency. So overall, I believe a combination of factors has left EMs vulnerable to crisis and contagion today.
Allison Nathan: But haven’t many EMs shifted toward issuing debt in local currency? Shouldn’t that help?
Carmen Reinhart: That is true for some countries like Thailand and Korea, which have become more reliant on domestic rather than external debt. But in general, the argument that debt is not a problem because it is “domestic” can oversimplify things. One has to be really careful about defining “domestic.” True domestic debt is what we talk about in Japan, i.e., debt that is issued in local currency under domestic law, and is held by domestic residents. On the other hand, the infamous tesobonos that Mexico issued during its 1994 peso crisis were classified as domestic debt despite being dollar-linked and largely held by Wall Street. And today, the line between what market participants consider domestic versus foreign debt seems dangerously blurred. “Domestic” debt can include debt that is issued and held domestically but is denominated in foreign currency; think of corporates or households borrowing from a local bank but doing it in dollars. It can also include debt issued domestically but held by non-residents. Argentina’s Lebac securities are a case in point: They are issued domestically in local currency, but a significant share is held by non-residents. Is that debt domestic or external? When it comes to creating trouble, it hasn’t made much difference.
Finally, I would say more broadly that although the focus has been on the increase in public debt—whether or not it is “domestic”—private debt also deserves careful attention. Remember that private debt often becomes public after a crisis. We’ve seen that movie many times before, in Chile in 1981, in Korea in 1997-1998, and in Ireland, Iceland, and the US more recently. From the standpoint of contingent liability, that’s an important consideration.
Allison Nathan: What can/should countries do to address their indebtedness? How do you rate the policy options?
Carmen Reinhart: The most desirable way to reduce debt is through growth, and countries should take advantage of periods of relatively stronger growth to reduce debt. This of course is the opposite of the current approach in the US. Beyond this, the menu of options is unappealing, both economically and politically. I have found along with Vincent Reinhart and Ken Rogoff that advanced economies have historically reduced moderate debt overhangs through fiscal restraint. Extreme debt overhangs, like those we saw around World War II, have required a more heterodox combination. Financial repression is one policy option, whereby the goal is to keep real interest rates as low as possible, and oftentimes negative, effectively inflicting a tax on bondholders. Financial repression also typically involves higher inflation that erodes domestic-currency debt, as we saw, for example, in Japan at the end of World War II, and to a lesser extent France and Italy. These approaches have been more common in advanced economies than in EMs because the former has historically had a larger share of debt in domestic currency. But, as I mentioned, countries like Greece and Italy today are limited in the use of these tools because of their shared currency, which perhaps increases the need for debt restructuring—the other tool in the toolkit—more so than in the past.