Archives for posts with tag: sovereign debt rating

After months of mental stagnation I’ve decided to return to the world of blogging with an extra spergy post on the economic policies being considered on both sides of the Atlantic. Before I expand on this subject I want to send a special thanks to economist bloggers Paul Krugman, Brad DeLong, and Matthew Yglesias for inspiring me. I absolutely don’t belong in the same category as them but I feel so much better informed by their blogs. For anyone looking to learn a little bit more about economics or economic theory I highly recommend following these blogs. For additional perspectives from economists you should also consider the blogs referenced in this compelling economist article.

The topic for this post will be the economic policies that are currently being considered in both the European Union and the United States. Before I go further I want to define two terms that I will be using a lot in this post:

Austerity: “In economics, austerity is a policy of deficit-cutting, lower spending, and a reduction in the amount of benefits and public services provided.[1] Austerity policies are often used by governments to reduce their deficit spending[2] while sometimes coupled with increases in taxes to pay back creditors to reduce debt.[3]” (from wikipedia)

Expansionism: “some have linked the term to promoting economic growth (in contrast to no growth / sustainable policies).” (also from wikipedia)

While some time has passed since the debt ceiling standoff and subsequent downgrade by Standard and Poor rocked US markets, the debate remains central to US economic policy. In recent Republican debates austerity has been almost universally endorsed. Governor Rick Perry went  so far as to propose eliminating three government agencies, though which three is still up for debate. This stance on austerity has also been endorsed by Republicans in Congress, with multiple proposals to reduce government spending in the short and medium term.

Across the Atlantic, similar proposals have not only been proposed but have been implemented in several countries that were affected by the Eurozone debt crisis. Germany’s Angela Merkel has been one of the most ardent proponents in the Eurozone for an austerity-centered response to debt crisis. The economist states:

Italy and Greece, under new technocratic governments, may now be more serious about living within their means and reforming their faults. France, which has run budget deficits since 1974, is adopting austerity. Spain has introduced a constitutional debt brake.”

In both Europe and the United States austerity has been proposed as a solution to the risk of bond market action on sovereign bonds. I think it is critical to understand a few key elements of what this “bond market action” implies here. When governments seek to borrow money, they auction sovereign bonds denominated in the currency used by those respective governments. Governments then have to pay back those bonds with interest. This interest is called the “yield” and has an inverse relationship to demand for those bonds. So if a bond is in high demand, the yield will be low, while a bond with low demand will have a higher yield.

Ratings agencies, which represent the interests of bond-buyers will give ratings on sovereign bonds based on how likely they think they will be repaid. Even though a nation’s sovereign debt rating can be related to its yield, the two don’t always correlate to one another.  When the United States lost its AAA rating from Standard and Poor (the other two major ratings agencies kept the AAA for the US) stock markets lost record volume but demand for US sovereign debt actually went up. As I write this the yield on US 10-year bonds stands at 1.89%, while it stood at 3.01% on July 20th, 2011.

While 2% is considered serviceable, higher yields can cripple a country by forcing it stop borrowing altogether. Greek 10-year bonds have yields more than ten times higher than their US or German equivalent:

At present, Greece would have to pay 34% interest on a ten year loan. This has effectively locked Greece out of selling its debt. It would seem natural then, that the countries that are now bailing out Greece would insist that Greece cut government spending sharply and try to raise more taxes to cut its deficit. After all, if Greece were able to finance its spending without having to borrow money, yields wouldn’t matter, at least in the immediate term. Germany, the biggest Eurozone economy, has led the push for austerity in Greece and other Euro countries with dangerously high yields (Italy, Spain, Portugal, Ireland have all faced high yields).

There is a danger to this logic though, that comes with the effects of austerity. In return for the first bailout, Greece agreed to sharply reduce public spending, including cuts in pensions and wages for public sector workers, yet it still fails to meet deficit targets set by the EU. Germany is now proposing that the EU take direct control over Greece’s government spending, something deeply unpopular in Greece (source). The problem that comes from this arrangement is that austerity has not let to growth in Greece’s economy. In fact, since the first bailout in April 2010, Greece has seen its economy contract sharply:

This is as troubling as this looks, it easily could have been predicted. When you lower spending like Greece has done, you are in effect giving public sector workers/pensioners less money to spend, lowering demand. This weakens economic output across all sectors of the economy, as private businesses adjust to lowered demand by laying off workers and producing less. This does more than just damage the livelihoods of Greek citizens, it actually exacerbates the government’s finances. As Greece’s tax base becomes less wealthy, the government must either raise taxes further (which certainly does not stimulate growth) or continue to run a budgetary deficit just to maintain the status quo.

Greece is not alone in its struggle to grow as the effects of austerity bite, other Euro countries that have recently implemented austerity have seen growth slow:

This graph measures annual GDP growth in the Q3 2011, and with the exception of Slovenia, all of the worst performers had to implement some form of austerity in response to high yields/EU intervention.

It is not just the opinion of amateur bloggers (like me) or angry protesters in Greece that austerity alone cannot ensure debt repayment. Standard and Poor recently downgraded 9 Eurozone countries, and in its FAQ explaining the downgrades stated:

… As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.”

The German response to the downgrade borders on intransigence:

German chancellor Angela Merkel has called on eurozone governments speedily to implement tough new fiscal rules after Standard & Poor’s downgraded the credit ratings of France and Austria and seven other second-tier sovereigns.”

This is especially swaying because ratings agencies like S&P have no vested interest in placating debtor states, but instead act on behalf of creditors. Fears over German stubbornness over austerity has led to a recent outpouring of criticism from the world’s economic leaders. IMF head Christine Lagarde, US Treasury Secretary Tim Geithner, and Financier George Soros all warned of dangers of austerity at the recent World Economic Forum at Davos. At a separate summit, Nobel prize-winning economist Joseph Stiglitz warned that Germany was pushing Europe towards a suicide pact, saying:

It is like blood-letting, where you took blood out of a patient because the theory was that there were bad humours. and very often, when you took the blood out, the patient got sicker. The response then was more blood-letting until the patient very nearly died. What is happening in Europe is a mutual suicide pact

It’s worth noting that Stiglitz had similarly critical things to say about US austerity, pointing out that the US has shed 700,000 public sector jobs over four years. While European austerity has been rightly criticized for its futility, it must be pointed out that Eurozone countries have faced something that the US has not, high yields. One of the most baffling aspects of the aspects of the recent push for austerity across the Atlantic is that, while the US has lost its AAA rating by S&P, its yields have stayed historically low. While it makes little sense for Greece to endure agonizing economic contraction from austerity, it makes considerably less sense for the United States to follow that path. While borrowing costs for the US government are historically low, unemployment remains stubbornly high.

It should be both shocking and perplexing that in spite of this Republicans in Congress have held up virtually every piece of expansionary legislation recently proposed. Republicans have been so opposed to promoting growth through legislation that they nearly blocked a tax cut designed to boost growth from being renewed until they came under intense political pressure and relented.

On both sides of the Atlantic there has been a drive for austerity that has hitherto done little to calm the markets OR promote growth. And while countries with high yields have faced inevitable pressure to reduce deficits, the real tragedy stems from the lack of leadership from countries with the room for maneuver to lead and coordinate expansionary policies. The political systems in Germany and the United States have both been alarmingly inflexible and wrong-footed in their respective approaches to promoting economic growth and stemming the threat of double dip recession.

I hate writing an ideological blog post for many reasons. Foremost I believe that research and information is easily dismissed when it is attached to an ideology. Secondly, I think it’s possible to learn a great deal about the world without resorting to an ideological framework, so why not avoid it? This blog forgoes some of this belief in the hopes of raising some clarity on one of the biggest issues in US politics right now: US public debt.

Partially born from the Tea Party movement, but also from earlier advocates of debt reduction, there is now wide concern over the dangers of our public debt. There’s even this website that shows US debt figures by the second and subsequently crashes your browser. There is legitimate cause for concern, as the Eurozone has witnessed astonishing upheaval over some of its members’ sovereign debt. The US borrows a lot of money, with its current gross debt at around $14 trillion. But while groups have painted the US debt as a leviathan that presents an existential threat, I feel this is hyperbole.  Yes, the US borrows a staggering amount of debt to finance its government, but it also produces an enormous amount of money. The US has a GDP of about $14.6 trillion; it’s easily the largest economy in either Purchasing  Power Parity or Nominal enumerations, making its debt more serviceable than Greece’s because it owes a smaller amount of money than it produces annually. When comparing gross public debt to GDP instead of gross debt in absolute terms, the US debt looks considerably less out of control:

This graph was taken from Google Public Data Explorer, and can be accessed here. The data comes from the IMF, and shows US debt ballooning in recent years, though its still considerably lower than Greece’s debt or Japan in particular. This doesn’t mean the US would be fine was its debt to reach Japanese levels. But it begs the question: why are we so concerned about government spending if we could simply outgrow our debt?

Critics of the debt policy we currently have argue that the government has become massive and spends enormous amounts of money inefficiently. We do spend trillions of dollars on our government, but again we produce trillions more in income every year.

Again this graph is from Google Public Data Explorer and can be found here. I used data from 2001 onwards because the US didn’t have figures for government spending before then. We see from this graph that our government actually spends some of the least compared with other developed countries. Only Australia spends less as a percentage of GDP compared to the US. France spends over 54% of its GDP on government compared with the US’s 41%. The US falls well below the Eurozone average of 49%. So in perspective, our government isn’t a leviathan unless you only look at spending in absolute terms.

Why did we get here? It has been argued that Obama ushered in a new era of government spending. Spending as a percent of GDP did in fact grow in 2009, though it should be noted that TARP and the early Stimulus package contributed largely to these figures. Also important to note is that while these two bills consumed trillions of dollars in bailouts and stimulus monies, they were both passed while the US was in a recession. This means that the US economy was shrinking while these spending increases were taking place. US economic growth has been feeble in recent times, and because of this US receipts from taxes and other sources have been lower than before the recession.

This brings up an important point, taxes and spending aren’t just related to US debt, they are the determinants of it. When Bush cut taxes in his term, he lowered the amount of money the government could use to pay for services, creating a deficit. Before this, the US actually ran on a budget surplus for several years of the Clinton administration. One reason was that taxes were a little bit higher than they are now. During the Bush administration US taxes were low, compared to the rest of the OECD (a rich country organization):

I found this graph from wikipedia which nicely shows US debt and its growth through several administrations:

This graph is self-explanatory. Obama’s administration has seen the debt increase, but so did Reagan’s government, and both Bush administrations. Debt to GDP actually shrank under every Democrat elected president after WWII.

The New York Times has a compelling interactive article that graphs the debt crisis.

Taken from the article is:

This graph shows many things, but I think two are most important: First, Obama has done much to increase the public debt of the US, but the Bush administration did much more over his 8 year term.  Second, while China owns the largest amount of US debt of any foreign country, they only owe slightly more than US ally Japan, and three times as much debt is owed to individuals, local governments, or corporations within the United States than is owed to China.

Another compelling infographic comes from the same article courtesy of the New York Times:

This graph shows something I wanted to briefly talk about last. Ratings agencies like Moody’s and Standard and Poor are used by investors (or any buyer of sovereign debt) to estimate how likely a country is to repay its debt. The US has enjoyed the highest possible rating for several decades now. Moody’s and Standard and Poor both recently changed the outlook on US debt from Stable to “Watch Negative.” S&P explained, they view any failure to raise the debt limit as a threat to US credit worthiness, and did so not because of the size of US debt, but because of the danger of the US failing to repay its debts in the short term.

Finally, yields (interest paid by a debtor country to its creditors) on US bonds is still at a healthy 3.0%, not as low as Switzerland or Germany’s but still stable. Bond markets can be subject to bizarre movements, as Japan has seen its yields drop the lowest rate of any sovereign debt, despite having the highest debt to GDP ratio of any country and despite having a lower credit rating than the US. At the same time, most buyers of treasury bonds have little choice but to continue to buy US debt. As a different NYT article points out:

“There are limits to cutting back because other large bond markets, in Europe and Japan, are not nearly as liquid. “As long as the dollar remains the dominant currency there’s little choice for many in the public sector but to hold U.S. debt,” said the senior European policy maker. ”

While public debt is certainly a medium-term and long term concern, it makes little sense for us to risk default or make painful cuts to entitlement programs when put into perspective, our public debt is hardly as worrying as US unemployment or weak consumer spending currently is.