August 29, 2010
How Dismal is the Fiscal Future For America and Europe?
How Dismal is the Fiscal Future For America and Europe? Becker
Posner lays out clearly many of the present and future solvency and default risks to the United States federal government. He bases some of the analysis on a valuable recent Morgan Stanley report with the provocative title "Ask Not Whether Governments Will Default, but* How*". Default on some of their debt by countries like Greece and Italy are real possibilities, and default by leading countries like the US and Germany is surely possible. But I do not believe their default is at all inevitable.
The report first presents the usual measure of default risk- the ratio of government debt (not held by other government agencies) to GDP in 2009- for the federal government of the US and for eight European nations: France, Germany, Greece, Ireland, Italy, Portugal, Spain and the United Kingdom. On this criterion, Greece and Italy look in trouble, with ratios of about 1.15, and the US looks in reasonable good shape, with a ratio of about ½, which is much lower than that for most of the other nations in their comparison set. For example, Germany's debt/GDP ratio is 0.73, while the United Kingdom's ratio is 0. 68.
Morgan Stanley's report argues debt/GDP is not a good measure of default risk, and suggests instead the ratio of debt to government revenues. On this measure, the US looks terrible, with a ratio of 3.58. This ratio is much higher than that of the eight European nations because they tax a much larger fraction of GDP than the federal government of the US does. Yet it is not obvious to me that using tax revenue rather than GDP in the denominator is a better measure of solvency risk. Countries that already collect a sizeable fraction of GDP as tax revenue have less room to raise taxes than do countries like the US that tax a much smaller fraction. This argument suggests that the high GDP/tax revenue ratio for the US makes its solvency risk lower rather than higher compared to Europe. On the other hand, that the American federal government raises so much less may be a sign of greater resistance to higher taxes in the United States than in Europe.
On balance I believe it is better to use the debt/GDP measure, although the discussion that follows would be the same with either measure. Two main factors will determine the size of the default risk for the US as well as Europe. As both Posner and the report emphasize, a frightening prospect is the expected growth in entitlements over time, especially the growth in medical care spending. This is partly due to the continuing aging of populations in developed countries since older persons take a greatly disproportionate share of spending on medical care. Even more important than aging itself is that spending on each older age group has risen at a fast rate over time with the development of expensive new drugs and surgeries.
In the Affordable Care Act that became law in March of 2010, Congress and the president tried to address the high and growing spending by the US on healthcare. The US ratio of spending to GDP is approaching 17%, which is essentially the highest ratio in the world. Unfortunately, in many ways this law worsens America's approach to health care rather than improves it. One main defect is the failure of this Act to increase the quite small ratio of out of pocket spending by older sick individuals on their own healthcare compared to their spending out of tax dollars. Obviously, individuals have much less incentive to economize on unnecessary health spending, such as the removal of the prostate for 85 year old men with prostate cancer, when the great majority of their spending comes from tax dollars rather than from their own income and wealth. Another serious defect of the law is that it extends rather than contracts the American reliance on employer provided health care. My post on the new law on March 28th discusses other defects.
The Morgan Stanley report does not give much weight to the potential of faster economic growth to reduce the likelihood of sovereign default risk. If the rate of growth in GDP were speeded up, the debt/GDP ratio might be kept under control even without governments collecting a much larger share of GDP in tax revenue, as long as the growth in government spending did not adjust upward to the faster growth in the economy. For example, if the economy grew in the long run by 2% per capita per year rather than 1.5% per capita per year, GDP per capita would double in about 36 years rather than in 48 years. This difference in the level of GDP achieved over time would greatly improve the ability of governments to handle their debt.
In recent months I have argued in several posts on this blog that governments should be concentrating on trying to speed up longer-term economic growth rather than promoting further stimulus packages and other short run palliatives. Faster long term growth in per capita incomes and real reform in the looming health and retirement entitlement are the only truly effective and efficient ways to greatly reduce the risk of eventual default on sovereign debt by the US, Europe, and other nations.
Is the Federal Government Broke? Posner
A company or other organization, or an individual, is insolvent when its liabilities (what it owes) exceed the market value of its assets. Bankruptcy is a legal mechanism for liquidating or reorganizing an insolvent entity in a way that maximizes value for the creditors. When a firm is insolvent, each of its creditors is eager to be repaid what he is owed, out of the firm's assets. By definition those assets are insufficient to satisfy all the creditors' claims, so the creditors race to obtain judgments, which are then satisfied by sale of the firm's assets, perhaps at fire-sale prices because of the race. Even if the firm could be saved as a going concern by eliminating some of its debt burden (its liabilities), transaction costs will make it difficult for the creditors to agree on how far their respective claims will be written down—how in short to share the grief. In a bankruptcy proceeding, the creditors are barred from suit and the judge supervises an orderly disposition of assets (whether by liquidation or by placing them in a reorganized entity) designed to maximize their value and hence the creditors' ultimate return.
Bankruptcy is not limited to individuals and business firms; under U.S. law, even a city can be declared bankrupt; and this happens occasionally. In one Illinois town, the bankruptcy judge ordered the sale of city hall to satisfy creditors' claims. U.S. states cannot be subjected to bankruptcy proceedings, and neither can the federal government, or the governments of other nations. But that doesn't mean that a state or nation can't be insolvent. Insolvency is the condition; bankruptcy is a method of treating the condition.
A nation has creditors in both a narrow and a broad sense. In the case of our federal government, they are of four types: owners of federal securities (Treasury bonds and short-term bonds called Treasury bills or Treasury notes); other persons or firms that have contracts with the federal government, for example for sale of goods or services to it; holders of federal entitlements, such as social security, Medicare, Medicaid, and the pensions of retired federal employees; and beneficiaries of government services (as distinct from transfer payments), such as drivers on interstate highways and visitors to national parks, as well as the population at large, which is protected from crime and foreign aggression by federal police and military forces.
The first two categories of holders of government "debt" in a broad sense—owners of government bonds and holders of government contractors—correspond closely to the creditors of private companies. The third does not because federal entitlements can always be cut with impunity, from a legal standpoint; and the fourth are not entitlements, but services that are funded by annual congressional appropriations and so can be altered without being thought to disrupt settled expectations; they are the domain of "discretionary" government spending, though in a legal sense entitlements are discretionary also rather than being fixed and legally enforceable obligations.
But remember that insolvency is the condition, bankruptcy merely a treatment for the condition; and a condition is not less grave just because the best treatment for it is unavailable—in fact the condition is more serious in that case.
These reflections are suggested by the first issue (August 25) of a new publication by Morgan Stanley called Sovereign Subjects. The first issue is captioned "Ask Not* Whether* Governments Will Default, but* How*." It is a criticism of the conventional method of evaluating a nation's economic condition, which is to compare public debt (government bonds) to Gross Domestic Product. In the case of the United States, that ratio in percentage terms is 53 percent, which is high by historical standards but lower than that of a number of European nations, which are listed in the report (France, Germany, Greece, Ireland, Italy, Portugal, Spain, and the U.K.). But as the report points out, this is not a proper way to determine solvency. The proper way is to compare assets and liabilities. The major asset of any government is its taxing power, which of course cannot be equated to the entire GDP, or the entire value of the nation's human and physical capital; for both economic and political reasons, the taxing power is limited to a percentage of GDP well below 100 percent. And, realistically, the liability side of the national ledger includes not only government bonds but also other contractual obligations, entitlements, and at least strongly anchored expectations concerning government services (we're not about to eliminate our armed forces). In addition, as especially emphasized in the Morgan Stanley report, the national balance sheet must be reckoned in dynamic terms, with due regard for likely increases both in GDP and in liabilities, especially increases in entitlement spending that are likely to result from the continued ageing of the population.
Because American tax rates are low by international standards and resistance to increasing them is fierce, Morgan Stanley's report estimates that the ratio of current U.S. public debt to realistically realizable tax revenues is 3.58 to 1, which is the highest by a large margin of the countries in the report's list; only Greece comes close (3.12 to 1). But America has certain advantages, such as a younger population and a more rapid rate of economic growth, and as a result its ratio of net worth to GDP is in the middle of Morgan Stanley's list of countries—but it is strongly negative, as are the ratios of all the countries in the list (Italy, surprisingly, being at the top, and Greece, unsurprisingly, at the bottom). According to Morgan Stanley's calculation (which obviously is merely suggestive, as the report emphasizes, because of the uncertainty of the future), America's net worth is negative, and this negative net worth is eight times larger than our GDP. This means that the net present value of the government's liabilities, minus assets, is approximately $120 trillion.
What does a firm or an individual do when it is broke and there is no bankruptcy regime? It defaults. Nations do occasionally default on their bonds or other contractual obligations; or, if the bonds or other obligations are denominated in the local currency, they inflate the currency and so repay their obligations in cheaper money, which is the equivalent of a partial default. The U.S. government is unlikely to do either of these things and therefore, in conventional parlance, is not insolvent. But as the Morgan Stanley report insightfully emphasizes, the government has other "stakeholders," and they are creditors in a loose but illuminating sense. A cut in social security, Medicare, or other entitlements amounts to breaking the government's promises to the holders of these entitlements, promises on which the holders have relied. So does reducing government services (highways, police, etc.) or increasing taxes, which reduces the net value of those services.
The deeper the financial hole that the government has dug for itself by incompetent economic management—and our government has dug itself a very deep hole, largely because of the mismanagement of monetary policy and financial regulation by the Federal Reserve under Greenspan and Bernanke and by other government agencies—the more difficult it is to climb out of the hole on the backs of holders of entitlements and recipients of government services. The political resistance is too intense. It's at that point that the bondholders, and holders of other contractual rights against the government, have to start worrying about the prospects for outright default or default through inflation. These are possibilities in our future, just as in the future of Greece.