Fiscal policy

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Fiscal space

  • Source: Fiscal Space IMF Staff Position Note, September 1, 2010

The fiscal challenges facing advanced economies are unprecedented, and bring to the fore questions about how to assess fiscal sustainability. Intertemporal solvency—the notion that governments eventually repay their debts—requires only that adjustments to bring debt dynamics back on track occur at some point in the future. Given the sovereign’s right to tax and (not) spend, changes in these variables can always make the problem of insolvency disappear. But markets are not impressed by promises that are unsupported by countries’ track record of adjustment (words unsupported by deeds), and so it is critical to examine this track record to see whether it is indeed consistent with satisfying the intertemporal constraint.

In this note, we reexamine the issue of debt sustainability in a large group of advanced economies. Our hypothesis is that, when debt is in a moderate range, its dynamics are sustainable in the sense that increases in debt elicit sufficient increases in primary fiscal balances to stabilize the debt-to-GDP ratio. At high debt levels, however, the dynamics may turn unstable, and the debt ratio may not converge to a finite level. Such a framework allows us to define a “debt limit” that is consistent with the country’s historical track record of adjustment in the sense that, without an extraordinary fiscal effort, any debt increment beyond this limit would cause debt to increase without bound.

It bears emphasizing that this debt limit is not an absolute and immutable barrier, but it does define a critical point above which the country’s historical fiscal response to rising debt becomes insufficient to maintain debt sustainability. Nor should the limit be interpreted as being the optimal level of public debt. Indeed, since the limit delineates the point at which fiscal solvency is called into question—and the analysis abstracts entirely from liquidity/rollover risk—prudence dictates that countries target a debt level well below the limit. Given the country’s normal pattern of adjustment, fiscal space is then simply the difference between the debt limit and current debt.

Applying our concepts to a sample of 23 advanced economies, we find a number of countries that have either very little or no additional fiscal space (again, based on their historical adjustment patterns). In particular, Greece, Italy, Japan, and Portugal appear to have the least fiscal space, with Iceland, Ireland, Spain, the United Kingdom, and the United States also constrained in their degree of fiscal maneuver, the more so owing to the run-up in public debt projected in coming years.

An absence of fiscal space should not be taken to mean that some form of fiscal “crisis” is imminent, or even likely, but it does underscore the need for credible adjustment plans—and it is noteworthy therefore that a number of countries have already demonstrated the political willingness to undertake adjustment that departs markedly from their historical performance. By the same token, other countries in the sample that have more fiscal space may still need to undertake medium-term adjustment on account of future demographic pressures and the possible realization of contingent liabilities.

In all countries, fiscal strategies must internalize both the need to support a still fragile recovery and the potential for financial stress prompted by concerns over sovereign risk—which underscores the criticality of firm commitment to credible strategies to lower fiscal deficits over time and, where funding pressures are present or seem imminent, supported by upfront measures.

A key issue confronting the global economy today concerns the degree to which countries have room for fiscal maneuver—fiscal space—and, relatedly, the extent to which adjustments in fiscal policies are necessary to achieve/maintain debt sustainability. 2 Financial markets have brought fiscal concerns to the front pages, and a more general reassessment of sovereign risk across a number of countries—given the fiscal legacy of the global financial crisis and looming demographic pressures—remains a palpable threat to the global recovery. But talk about what fiscal space is, how to measure it, and possible policy implications has been rather fuzzy. This note sets out to remedy that problem by providing a definition of fiscal space, making it operational, and estimating it for a number of advanced economies.

US debt clock

An aggregation of economic and financial statistics related to the federal, state and local governments of the Unites States of America.

President's Fiscal Commission draft proposal

Our Guiding Principles and Values
  1. We have a patriotic duty to come together on a plan that will make America better off tomorrow than it is today America cannot be great if we go broke.Our economy will not grow and our country will not be able to compete without a plan to get this crushing debt burden off our back.
  2. Throughout our history, Americans have always been willing to sacrifice to make our nation stronger over the long haul. That’s the promise of America:to give our children and grandchildren a better life.
  3. American families have spent the past 2 years making tough choices in their own lives. They expect us to do the same. The American people are counting on us to put politics aside, pull together not pull apart, and agree on a plan to live within our means and make America strong for the long haul.
  4. The Problem Is Real –the Solution Is Painful –There’s No Easy Way Out –Everything Must Be On the Table –and Washington Must Lead. We must stabilize then reduce the national debt, or we could spend $1 trillion a year in interest alone by 2020. A sensible, real plan requires shared sacrifice –and Washington should lead the way and tighten its belt.
  5. It Is Cruelly Wrong to Make Promises We Can’t Keep. Our country has tough choices to make. Without regard to party, we need to be willing to tell Americans the truth.

GAO audit of the US public debt FY 2010 and 2009

As of September 30, 2010 and 2009, federal debt managed by BPD totaled about $13,551 billion and $11,898 billion, respectively. Total gross federal debt outstanding increased over each of the last four fiscal years.

During the last four fi scal years, managing the federal debt has been a challenge, as evidenced by the growth of total federal debt by $5,058 billion, or 60 percent, from $8,493 billion as of September 30, 2006, to $13,551 billion as of September 30, 2010. The increase to the federal debt became particularly acute with the onset of the recession in December 2007.

Reduced federal revenues and federal government actions in response to both the fi nancial market crisis and the economic downturn added signifi cantly to the federal government’s borrowing needs. And, due to the persistent effects of the recession, which ended in June 2009, federal fi nancing needs remain high. As a result, the increases to total federal debt over the past three fi scal years represent the largest dollar increases over a three year period in history.

During fiscal years 2008, 2009, and 2010, legislation was enacted to raise the statutory debt limit on five different occasions. During this period, the statutory debt limit went from $9,815 billion to its current level of $14,294 billion, an increase of 46 percent.

Fiscal Year (FY) 2009 Financial Report of the US Government

The U.S. Department of the Treasury and the Office of Management and Budget today released the Fiscal Year (FY) 2009 Financial Report of the United States Government (Report). The Report details the U.S. Government's current financial position, as well as its short-term and long-term financial outlook, complementing the President's Budget released earlier this month.

This year's Report gives particular emphasis to two key issues: the Government's ongoing efforts to jump-start the economy and create jobs, and the need to achieve fiscal sustainability over the medium and long term. The report is prepared pursuant to Federal accounting standards.

For the third consecutive year, Treasury and OMB are also releasing an accompanying "Citizen's Guide to the Financial Report." The Report and the Guide can be found here.

Proposed 2011 national budget

U.S. President Barack Obama faces major hurdles to get his $3.8 trillion budget plan through Congress. Obstacles include members of his own — at times fractious — Democratic Party.

Obama proposed and Congress ignored many of the same policies last year, though expiration of individual tax cuts enacted by former President George W. Bush at the end of this year virtually ensures individual tax issues will be addressed.

Below is a summary of roadblocks facing some of Obama’s key proposals.


Fulfilling a campaign pledge, Obama proposed extending the Bush tax cuts for individuals earning less than $200,000 and couples making less than $250,000. For those making more than that, Obama proposed letting the cuts expire. That would bring the top two income tax brackets back to 39.6 and 36 percent, from 35 and 33 percent respectively.

Some fiscally conservative Democrats in the House of Representatives have called for keeping the rates lower for at least two years to sustain the economic recovery.

Democratic Senate and House leaders are generally believed to back letting the lower rates expire for the upper income groups, although they have not addressed the issue recently.


Obama proposes raising the long-term capital gains and dividend tax rates back to 20 percent for those making more than $200,000 and couples at more than $250,000. Again, a small group of Democrats have called for a temporary extension of the 15 percent rate, citing the fledgling recovery.


Obama once again proposed taxing “carried interest” earned by hedge fund and private equity fund managers as ordinary income, which would boost the tax rate from 15 percent to typically the highest income bracket.

The proposal passed in the House late last year but has hit a roadblock among Democrats in the Senate.


Obama proposed limiting itemized deductions, including for mortgage interest, for those making more than $200,000 or couples making more than $250,000, to 28 percent of their income. This idea was proposed last year and met with fierce opposition — from realtors, charities and members of both parties.


Obama’s proposed big bank tax is expected to face tough opposition from Republicans, who will likely try to shield some of the largest companies from a $90 billion tax spread out over 10 years. The tax, which is designed to recoup taxpayer losses associated with the financial bailout, is expected to be a target of intense lobbying from the financial industry.

House Republicans have already come out against the bank fee, saying it will simply drain capital from the banking industry and hurt lending. Even Warren Buffett, one of the world’s most respected investors and an Obama supporter, said the bank tax does not make sense, as big banks would be largely paying for the bailout of the automakers and AIG.


Obama proposed cutting farm subsidies and federal support of crop insurance by $10 billion over 10 years.

Farm leaders from both parties on Capitol Hill stated opposition to the cuts within hours of the proposal.

Agriculture Secretary Tom Vilsack offered to work with lawmakers to find an acceptable package of cuts, but lawmakers rejected similar cuts last year. Obama says the farm program should focus on family farmers and restrict subsidy payments to wealthy growers.


Liberal Democrats, including House Speaker Nancy Pelosi, have said Obama’s proposed freeze should also apply to military spending, which he exempted. House Appropriations Committee Chairman David Obey said he will stay within the overall spending limits suggested by the White House, but might allocate it in a different manner — for example, more could be cut from the Pentagon’s budget to make way for more spending on transportation, environmental protection, or other domestic programs.

Congress raises debt ceiling to $14.3 trillion

In a procedurally complex but important vote, the House voted Thursday on a rule that has the effect of increasing the debt ceiling by $1.9 trillion to $14.294 trillion.

The House vote to approve the rule was 217 to 212. No Republican voted to support the debt ceiling increase.

House Majority Leader Steny Hoyer said increasing the debt ceiling is necessary to pay for obligations that have already been incurred by the U.S.

"This is not a vote about party. This is a vote about country," he said.

Hoyer said there is "no rational alternative" to increasing the statutory debt ceiling.

"This is a vote for American responsibility," he said.

The House is now debating, and will vote later Thursday afternoon, on the underlying bill which would renew pay-as-you-go budget enforcement rules. These rules require that any new tax cuts or entitlement programs must be offset with tax increases or spending cuts.

Once the House approves the underlying bill, the package will be sent to President Obama for his signature.

The Senate voted last week to approve the legislation to increase the debt limit ceiling and renew PAYGO.

In late December, Congress voted to increase the debt ceiling by $290 billion to $12.394 trillion.

US debt to receipts

Using data from, the chart to the right shows debt to receipts going back to the mid 1800's.

Treasury debt sales top $2.1T for 2009

Wednesday's successful $32 billion seven-year note auction wraps up a record year of debt sales by the U.S. government.

The Treasury sold more than $2.1 trillion in notes and bonds this year, more than in the previous two years combined, to fund a widening budget shortfall and finance programs to rescue the banking system and support the economy.

Yet, despite the supply onslaught, buyers—from foreign central banks to U.S. households and domestic commercial banks—flocked to the sales. As a result, the government's borrowing costs fell to historic lows in 2009. That provided further support to the economy because Treasury rates are the benchmark for many types of corporate and consumer borrowing.

Strong demand for U.S. debt came when the U.S. economy was in dire straits, with unemployment rising as high as 10.2% and the government's deficit ballooning to $1.4 trillion in the fiscal year to September 2009. Beside the prospect of a recovering economy, concerns that buyers could stay away from this week's record-tying $118 billion in note sales led to a sharp spike up in Treasury yields in December. Two-, five- and 10-year yields rose to their highest levels since mid-August this week.

The average yield in the two-year note auctions dropped to 1.002% in 2009, down sharply from 2.078% in 2008 and 4.307% in 2007, according to Ian Lyngen, senior government bond strategist at CRT Capital Group LLC. The average auctioned yield for the 10-year note fell to 3.262% from 3.681% last year and 4.632% in 2007, he said.

Wednesday afternoon, the benchmark 10-year note was up 6/32 point, or $1.875 per $1,000 face value, at 96 21/32. Its yield fell to 3.786% from 3.809% Tuesday, as yields move inversely to prices. The 30-year bond was up 22/32 point to yield 4.605%.

"It is a victory for the U.S. government," said Amitabh Arora, head of Citigroup Global Markets' U.S. rate-strategy group. Had the auctions not gone so well, he said, interest rates would be much higher, raising borrowing costs for homeowners and companies.

But, for investors, Treasurys weren't such a good investment as an improving economy boosted the returns on riskier assets such as stocks and corporate bonds. After a 14% return in 2008, Treasurys have handed investors a loss of 3.43% through Tuesday in 2009, putting them on pace for the worst annual return since at least 1973, according to data from Barclays. In contrast, U.S. high-yield corporate bonds have delivered a return of 57.9% this year.

Nonetheless, demand at Treasury auctions remained resilient throughout the year as the Federal Reserve held rates near zero amid the still fragile economic recovery and subdued inflation pressures. The Fed's $300 billion Treasury-buying program to support the economy also helped, while many foreign central banks bought Treasurys as a way to temper gains in their own currencies, which would have undermined their exports.

Foreign investors, including central banks and private investors, are forecast to buy a net $333 billion in Treasury notes and bonds this year, up from $315.4 billion for 2008 and the average of $282.9 billion from 2003 to 2007, according to a research report earlier this month by Mr. Arora and colleague Vikram Rai. The strategists expect net buying from foreign investors to be $325 billion in 2010.

China, the biggest owner of Treasurys outside the U.S., bought a net $71.5 billion through the end of October, according to the latest data from the Treasury Department. Japan, the second-largest foreign holder of Treasurys, was the biggest buyer this year, with a net purchase of $120.5 billion over the same period.

Next year, the Treasury is expected to sell about $2.45 trillion in notes and bonds, setting another record. But yields may need to rise to entice buyers, particularly as the economic recovery gathers pace. Treasury Secretary Timothy Geithner said recently the economy is growing again and that job losses are expected to come down rapidly. That makes it attractive for investors to hold riskier assets in seeking better returns.

OECD on fiscal consolidation


Governments and central banks have implemented comprehensive support packages in response to the global crisis that erupted in September 2008. Discretionary fiscal measures, coupled with cyclical revenue losses and expenditure hikes, have resulted in a sharp increase in budget deficits and a concomitant build-up of government indebtedness in many G20 countries. Although a fragile recovery warrants full implementation of the stimulus measures planned for 2010, many governments are already preparing exit strategies to ensure longer-term fiscal sustainability. OECD projections suggest that countries should be in a position to begin to withdraw fiscal support by 2011 at a pace that is contingent on the recovery and the state of public finances, as well as on the scope for monetary policy to provide support to the economy, if needed.

This note summarises the OECD assessment of fiscal policy developments after the crisis. The note draws heavily from the analysis reported in recent editions of the OECD Economic Outlook (June and December 2009) and highlights the need to prepare fiscal consolidation strategies for implementation from 2011.

Recent trends and projections1

Ongoing fiscal stimulus has underpinned the recovery. The size and composition of fiscal support packages have varied across countries, but has in general included i) hikes in government final consumption, ii) cuts in direct taxes, iii) new public infrastructure projects, and iv) measures that have helped to boost or bring forward private demand through car scrappage incentive schemes, direct lump-sum income payments to households and temporary reductions in indirect taxes and housing tax credits. At the same time, activity is also being supported by conventional and unconventional monetary ease and a gradual normalisation of financial conditions.

Consistent with ongoing fiscal support and the cyclical downturn, budget deficits are expected to reach historical highs in 2010 in several countries. Most of the deficit is estimated to be structural, notwithstanding a large margin of error in the computation of budgetary aggregates on a cyclically-adjusted basis in current circumstances (Table 1). Underlying balances are projected to improve slightly in 2011 but to remain in general high throughout the medium term. Projected improvements are predicated on the assumption that temporary parts of the fiscal stimulus programmes are being withdrawn depending on the specific national legislation. Underlying deficits will nevertheless remain at unprecedentedly high levels of 8% of GDP or more in Japan,2 the United Kingdom and the United States.3

EU wants member countries to co-ordinate budgets

The European Commission wants EU countries to co-ordinate plans for national budgets in a move to strengthen financial co-operation.

It would involve submitting budgets to the EU for a "peer review", possibly before they go to national parliaments.

Some reports suggested the proposal would involve just the 16 countries using the euro currency, though this has not been made clear.

The Commission said its aim was to help prevent another EU financial crisis.

But the move, controversial as it would mean encroaching on sovereign territory, was immediately criticised by Sweden's prime minister.

The EC statement said: "The Commission proposes to reinforce decisively the economic governance in the European Union [which has 27 members].

"An early peer review of fiscal policies would help shape a fiscal stance for the EU and the euro area as a whole.

"Union countries should begin co-ordinating preparations for national budgets and economic reforms.

"Member states would benefit from early coordination at European level as they prepare their national budgets and national reform programmes," the statement said.

'Deeper surveillance' Olli Rehn, Europe's economic and monetary affairs commissioner, appeared to suggest that the measures applied to eurozone countries.

He said: "Coordination of fiscal policy has to be conducted in advance, in order to ensure that national budgets are consistent with the European dimension, that they don't put at risk the stability of the other member states."

And he added: "For [the] euro-area it means deeper and broader surveillance, in particular with regard to macroeconomic imbalances."

No one in Mr Rehn's office was available for clarification.

'Shining exception' Sweden's prime minister, Fredrik Reinfeldt, opposed any tighter surveillance on his country. "That this should concern all countries is something we find a little strange," he told a press conference.

"This kind of discussion could perhaps be possible for [countries] with a budget policy that goes against the [EU] stability and growth pact," he said.

"But countries like Sweden, we are a shining exception with good public finances and don't even come close to the limits one is not permitted to surpass. It is not fair to treat us the same way."

Sovereign state challenges outlined by Moody's

"Moody’s has compiled a 1970s-style ‘Misery’ index. But instead of showing inflation and unemployment rates, it shows the fiscal deficit and the unemployment rate.

On that basis, Spain, followed by Latvia, Lithuania, Ireland, Greece and the UK are the gloomiest Moody’s-rated sovereigns in the world. The US is eighth — just after Iceland.

What’s more, Moody’s has come up with some rather ominous ‘themes’ for the 2010 New Year. Among them; the idea of an extremely painful debt overhang, potential social unrest and a significant amount of “exit risk” for governments trying to withdraw their unconventional economic and low interest rate policies.

Here are the themes, with selected excerpts and highlights:

Theme 1

Aaa countries will probably not have the luxury of waiting for the recovery to be secured before announcing credible fiscal consolidation plans.

. . . A key concern is naturally an abrupt increase in real long-term interest rates after a long period of very low yields which has enhanced public debt affordability. We will address this risk in future publications and also discuss the unlikely risk of the dollar abruptly losing its predominant reserve currency status.

However, this type of risk is not certain. After all, Japan has now lived for many years with elevated public debt, deflationary pressures and very low interest rates. Also, large economies are hoping to durably influence long-term interest rates through skilful quantitative easing (QE).

But the risk is significant enough to focus governments’ minds. ―All this would require for the risks to materialise, is the combination of a global economy that is closer to (the new) economic potential, perhaps some ex ante change in the saving-investment balance at the world level (with China and surplus savers having to purchase fewer US bonds) and/or an inflation-led panic.

Therefore, it is very likely that most governments will not have the luxury to wait until 2012 to start cleaning up public finances. 2010 will probably see the inflexion point in highly accommodative policies. In the meantime, tactical changes in debt management strategies will help. The US Treasury is trying to re-profile the maturity of its debt in order to lengthen it with the aim of reducing its vulnerability to such a possible shock. —–

Theme 2

The “growth versus adjustment” debate is artificial: advanced economies will need as much adjustment as necessary, and as much growth as possible. —–

Theme 3

For countries operating at sharply lower output levels and with reduced growth potential, the debt equation will look increasingly complicated..."

"Double the holdings? It is definitely impossible."

IT is getting harder for governments to buy United States Treasuries because the US's shrinking current-account gap is reducing supply of dollars overseas, a Chinese central bank official said yesterday.

The comments by Zhu Min, deputy governor of the People's Bank of China, referred to the overall situation globally, not specifically to China, the biggest foreign holder of US government bonds.

Chinese officials generally are very careful about commenting on the dollar and Treasuries, given that so much of its US$2.3 trillion reserves are tied to their value, and markets always watch any such comments closely for signs of any shift in how it manages its assets.

China's State Administration of Foreign Exchange reaffirmed this month that the dollar stands secure as the anchor of the currency reserves it manages, even as the country seeks to diversify its investments.

In a discussion on the global role of the dollar, Zhu told an academic audience that it was inevitable that the dollar would continue to fall in value because Washington continued to issue more Treasuries to finance its deficit spending.

He then addressed where demand for that debt would come from.

"The United States cannot force foreign governments to increase their holdings of Treasuries," Zhu said, according to an audio recording of his remarks. "Double the holdings? It is definitely impossible."

"The US current account deficit is falling as residents' savings increase, so its trade turnover is falling, which means the US is supplying fewer dollars to the rest of the world," he added. "The world does not have so much money to buy more US Treasuries."

China continues to see its foreign exchange reserves grow, albeit at a slower pace than in past years, due to a large trade surplus and inflows of foreign investment. They stood at US$2.3 trillion at the end of September.

Sovereign debt and credit rating agencies

Fitch, Moody's and Standard & Poor's. Remember these three names now, because this year they are going to become worryingly familiar. For months the three credit-ratings agencies have been popping up in the financial pages, sucking their teeth over how much various countries have borrowed. In the run-up to Christmas, crisis-hit and debt-laden Greece saw its government debt downgraded for the third time in a month. And every time one of these grim announcements is made, the right whether in parliament or the press leap upon it as a taste of things to come for Britain.

Last month, when Moody's ranked UK debt as "resilient", the Telegraph still managed to find the black cloud [1] if things got really bad the raters foresaw a "full-blown, irreversible fiscal crisis by 2013".

Cue George Osborne warning that "Britain faces the disaster of having its international credit rating downgraded". Of course, if Britain did face that particular worst-case scenario, just what financiers made of the outlook for its sovereign debt would not be the first question on anyone's lips. But if Moody's says it and it is sufficiently downbeat about Labour's fiscal policy then it must be fit to print.

There are three problems with this. First, whatever the status newly accorded to them by the Tories and their friends in the press, the credit-ratings agencies are not economic experts nor do they claim to be. Second, they get plenty of things wrong. And third, there are serious doubts about the impartiality of the agencies which have been raised by American and European regulators.

Bill Clinton's former adviser James Carville once said, "I used to think that if there was reincarnation, I wanted to come back as the president or the pope... But now I would like to come back as the bond market. You can intimidate everybody."

That presumably goes double for Moody's and the rest [2], which are the gatekeepers to the bond markets. They give bonds issued by governments and companies a rating from excellent down to poor of the likelihood of investors getting their money back. They are not world-leading economists or even loan officers, but primarily statisticians who look at how country A or company B has behaved in the past. Crucially, their perspective is that of the money-lender; questions about unemployment or long-term growth are not for the ratings agencies to answer.

Even then, the agencies regularly commit huge blunders. At the beginning of 2008, there were about a dozen top-rated countries in the entire world, according to Moody's and Co. but there were 64,000 CDOs, CLOs and the like that were at the same notch, much of which turned out to be rubbish. The agencies thought Enron was fine until just four days before it went bust. They got southeast Asia wrong, and before that Latin America. They are highly fallible; just ask any number of out-of-pocket investors or hard-done-by governments.

In 2002, Moody's downgraded Japan to a lower level of risk than Botswana [3] Moodys downgraded Japan to a lower level of risk than Botswana a ludicrous judgment even then. Finally, there have long been doubts about how much the big agencies are to be trusted, because they are usually paid by the would-be borrowers to assess their credit-worthiness. This time, there must be doubts about how impartial any part of the financial-services industry will be in assessing the economic policies of a government that has hit them with tax rises and bonus clampdowns.

This does not mean that Britain and the rest of the west have not racked up a huge debt in bailing out their banks and averting a second Great Depression; simply that the rating agencies are not the bodies to decide how and when that debt is repaid. The past couple of years should have finally given the lie to the notion that the City experts know best. Yet when a part of the finance industry tut-tuts over Labour's fiscal plans, the rightwing press treats it like the ruling of a high court judge. Why is that?

Is United States bankrupt?

Laurence Kotlikoff of Boston Univ wrote this paper in 2006.

Is the U.S. bankrupt? Or to paraphrase the Oxford English Dictionary States at the end of its resources, exhausted, stripped bear, destitute, bereft, wanting in property, or wrecked in consequence of failure to pay its creditors?

Many would scoff at this notion. They’d point out that the country has never defaulted on its debt; that its debt-to-GDP (gross domestic product) ratio is substantially lower than that of Japan and other developed countries; that its long-term nominal interest rates are historically low; that the dollar is the world’s reserve currency; and that China, Japan, and other countries have an insatiable demand for U.S. Treasuries.

Others would argue that the official debt reflects nomenclature, not fiscal fundamentals; that the sum total of official and unofficial liabilities is massive; that federal discretionary spending and medical expenditures are exploding; that the United States has a history of defaulting on its official debt via inflation; that the government has cut taxes well below the bone; that countries holding U.S. bonds can sell them in a nanosecond; that the financial markets have a long and impressive record of mispricing securities; and that financial implosion is just around the corner.

This paper explores these views from both partial and general equilibrium perspectives.

The findings:

The third section turns to economic measures of national insolvency, namely, measures of the fiscal gap and generational imbalance. This partial-equilibrium analysis strongly suggests that the U.S. government is, indeed, bankrupt, insofar as it will be unable to pay its creditors, who, in this context, are current and future generations to whom it has explicitly or implicitly promised future net payments of various kinds.

The world, of course, is full of uncertainty. The fourth section considers how uncertainty changes one’s perspective on national insolvency and methods of measuring a country’s long-term fiscal condition. The fifth section asks whether immigration or productivity improvements arising deepening can ameliorate the U.S. fiscal condition. While immigration shows little promise, productivity improvements can help, provided the government uses higher productivity growth as an opportunity to outgrow its fiscal problems rather than perpetuate them by effectively indexing expenditure levels to the level of productivity.

He suggests reforms in 3 areas:

The final section offers three radical policies to eliminate the nation’s enormous fiscal gap and avert bankruptcy. These policies would replace the current tax system with a retail sales tax, personalize Social Security, and move to a globally budgeted universal healthcare system implemented via individual-specific health-insurance vouchers. The radical stance of these proposals reflects the critical nature of our time. Unless the United States moves quickly to fundamentally change and restrain its fiscal behavior, its bankruptcy will become a foregone conclusion.

A good radical read on state of US public finances. He estimates the total fiscal gap to be USD 65.9 trillion including social security, medicaid etc payments. This was in 2006. I am sure the fiscal gap has increased much more because of the current crisis. There have been many studies lately on US public debt but I don’t really know whether they estimate all possible costs of US government.

Waiting for an update from Kotlikoff on the same.

EU reaches to greater economic oversight

Sweeping new powers to co-ordinate all EU economies as part of a landmark €30 billion (£27 million) bailout package for Greece were agreed last night in a deal driven by Germany and France.

The plan will put Herman Van Rompuy, the new permanent European Council President from Belgium, in charge of “the economic governance of Europe”.

Angela Merkel and Nicolas Sarkozy insisted on a greater role for the EU leaders in economic planning and scrutiny as they thrashed out a rescue plan for Greece using a combination of finances from the 16-nation eurozone and the International Monetary Fund.

It will be seen as a direct challenge to Gordon Brown, who will want to make sure that Britain does not surrender any control over its own economy to Brussels. The next government in London may also face a tough fight in Europe because the German Chancellor suggested yesterday that a new treaty would be needed to give the EU extra economic powers — despite the pledge from EU leaders last year that the Lisbon treaty would be good for a decade.

Ms Merkel and Mr Sarkozy came to their agreement in a one-to-one meeting before last night’s EU summit in Brussels.

Despite succeeding in her insistence that the IMF should play a “substantial” role in any bailout, Ms Merkel could yet pay a heavy political price for agreeing that eurozone economies should find the majority of the funds...

Australia's Intergenerational Report 2010

Fiscal strategy

The Government’s fiscal strategy will make an important contribution to addressing the fiscal pressures that will come with an ageing population. As the economy recovers, and grows above trend, the Government will allow the level of tax receipts to recover naturally and hold real growth in spending to two per cent a year until the budget returns to surplus.

Constraining annual real spending growth to two per cent in years where the economy is growing above trend until the budget is in surplus will deliver permanent structural savings of around one percentage point of GDP from 2015–16. This Government has already delivered $56 billion in savings in the 2008–09 and 2009–10 Budgets.

Deficits do matter

The New York Times has a good essay on debt:

But that happy situation, aided by ultralow interest rates, may not last much longer.

Treasury officials now face a trifecta of headaches: a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

Even as Treasury officials are racing to lock in today’s low rates by exchanging short-term borrowings for long-term bonds, the government faces a payment shock similar to those that sent legions of overstretched homeowners into default on their mortgages.

With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

The potential for rapidly escalating interest payouts is just one of the wrenching challenges facing the United States after decades of living beyond its means....There is little doubt that the United States’ long-term budget crisis is becoming too big to postpone.

Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode.

The competing demands could deepen political battles over the size and role of the government, the trade-offs between taxes and spending, the choices between helping older generations versus younger ones, and the bottom-line questions about who should ultimately shoulder the burden. For more on issues regarding age demographics, benefits and the tension between young and old, see this and this.

The Times continues:

“The government is on teaser rates,” said Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that advocates lower deficits. “We’re taking out a huge mortgage right now, but we won’t feel the pain until later”...

The problem, many analysts say, is that record government deficits have arrived just as the long-feared explosion begins in spending on benefits under Medicare and Social Security

The current low rates on the country’s debt were caused by temporary factors that are already beginning to fade. One factor was the economic crisis itself, which caused panicked investors around the world to plow their money into the comparative safety of Treasury bills and notes. Even though the United States was the epicenter of the global crisis, investors viewed Treasury securities as the least dangerous place to park their money.

On top of that, the Fed used almost every tool in its arsenal to push interest rates down even further. It cut the overnight federal funds rate, the rate at which banks lend reserves to one another, to almost zero. And to reduce longer-term rates, it bought more than $1.5 trillion worth of Treasury bonds and government-guaranteed securities linked to mortgages...

The Fed, meanwhile, is already halting its efforts at tamping down long-term interest rates. Fed officials ended their $300 billion program to buy up Treasury bonds last month, and they have announced plans to stop buying mortgage-backed securities by the end of next March.

Eventually, though probably not until at least mid-2010, the Fed will also start raising its benchmark interest rate back to more historically normal levels...

Even a small increase in interest rates has a big impact. An increase of one percentage point in the Treasury’s average cost of borrowing would cost American taxpayers an extra $80 billion this year — about equal to the combined budgets of the Department of Energy and the Department of Education...

The White House estimates that the government will have to borrow about $3.5 trillion more over the next three years. On top of that, the Treasury has to refinance, or roll over, a huge amount of short-term debt that was issued during the financial crisis. Treasury officials estimate that about 36 percent of the government’s marketable debt — about $1.6 trillion — is coming due in the months ahead.

As Karl Denninger has repeatedly pointed out, we are on an unsustainable track guaranteed to lead to a debt crisis. Denninger posts the following chart to make his point:

Under any scenario, debt gets further and further ahead of GDP, and America slowly digs its own grave.

And as Tyler Durden noted on November 1st:

As the assets on the US balance sheet become increasingly long-dated, courtesy of QE, and locking in record low rates, US liabilities in turn have shortened their duration to a record level. Almost $3 trillion in US debt will have to be rolled by the end of 2010. If realistic inflation expectations are any indication, all hopes of getting comparable interest terms on these securities once refinancing time rolls around, will be promptly dashed (we are not saying inflation is inevitable, even with QE 2.0 around the corner). Yet for all who claim inflation is a good thing, the one security that will be hit the most and the fastest will be precisely the T-bill universe, once all the curve steepeners already in place unwind very, very quickly. The result would be a major spike in interest expense payments by the government. The chart below presents the historical annual interest expense on all USTs by year. 2009 will be the first year in which the interest expense alone will be over half a trillion dollars (Zero Hedge estimates).

The concern is that even as the US debt, which as of Friday was at $11,868,457,477,911.94, and looks like it will hit the $12.104 trillion limit within a few weeks, continues to skyrocket, the interest expense paid on holdings will continue creeping ever higher. Keep in mind, at September 30, the average interest rate on Bills was a historically low 0.347%, and Notes yielded a QE-facilitated 3.043%. With the Fed out, can China and US retail investors support this record low interest at a time when UST supply keeps coming and coming?

And as the Times points out, America is competing with other countries to sell debt:

The United States will not be the only government competing to refinance huge debt. Japan, Germany, Britain and other industrialized countries have even higher government debt loads, measured as a share of their gross domestic product, and they too borrowed heavily to combat the financial crisis and economic downturn. As the global economy recovers and businesses raise capital to finance their growth, all that new government debt is likely to put more upward pressure on interest rates.

Paul Krugman disagrees, believing that debt is a "phantom menace". But this is not because Krugman is a liberal. Government economists in the Reagan, Bush and Obama administrations have all believed pretty much the same thing: deficits don't matter.

But many experts disagree:

The St. Louis Federal Reserve Bank posted a paper entitled "Is The United States Bankrupt?". The paper provides the following answer: "The United States is going broke" People seem to think the government has money," "said former U.S. Comptroller General David Walker. "The government doesn't have any money"

The United States Department of the Treasury and the Office of Management and Budget published a report stating that the U.S. cannot grow our way out of the government's liabilities, that the liabilities are quickly growing, and that failing to take drastic and immediate action would lead to very bad consequences (the report was written in 2006)

Nouriel Roubini writes:

Ultimately, deleveraging requires the writing down of debt as reflationary policies are not a free lunch and won't solve the debt overhang problem (Dr. Roubini). Important case study: Japan back into deflationary territory despite huge public debt and QE (Chinn).

The International Monetary Fund - which oversees third-world economies - is so concerned about the solvency of the U.S. economy that, during the Bush administration, it started conducting a complete audit of the whole US financial system. The IMF previously only audited banana republics (then again ...)

The American Enterprise Institute for Public Policy Research (AEI) published a paper indicating that “by all relevant debt indicators, the US fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.” Obama told Fox news that the United States' climbing national debt could drag the country into a double-dip recession

Of course, all it takes is a quick read of Minsky or Keen to see that massive debt overhangs drag economies down into the abyss.


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