USA: Fiscal Sequester 2.0

The news media report today that the US government is warning that the federal government will face a possible shutdown if the current debt ceiling of 16.7 trillion US-Dollars is not lifted around mid-October. This gives a stark signal to the public that possible trouble a lying ahead in the coming weeks.
With the Republicans and Democrats far apart in their budget talks at the US-Congress and if the current deadlock cannot be broken until mid-October, the US government will have to stop payments of some of their bills after the official debt ceiling has been reached. A similar situation has emerged already last year. Similar situations already appeared in California, when the state government paid their public servants instead with cash with government bonds issued by the state of California. Another option is furlough days, i.e. unpaid holidays for civil servants of the government. The value of the government bonds lost rapidly in their nominal value so that employees of the state of California had to accept wage cuts when changing those payments into cash. The fiscal situation in the US is fragile. After years of excessive public deficits to overcome the financial and economic crisis, the US may face a turning pointing its recovery. A look at the most recent budget projection of the CBO reveals that no problems like this should have emerged. However, this illustrates that reality and forecasts are not in line. Other forecasts predict that the US public debt will cross the 100% GDP-to-debt ratio this year already without any sufficient indication of a major sustainable stabilization in the coming years. Maybe the revision of the national accounts last month by the BEA helped a little to disguise the fiscal crisis but that is only creative accounting in favor for the government. The key problem is that beside the debate on raising the debt ceiling this will have possibly major repercussions on the rating of the US government bonds. Last year the US was downgraded by Standard & Poor’s from its traditional AAA to AA+. Another downgrade might happen, if the US Congress shows again unable to find a solution for a sustainable fiscal position. Egan-Jones, another rating agency, already cut its rating a third time from AA to AA-, the lowest of what is considered „high grade“, as a reaction to QE3. Other major rating agencies like Moody’s and Fitch might follow this line. All this point towards an acceleration of the already increasing interest rates on government bonds which started mid-year in 2012 after a similar budget turmoil (see figure 1).
Rising interest rates on US government bonds
Since last year the interest rates for US government bonds have started rising even after the Fed tried to stop this by QE3 beginning in September 2012. The success of the Fed to support the US government to overcome the fiscal crisis due to rapidly increasing financing costs for its huge government debt accumulated over the past couple of years, has shown to be a failure. This led to the reaction of the Fed that this program might be tapered out beginning in most likely in mid-September this year and ending mid-year in 2014.
Waning trust in the US fiscal position abroad
In particular foreign investors begin to retreat from the US government bond market. Since the US runs beside its fiscal deficit and high debt another huge deficit in its current account balance sheet, the willingness of foreign creditors in particular in Asia like China and Japan in waning that the US is still a safe haven for investments. This situation is further complicated because China as well as Japan are in economic and financial troubles as well.
China has to face a major economic slowdown combined with huge debts and malinvestments from the last years of excessive stimulus programs. Japan has accumulated world record public debt since the early 1990s and never managed to break the slow growth trap since then. China as well needs a major restructuring of its economy to meet long-term goals of environmental protection, better governance to reduce corruption and transforming their economy to higher quality products and services addressing their domestic needs. Export-led growth based on cheap labor costs and lax regulations are unfeasible options for the Chinese economy which otherwise will end in the typical middle income trap. All this will be costly and need resources invested before abroad.
Abenomics as cure propagated by the current government a mixture of easy money politics similar to QE3 and structural reforms should again break this deadlock. However, doubts are rising that this attempt might again end in failure. So beside the US troubles there are strong incentives in both Asian countries to reduce their financial exposure to US government debt. Instead of financing the US deficit they need their money at home. Since the private sector in the US is unable to cover the huge demand for credits of the US deficits and refinancing the huge debt overhang, this might cause major turbulences in the coming months or years. Policy will lose control when the private sector denies following their guidance any longer.
Similarly in Europe the ongoing Euro crisis makes it less likely that European investors are willing to finance public US deficits. They as well tend to repatriate their investments in particular in US-government bonds. Rising interest rates on US governments bonds has a major negative effect on the existing stocks bought before at lower interest rates. They lose in market value because they are inversely related to the current interest rate on government bonds. Facing increasing losses on their past investments in US government bonds the exit of foreign investors might easily accelerate in the coming months. Those who wait too long will face higher losses than those who exit early. As soon as this problem permeate into the consciousness of the financial community the more dramatic this process might become.
Double trouble ahead
The US will face double trouble. On the one hand, it’s the unsustainable public fiscal position which might face an abrupt stop if the debt ceiling is not raised in October and a federal budget plan for 2014 cannot pass US-Congress due to the current deadlock there. This will trigger the second stage of the fiscal sequester which will become even more painful than the first one. Shrinking public expenditures will slow economic growth and cause a negative feedback loop of shrinking public revenues, increasing public deficits and rising interest rates to finance it. Not a very promising future outlook.
Furthermore, if the Fed begins with tapering out their QE3 program demand for public debt and ABS especially from the real estate sector will diminish at the same time. This will raise interest rates on US governments bonds even more. Since usually interest rates on public debt are considered as a floor for interest rates paid by private debtors like corporations and households, this would transmit this interest rate shock prom the public to the private sector. As in 2007/2008 this could trigger a series of defaults there with higher unemployment rates and foregone production. It is this intricate interlinking of different feedback loops which can lead to a rapid deterioration of the whole US economy which is causing headaches for the policy makers at the government and the Fed and the financial markets managers as well. Nobody really can foresee how different heterogeneous agents at home and abroad will finally react to the current dynamics of the US fiscal and monetary troubles. As Alan Greenspan knew or finally had to learn, markets face the risk of irrational exuberance. If this process kicks in, the situation become more and more unpredictable and normal political measure will lose their impacts. The US economy is again at the brink of a major collapse. It might be even worse than the last one.


6 Gedanken zu „USA: Fiscal Sequester 2.0

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