Bank for International Settlements: Brace for Impact

The adjective 'sobering' doesn't do the latest Bank for International Settlements (BIS) working paper (PDF) justice. The executive summary of the paper, which is entitled The future of public debt: prospects and implications, concludes with a recommendation that is certain not to be heeded by the current administration.

Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments...

Introduction

2008's historic financial meltdown led to industrialized countries taking on an unprecedented amount of public debt. According to the OECD, public sector debt will top 100% of GDP in 2011 for all industrialized countries. This level has never been seen during peacetime.

Worse, these projections ignore the "off-the-books" obligations -- Social Security and Medicare, for example -- which are many times the size of the documented debt. Given the aging of key demographics in these countries, "there is no definite and comprehensive account of the unfunded, contingent liabilities that governments currently have accumulated."

The current interest rate environment is, in historical terms, exceptionally low. The question BIS grapples with is a critical one: given governments' traditional unwillingness to implement tough frugality measures, when will investors begin demanding higher interest rates that correspond to the real risks associated with out-of-control spending?

When this occurs, the game is up. Higher interest rates to higher debt levels, which lead to higher interest rates, and so on. The question is when, not if, we enter that particular vortex.

The facts

The acceleration in accumulated public debt should be of tantamount concern, according to BIS.

A key fact emerging from the table is that over the past three years public debt has grown rapidly in countries where it had remained relatively low before the crisis. This group of countries includes not only the United States and the United Kingdom but also Spain and Ireland..

...overall fiscal balances have been deteriorating sharply – by 20–30 percentage points of GDP in just three years. And, unless action is taken almost immediately, there is little hope that these deficits will decline significantly in 2011. Even more worrying is the fact that most of the projected deficits are structural rather than cyclical in nature...

Table 1 points to a rather stunning fact: by 2011, U.S. public debt will have increased from 62% of GDP to 100% in just four years. When measured against the other countries in the table, the U.S. will move from seventh highest debt load to fourth, trailing only Japan, Italy and -- drum roll, please -- Greece.

Even more concerning is the fact that the fiscal policy of increased spending unhappily coincides with accelerating -- and unfunded -- spending tied to social programs for the elderly. In the case of the U.S., Social Security and Medicare represent huge expenditures that will increase dramatically as the baby boomer generation retires en masse.

Further compounding the problem is the rise in per capita health care costs in all industrialized countries -- including those with completely socialized delivery of medical services.

A 2007 study -- one of the few that attempted to estimate the total debt situation for seven major countries -- and determined, on average, that each country would have to improve their spending-to-revenue ratio by 4.5% of GDP to make good on their debts. The U.S. was far worse than average -- and, remember, this is 2005 data -- because it required a roughly 7% of GDP budget fix. In today's dollars, that would mean cutting about a trillion dollars in spending annually (or bringing in a trillion more revenue). The situation is far more dire today.

The future public debt trajectory

BIS also attempts to do 30-year projects for the debt/GDP ratio for a dozen major economies: Austria, France, Germany, Greece, Ireland, Italy, Japan, the Netherlands, Portugal, Spain, the United Kingdom and the United States.

...in our baseline scenario, conventionally computed deficits will rise precipitously. Unless the stance of fiscal policy changes, or age-related spending is cut, by 2020 the primary deficit/GDP ratio will rise to 13% in Ireland; 8–10% in Japan, Spain, the United Kingdom and the United States; and 3–7% in Austria, Germany, Greece, the Netherlands and Portugal. Only in Italy do these policy settings keep the primary deficits relatively well contained – a consequence of the fact that the country entered the crisis with a nearly balanced budget and did not implement any real stimulus over the past several years.

...in the baseline scenario, debt/GDP ratios rise rapidly in the next decade, exceeding 300% of GDP in Japan; 200% in the United Kingdom; and 150% in Belgium, France, Ireland, Greece, Italy and the United States. And, as is clear from the slope of the line, without a change in policy, the path is unstable.

...Seeing that the status quo is untenable, countries are embarking on fiscal consolidation plans. In the United States, the aim is to bring the total federal budget deficit down from 11% to 4% of GDP by 2015... [but the] consolidations along the lines currently being discussed will not be sufficient to ensure that debt levels remain within reasonable bounds over the next several decades.

...An alternative to traditional spending cuts and revenue increases is to change the promises that are as yet unmet. Here, that means embarking on the politically treacherous task of cutting future age-related liabilities. With this possibility in mind, we construct a third scenario that combines gradual fiscal improvement with a freezing of age-related spending-to-GDP at the projected level for 2011. The blue line in Graph 4 shows the consequences of this draconian policy. Given its severity, the result is no surprise: what was a rising debt/GDP ratio reverses course and starts heading down in Austria, Germany and the Netherlands. In several others, the policy yields a significant slowdown in debt accumulation. Interestingly, in France, Ireland, the United Kingdom and the United States, even this policy is not sufficient to bring rising debt under control.

Given that, BIS asks the question: just what level of spending reductions would be necessary for these countries to achieve economic stability?

For the U.S., 8.1% of GDP must be either cut or found in revenue. In today's dollars, this represents roughly $1.2 trillion -- coincidentally, that's roughly the total amount of the Democrat Stimulus and Omnibus spending packages of 2009.

Each and every year, for the next five years, the U.S. must rein in spending by this amount. And the longer it is put off, the more painful it will be.

Worse still, BIS asserts that interest rates are certain to rise for all of these countries as investors demand higher risk premia. The implications are brutal: as higher amounts of public debt come due, ever larger percentages of an economy's production are dedicated to servicing debt.

The confluence of these factors imply increased taxes, which suppress the prospects for real economic growth. According to BIS, taxes crowd out productive private capital.

Not only that, but a vicious cycle soon emerges: "a persistent slowdown in the rate of economic growth."

The vortex of debt sucks the life from the private sector and reduces economic vigor and opportunity.

Conclusion

BIS offers several important takeaways:

• The fiscal problems facing the U.S. and other industrialized countries are far worse than they appear.

As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population. The related unfunded liabilities are large and growing, and should be a central part of today’s long-term fiscal planning.

Unfortunately, today's Democrats are ignoring the looming disaster and -- worse still -- ladling on a brand new and completely unaffordable entitlement.

• Second, the amount of debt that must be financed is outrageously high -- and interest rates are certain to rise as reality confronts bond investors.

• Third, the persistently high levels of debt will severely harm the private sector, which reduces the prospects for long-term growth and recovery. As the debt/GDP ratio approaches the 100% limit, economic instability becomes a distinct possibility.

• Long-term fiscal imbalances (spending far beyond one's means) "pose significant risk" to the entire monetary system. Rampant inflation -- perhaps even hyperinflation -- are possible outcomes as debt is monetized (money is printed to "purchase" the debt) or inflation is outright encouraged by a government that wishes to reduce its real outlays.

Sensible measures -- like raising minimum ages for Social Security, Medicare and Medicaid benefits -- are required in short order. The importance of the November elections -- and restoring fiscal sanity to the country -- can not be overstated.