She was a nice lady. My apologies for not being there at the End.
Thanks for flying Air USA. Please ignore the exits
Perhaps this comes from too much time spent on airplanes but this week’s White House budget projections reminded me of nothing more than a pre-flight safety video. The voiceover tells passengers to “stay calm and listen for instructions from the cabin crew in the event of a sudden loss of cabin pressure” as eerily placid actors carefully strap on their oxygen masks or inflate their underseat life vests before attending to their children.
Of course this bears no resemblance to the unbridled panic that would ensue if a hole opened up in the fuselage at 35,000 feet. Perhaps US government economists operate on the same principle as airlines who refrain from showing videos of passengers trampling one another underfoot as the cabin fills with smoke. On the current fiscal trajectory, investors in America’s Treasury market will rush madly for the emergency exits one of these days, but official forecasts assume they will never even break a sweat.
Of all the variables in any budget projection – economic growth, taxes, foreign military engagements – the thorniest is what Treasury investors will do. Discretionary items and even entitlements like social security can be cut but interest must be paid no matter what and, in the absence of perpetual quantitative easing, the government must pay what the market deems fair.
Perhaps one reason we are so sanguine about the interest burden is that it is one of the few costs that has come down recently. The post-crisis flight to safety, muted inflation and bond-buying by the Federal Reserve have pushed this expense down to just 5.7 per cent of federal spending despite record deficits. This is a third of the proportion back in 1995 when Republicans briefly refused to raise the debt ceiling, shutting the government. At an average rate of 2.3 per cent, the cash outlay was just $200bn last year, the same as in 1992. During the same period entitlement and defence spending rose about threefold.
Even panglossian White House economists, who envision sharply lower deficits starting next year (the moment of virtue always seems to be a year away) concede that net interest costs will treble by 2016 as rates normalise. More surprisingly, the apolitical Congressional Budget Office, which makes much longer forecasts, sees rates normalising and then staying there for decades, come hell or high water. But the river is rising too quickly for the bond market to ignore much longer.
“We’re pretty close to an inflection point where, in the next couple of years, Congress and the administration need a credible plan to reduce the deficit,” says Ira Jersey, interest rate strategist at Credit Suisse.
Under the CBO’s more pessimistic “alternate” fiscal scenario, debt held by the public will exceed the size of the economy by 2020 but the average yield on Treasuries will remain below 5 per cent. And there it stays in perpetuity as debt ratios reach once, twice and thrice Greek levels. Even in distant 2084 when the CBO foresees eight-tenths of all US output servicing the debt, investors are seen calmly buying new bonds at the same rates.
The market behaving this way is about as realistic as hundreds of airline passengers maintaining a zen-like calm with Osama Bin-Laden in the cockpit and both engines on fire. America would in any case default or lapse into hyperinflation well before such extremes. The question is only when investors begin to price in some small probability of ruin. Since the average debt maturity is now just 59 months, a little fear could become self-fulfilling fairly quickly.
“The problem isn’t the 30-year bond but the two trillion in T-bills outstanding,” says Mr Jersey. “Rollover risk probably doesn’t exist for the government – the question is at what rate they’ll issue.”
For example, if investors demanded rates just a percentage point higher and projected deficits overshot by just $100bn annually through 2020 then the yearly cost of debt service would be a quarter of a trillion dollars higherthan otherwise, according to the CBO.
Thank you for flying Air USA. In case of turbulence, please return to your seats and disregard the emergency exits.