ANALYSIS

The private sector crisis is going public

LADD_Edward_webIn this opinion piece Edward Ladd, chairman emeritus of Standish Mellon, looks at real effects of the shift in debt from the private to public sectors, with particular emphasis on the implications the situation in the US may have on global markets.

During the financial crisis, governments across the developed world stepped up their spending dramatically to compensate for the pullback in private spending.

But this vast expansion in government spending, deficits and guarantees for faltering financial institutions has now shifted concern from the tattered state of private-sector balance sheets to the ballooning debts on sovereign balance sheets.

Last year every developed country except oil-rich Norway ran a deficit, with Iceland, Greece and the UK, Ireland and the US having the deepest deficits.

While the huge increases in annual operating deficits in many developed countries as a result of the recession are serious, it is the tidal wave of long-term healthcare and retirement liabilities threatening to engulf those same countries that is the far greater – and largely overlooked – problem.

But now demography is catching up with them. As the baby boomers begin to retire in greater numbers, the financial implications of their demographic bulge will become more dire as fewer younger workers remain to support those costs.

The red ink of crisis-induced governments deficits is bleeding the enormous out-year liabilities that have been looming on the horizon but are now hurtling toward us as the population ages and birth rates decline.

This unprecedented accumulation of operating deficits and long-term debts from pay-as-you-go health and retirement systems in the developed world could be setting the stage for the next financial crisis. Without meaningful reform, that debt could have catastrophic implications for government credit premiums, higher real interest rates and currency declines.

While Greece has dominated headlines, it is by no means alone in its balance sheet problems. Many European countries, including the UK, are running annual budget deficits close to or in excess of 10 per cent of GDP. Despite the European Growth and Stability Pact meant to keep explicit public debt under 60 per cent of GDP, many EU members have total cumulative debt and out-year liabilities reaching 300 per cent (and by some estimates 500 per cent) of GDP.

In the US, the focus has also been on the annual budget deficit and the public debt outstanding. While the US is not experiencing the same declining birth rates as many European countries, it still faces massive out-year liabilities.

Experts have estimated the present value of these out-year liabilities as between $70-100 trillion, roughly five to seven times GDP.

Put differently, that debt load alone amounts to an additional liability of $200,000 to $300,000 for each US citizen on top of other debt.

The largest liabilities in the US are from Medicare and Medicaid, followed by Social Security, which will pay out more than it takes in this year, seven years sooner than predicted.

Healthcare costs already comprise 16 per cent of GDP and could rise by another 8-10 percentage points if left unchecked. The current health care legislation appears to be slightly deficit positive but puts only a small dent in the out-year liabilities over the next 20 years.

Other substantial long-term debt includes the unfunded liabilities of state and local pension plans (many of which use unrealistically high assumed returns); state and local post-retirement healthcare liabilities; the financial guarantees extended to Fannie Mae, Freddie Mac and other financial institutions; and the Pension Benefit Guaranty Corporation deficit.

Meanwhile, the Federal Highway Trust Fund has exhausted its surplus, while the Federal Housing Authority has run out of money. The American Society of Civil Engineers estimates that the US should spend an additional $2 trillion in the next five years to upgrade aging infrastructure. This is an imposing list that doesn’t even include the ultimate cost of two wars and the potential expenses to address climate change.

How can the US possibly finance all of this? Trying to inflate its way out of the problem will create problems of its own for the US. Foreign appetite for US debt, which made the 20-year spending spree possible, has diminished.

Annual foreign capital inflows have nearly halved from close to $800 billion in 2006 to $400 billion. Chinese purchases of US Treasuries have slowed considerably as the Chinese focus on spurring domestic demand. Meanwhile, other foreign buyers seem increasingly reluctant to buy US government issues out of concern they could be paid back in devalued dollars if the US debt continues to expand.

While current-account deficit dollars will be recycled, the buyers may be unwilling and prefer other assets. There is clearly a risk for the US in being dependent on external capital, especially when many of its liabilities are short-term. If the US runs large government deficits, the long-run requirement will be either reduced domestic productive investment or a higher level of domestic savings. Making that happen will probably require materially higher interest rates.

Economic recovery will bring some rebound in government revenue, but government financing needs will continue to grow because of the long-term liabilities coming due. A modest economy recovery and increase in private credit demands will conflict with governmental deficits and could risk substantial yield increases. It is not difficult to imagine what the ripple effects could be across global financial markets.

There is no precedent for the scale of these liabilities as a proportion of economic activity and there are no easy answers. But raising awareness of the potential global financial market fall-out from inaction could galvanize public and private industry leaders to address a gathering crisis that has often been dismissed as too far out to matter.

There is an inevitability of either reducing government obligations or raising government revenues to meet those obligations. In any event, those obligations are coming due sooner than we think and could destabilise government finances and societies across the world for many years to come.