Canary in a Coal Mine

Wednesday, 12 May 2010 00:13 Last Updated on Wednesday, 12 May 2010 00:20 Written by James Van de Voorde

 According to Wikipedia, coal miners in the United Kingdom and United States, well into the 20^th century, brought canaries into coal mines as an early-warning signal for toxic gases such as methane and carbon monoxide.  The canaries, being more sensitive, would become sick before the miners, who would then have a chance to escape or put on protective respirators.  Today, the pharse “canary in a coal mine” refers to an early warning of danger. 

We can’t think of an analogy that better captures the plight of Greece relative to the world’s fiscal challenges in the wake of the Great Recession of 2008-09.  The canary is to the coal miner what Greece now represents to the United States and many other industrialized nations, an early warning of the grave dangers of unbridaled government spending and escalating budget deficits.  Greece is now suffocated by the toxic gases of its own fiscal recklessness, forced by the hand of bond vigilantes that now demand punitively high interest rates.  Rising risk premia for sovereign debt in Greece has begun to spread to Portugal and even Spain.  Even the previously unthinkable, that Greece may secede from the European Union (EU), choosing to run a printing press of drachmas and inflate away its debt, now seems somehow plausible. 

First, let’s gather some perspective.  Relative to the rest of Europe, Greece is the size of a canary and represents only 2% of EU Gross Dometic Product (GDP).  In 2009, Greece ran an annual budget deficit at 12.7% of GDP, its total debt as a percentage of GDP is expected to grow to 101% by 2011 and its post-crisis GDP is expected to be only 1.6% this year.  The United States did manage to run an annual budget deficit at 11.2% of GDP in 2009, yet the U.S. total debt as a percentage of GDP is presently just north of 90% (check out www.usdebtlcok.org).  Meanwhile, U.S. GDP is expected to average 3.4% this year.  In a nutshell, the United States is not Greece, yet.  While we may be many years from sharing any fate that even slightly resembles this Greek tragedy, it would be a shame to let the coal mine’s canary die in vain.  Our goal herein is to succinclty decribe the nature of the problems created by burdensome deficits and briefly outline potential solutions.  While it may be too late for Greece, it is not too late for the United States and many of its economic partners that face potentially similar fates.

A very recent study by Harvard’s Ken Rogoff and the University of Maryland’s Carmen Reinhart evaluated the impact of high levels of national debt on economic growth in the U.S. and around the world during the last two centuries.  Perhaps not surprisingly, higher levels of government debt as a percentage of GDP correlated very strongly with slower growth.  The study revealed that as long as gross government debt remained below 90% as a percentage of GDP, average GDP growth could be sustained at 3% or higher.  Conversely, government debt as a percentage of GDP above 90% correlated with lower growth rates, with average growth hovering near 1.75%.  The study indicates that debt to GDP ratios at 90% and above have historically reduced economic growth by at least 1%. 

Since higher deficits often lead to subsequent “remedies” such as higher taxes and rising interest rates, we should not be surprised to see such correlation.  The recent global economic crisis added fuel to the deficit fire, serving to expose those countries, such as Greece, with the most unsustainable deficits and highest levels of debt relative to GDP.  As fear spread around the world, investors jettisoned stocks at fire sale prices, businesses and consumers hunkered down and global GDP plunged, in turn dramatically reducing tax revenues necessary to run government.  Compounding the problem, governments borrowed more money, creating even more enormous deficits to stimulate economic growth by replacing consumer spending with government spending.  As Warren Buffet so famously quipped, “when the tide goes out, you learn who is swimming naked”.   Greece proved to be naked. 

According to the International Monetary Fund (IMF), the average gross government debt to GDP ratio in advanced economies was 75% by the end of 2007 and will rise to about 110% by 2014, even assuming that crisis-related stimulation measures are withdrawn in the coming years.  The IMF expects all G7 countries except Canada and Germany to have debt-to-GDP ratios close to or exceeding 100% by 2014.  And a recent working paper by the Bank for International Settlements (BIS) projects “debt/GDP ratios to 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”.  The BIS paper clearly states that “without a change in policy, the path is unstable”.   Given the correlation between rising deficits and diminished growth, the first and rather obvious conclusion is that ever increasing thresholds of debt are unacceptable for any sovereign nation (that wishes to grow).  If economic growth diminishes with debt-to-GDP ratios above 90%, just imagine what might happen to growth should debt-to-GDP explode beyond 150%.   One can argue that there are historical examples, such as the United States post WWII and modern day Japan, where debt-to-GDP ratios north of 100% did not lead to economic calamity.  However, we would counter that the debt built up to win WWII led to one of the greatest peace dividends and periods of prosperity that our country has ever known.  Today’s build up of debt in the United States is very different.  And we do not know of any investor or economist that aspires to be more like Japan.  So, we start with the simple premise that deficits must be curbed, at least to levels below the 90% threshold.

The fundamental question is how.  How do we reduce deficits and debt-to-GDP ratios to acceptable levels?  Interestingly, the IMF estimates that only approximatley one-tenth of the projected debt increase results from “discretionary fiscal stimulus”.  So, winding down crisis-induced  stimulus will “not come close to bringing deficits and debt ratios back to prudent levels”.  As much as bailouts, stimulus packages and quantitative easing campaigns make the news more interesting, they are not the primary culprits to our growing deficit problem.  That said, it is expected that companies will repay bailout monies, that stimulus packages will cease and quantitative easing will end.  Using the IMF estimates then, the United States is well on its way to tackling at least 10% of the problem.  

The other 90% of the solution will be found in the following four areas: government spending, entitlement spending, tax policy and economic growth.  Think of all these factors on a continuum, where nations have the choice of raising or lowering government spending, increasing or reducing entitlements, increasing or decreasing taxes and stimulating economic growth or not. 

Before turning to specifics of the United States, let’s again return to Greece.  Greece no longer has any real choice.  They have surpassed the 100% debt-to-GDP ratio and their growth has suffered as a result.  There is little they can do to grow their way out of their debt crisis.  Before them is a “bailout” package from the IMF and fellow EU nations that will require severe austerity measures and major debt restructuring so that Greece can meet its debt obligations.  Greece must reduce government spending.  Greece must drastically reduce entitlements and Greece must live with higher taxes.  The only other alternative may be for Greece to secede from the EU, turn on the drachma printing press and effectively become a banana republic.  The bond vigilantes now hold the cards in Greece and have made it impossible for Greece to fund its future obligations in the same fiscally irresponsible manner as it had in the past. 

At press time, the EU and International Monetary Fund jointly unveiled a $955 billion “shock and awe” bailout plan for Greece and any other European country that may find itself in the same boat.  The EU is essentially sending a bold statement to the markets in general and bond vigilantes in particular that sufficient liquidity will be available to support ailing EU nations.  However, $440 billion of the bailout is to be borrowed, set up in a “special purpose vehicle” and loaned out as needed, country by country.  While mandatory austerity measures are part and parcel to the deal, the EU is kicking the can down the road by “solving” the debt crisis with even more debt.  Further, the European Central Bank has decided to start buying member government debt, joining the Federal Reserve in a massive quantitative easing campaign.  With these “all-in” moves, the EU has decided to protect its solidarity at all costs. With bond traders no longer willing to hold Greek and other troubled member’s debt, absent these new guarantees, the EU has resorted to “monetization” and the seemingly inevitable result will be inflation.  The risk to such a strategy is the means by which potential future inflation may be curbed.  The BIS working paper warns that “fighting rising inflation by tightening monetary policy would not work, as an increase in interest rates would lead to higher interest payments on public debt, leading to even higher debt” and “in the absence of fiscal tightening, monetary policy may ultimately become impotent to control inflation, regardless of the fighting credentials of the central bank.”  

Now, let’s take a closer look at the United States.  The 2011 Obama budget takes the U.S. gross debt to 103% of GDP by 2015, well over the statistically important 90% precipice.  This budget was passed before the passage of the recent healthcare reform bill and does not include approximately $5 trillion of Fannie and Freddie debt obligations, even though these two government sponsored enterprises (GSEs) were nationalized during the economic crisis.  The Health and Human Services Department announced on April 22^nd that the President’s health care reform plan raises projected spending on health care by 1% over 10 years, disputing claims to the contrary that the bill would lower health care costs.  The true cost of health care reform aside, if we add Fannie and Freddie’s debt to our gross debt, the present debt-to-GDP ratio for the U.S. would be 125%.  Without Fannie and Freddie, www.usdebt.org estimates that the proportional share of the U.S. debt for every U.S. taxpayer at $117,733 and $41,893 for every U.S. citizen.  Including Fannie and Freddie debt, the proportional share for every taxpayer grows to $163,000 per taxpayer and $58,000 per U.S. citizen.  The United States is on a slippery slope.  We must make the right choices before it’s too late and we find ourselves facing a similar fate as Greece, under the gun of the bond vigilantes and forced to reconcile sudden and severe austerity measures.   

As a sidebar, Senator John McCain and other Republicans have proposed inclusion of Fannie and Freddie reform in the financial industry overhaul legislation now under debate in Congress.  The proposed McCain amendment would significantly reduce Fannie and Freddie’s mortgage portfolios, following a mandate that government conservatorship end within 30 months.  Should the companies be unable to stand on their own post-conservatorship, they would be placed into receivership and liquidated.  We believe that this is precisely the kind of initiative that we need to see from Washington.   

Again, it’s not too late for the Unites States and we have important choices before us to make sure that we do not follow the path of Greece.  In the 2011 budget, 55% is spent on “mandatory” entitlement programs such as Social Security, Medicare and pension benefits for government employees.  Approximately 40% of the budget falls under the “discretionary” category which is negotiated by the President and Congress each year, half of which includes military spending.  The final 5% of our budget is spent on interest payments to service our national debt.  Ironically, this portion of the budget spent to service our debt declined year-over-year even as debt levels mushroomed due to the historically low level of interest rates.   

To turn the tide in the United States, a combination of three potential solutions is likely.  Let’s go back to our “solutions continuum” where 90% of the attack must take place.  It seems clear to us that, at a minimum, the United States must reduce government spending and reduce entitlement spending or be prepared to live with much higher taxes.  As for the potential for growth to become an important part of the solution, this will be especially difficult as our debt burden grows above the 90% threshold.  We would further make the case that higher taxes, on the margin, will dampen growth prospects.  In other words, it seems that the only way that the growth continuum can be triggered to stimulate is through reduced government spending and stable taxes.  In his budget, President Obama pegs growth expectations at 2.5%.  Even this may prove optimistic if we continue down our current, unsustainable path.  In all likelihood, higher taxes will play a role in helping reduce the deficit, at least under the present administration.  So, especially in a post-crisis, “new normal” economic environment, it will be very difficult to stimulate growth as a tool to bring down the deficit and our national debt.  The trigger points that are the most likely candidates, then, are to reduce discretionary government spending, reduce “mandatory” and entitlement spending and raise taxes.       

The lion’s share of reform, however, must come from reduced entitlement spending.  At 55% of total expenditures, mandatory and entitlement spending is already our largest budgetary item.  Due to the swelling number of aging Baby Boomers, spending on just Social Security and Medicare have grown from 28% in 1988 to 34% in 2008, and is expected to reach just under 40% by 2019.  These percentages do not include the President’s recent health care reform package and further does not include spending on other mandatory items  such as Medicaid, food stamps, unemployment compensation, student loans and retirement and disability programs for government employees and military personnel.  Entitlement reform should at least include raising the retirement age for Social Security eligibility and means-testing, if not an outright reduction in benefits.  Interestingly, the aforementioned BIS working paper suggests that raising the retirement age may lead to an increase in personal consumption, a beneficial side effect that may help nudge the growth continuum. 

As Greek citizens take to the streets of Athens, protesting the reduction of their entitlements and accusing the government of squandering their nation’s prosperity, we are heartened by the fact that, unlike Greece, we still have choices.  We still have it within our control to make the hard decisions that will bring our great nation back to the path of fiscal responsibility and conservatism.  Perhaps greater than any other issue, this is why the November elections loom so large.  Voters need to ask themselves which candidate and which party is more likely to support measures that will reduce discretionary government spending, reduce mandatory and entitlement spending and promote growth.   If voters and our elected officials do not make the hard choices, the bond vigilantes will eventually serve notice and force us to reform our ways.  With a higher debt burden and vigilante-induced higher costs to service that debt, the percentage of our budget spent on interest payments will skyrocket and force the tough choices.  The canary in a coal mine that we witness today, this Greek tragedy, has provided ample warning for our political leaders and should serve as a wake-up call.   In fact, Greece may actually be a harbinger for the beginning of the end of big government.  November’s elections should bear testament to this possibility.  The end of big government and return of fiscal conservatism would mark a watershed event for our markets that, combined with the underlying economic recovery underway, could unleash a very powerful, durable bull run in stocks.         .