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Weekly Economic Commentary
Northern Trust
By Carl Tannenbaum
April 19, 2013


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The world’s public debt is much larger than it may appear

April 19, 2013

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  • The world’s public debt is much larger than it may appear
  • The lines have been drawn in the U.S. budget debate
  • Rates of disability are affecting labor force participation

 

When I landed my first job, it presented a Catch-22. To earn my salary, I had to wear suits to the office. But being broke at the time, I wouldn’t have the money to buy the suits until I started to draw a salary. Fortunately, my company opened a charge account for me (secured by my future wages and not my good name). Those first three suits lasted me more than a year … at the end, they could stand up all by themselves.

I viewed getting that first credit card as quite an achievement. It was a personal endorsement, a reflection of trust. While I was lucky to get a fast track to approval, creditworthiness is typically established only over time. But it can be lost quickly, and once lost, it is difficult to restore.

Sustaining support from your financiers requires transparency. Obfuscation can be very damaging; Lehman Brothers and the Greek government learned that lesson the hard way.

Today, governments rely on the ongoing support of investors and (in some cases) international agencies to remain solvent. Keeping the confidence of those creditors requires candor about the full depth of leverage and prospects for repayment. And yet governments around the world often cloud these issues. This practice presents risks to investors and the financial system.

There are three areas where a clear line of sight into public indebtedness is difficult to obtain. First, government entities astride or below the Federal level often borrow considerable sums that are not always well accounted for in the assessment of national debt. In the United States, state and local government debt represents an additional 19% of our GDP, on top of the 73% of GDP the U.S. Treasury owes. In Europe, local borrowing varies across countries, but is generally more modest.

weekly econ commentary 04192013 chart 1
 
Obligations at these two levels are often aggregated. But the debts are secured by different revenue streams, depend on different economic conditions and carry different ratings. Calling on resources at one level to service borrowing at another often runs into political and legal roadblocks. There could therefore be pockets of insolvency even amid a broad picture which seems unthreatening.

Second, many governments have explicit or implicit responsibility for debts incurred by businesses and consumers. In the United States, government agencies have assured the repayment of home loans to investors in many mortgage-backed securities, assumed the credit risk for students and taken on exposure to small businesses. Elsewhere in the world, state-owned or state-guaranteed companies accumulate debt for their operations that could ultimately become a Federal responsibility.

In particular, many governments have become owners or conservators of leading financial institutions over the last five years, at a time when those institutions were insolvent. Consolidation of liabilities in these cases can add substantially to national debt. This commingling of bank and sovereign obligations created a particularly pernicious feedback loop in Cyprus, for example.

Finally, governments have significant obligations under public pension and health care systems that are not well disclosed. These longer-term burdens threaten to bankrupt providers.

Global pension accounting standards do an incomplete job of reflecting the economics of retirement plans, typically allowing generous assumptions to assess the present value of future obligations and long periods to restore any funding shortfalls. Even by these low standards, public pension systems in the United States are in serious difficulty.

weekly econ commentary 04192013 chart 2
 
More shockingly, a recent report from the Pew Center estimated that state governments in the United States have set aside only 5% of the money they will need to pay for retiree medical benefits.

In Britain, the government has been sparring with the International Monetary Fund over the calculation of its national pension liability, but it adds considerably to national debt. Other countries across the globe are facing a similar situation.

As time and demography work to bring these obligations from the shadows into the light, the stress on public budgets will be substantial. As states consider the best way to address these issues, the political dynamic will continue to be a complication: legislators typically have a short time until their next election, while the consequences of inactivity are further into the future.

But the distance between these two horizons is narrowing, and promises made long ago are soon to come due. Unless states recognize these fully, disclose them properly and deal with them promptly, the retirement of debt and the populace will not be secure.

The 2014 U.S. Federal Budget – Will They Strike a Compromise?

The President, House Republicans and Senate Democrats each have published their 2014 federal budget plans, which are essentially wish lists. Only parts of their budget proposals have a chance to become the law of the land.

Looking at the broad contours, the White House budget continues to record deficits over the next 10 years, but their magnitude is smaller than what would occur under current law. This plan results in a declining path of the federal debt as a percent of GDP during the next 10 years, with the level holding over 70%.

Spending cuts in the House Republican budget result in a balanced federal budget by the end of the next decade with federal debt falling to less than 60% of GDP (see charts below).

weekly econ commentary 04192013 chart 3 
 
Trajectories of receipts and outlays of both budgets over the next 10 years point to significant differences. On the spending side, the House Republican budget reduces outlays by $6.2 trillion from the current baseline over 10 years. A repeal of the Affordable Care Act, conversion of Medicare to a voucher program, and reductions in Medicaid, food stamps, and college tuition grants are a few of the sources of spending reductions. The ambition to cap Medicare expenses is noteworthy, given that these expenses are growing noticeably faster than overall inflation.

weekly econ commentary 04192013 chart 4
 
Outlays as a percent of GDP in the White House budget remain above the historical norm during the entire decade despite the $1.8 trillion reduction in the deficit. Upgrades of highways, bridges, airports and seaports account for part of the increase in spending.

Yet members of Congress have had little success in cutting spending over the past generation. In fact, they are in the process of watering down automatic expense cuts under the sequester as the impact of individual elements becomes apparent. Further, steep cuts in spending will have a sharper impact on short-term economic growth.

Suzanne Shier, Northern Trust’s Director of Wealth Planning and Strategy, has published an in-depth commentary on individual tax implications of the White House budget. The House Republican budget aims to overhaul the tax code to only two brackets for individual income tax (10% and 25%) from the current structure of seven tiers. The simplification of the tax code is a laudable goal given its current complexity. But the plan does not shed light on how to recover the possible loss in revenues from adopting a lower top rate compared with current top rate of 39.6%, if the plan has to remain revenue neutral.

Projections of revenues as a percent of GDP in the White House budget exceed the 18% historical mean, partly due to real GDP forecasts (2.9%, 10-year average) that are higher than the Congressional Budget Office’s estimate of 2.7% over the next 10 years. The rosy forecast should be viewed with caution.

The vastly different preferences pertaining to outlays and receipts suggest that a budget compromise in the weeks ahead will be difficult to achieve. Looming over the process is the debt ceiling, which we will next hit in July or August.

The U.S. Labor Force Participation Rate – Unsolved Puzzle

 

The U.S. labor force participation rate (LFPR) peaked at 67.3% in January 2000 and has declined steadily since, with the March 2013 reading at 63.6%. This sustained downward trend lacks a well-grounded explanation. It is widely accepted that the aging of the population, the growing number of discouraged workers and an increase in the count of disabled individuals could be part of the explanation.

In 2012, 8.8 million workers received benefits from the Social Security Disability Insurance Program (SSDI); which is roughly 6.0% of the labor force. The SSDI program has recorded a 3.8 million increase in the number of beneficiaries between 2000 and 2012, with 45% of the gain occurring since the Great Recession commenced in 2007. The cost of workers’ disability benefits was close to $35 billion for the four years ended in 2011. The 50- to 64-year-old age cohort accounted for 65% of disability insurance beneficiaries in 2011. This share has climbed steadily in the past few years (see chart).

 

weekly econ commentary 04192013 chart 5 
Is there a relationship between the challenging employment situation and the increase in disability insurance beneficiaries? What is the likelihood that those currently on disability will be able to return to work? A more detailed analysis of data from the SSDI program is essential to identify the nature of disability in this group of workers to answer these sorts of questions.

It is important to identify the reasons for the downward trend of LFPR because it would enable a better understanding of the unemployment rate. If those who have left the labor force are likely to come back, then official jobless rates will fall more slowly as those who had been discouraged resume job searches. If retirement and disability are depressing participation more permanently, then we may be closer to full employment than previously thought.

 

(C) Northern Trust

www.northerntrust.com

 

 

 

 

 

 

 

 

 


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