The economy of the next few years could well make the long stagnation of the early 1990s look like a boom. Although as recently as last year pundits were brushing off concerns about the savings rate, it would be a lot easier to float the proposed $700 billion if our savings rate were 8% instead of 0%. The restructuring of our financial landscape will have to be accomplished at the same time as the wrenching shift away from debt-supported consumption as the driving force of our economy, and, as we have stressed many times, restoring economic growth and competitiveness will require higher levels of public and private investment. This all makes it especially galling to contemplate spending $700 billion in an attempt to salvage the debts racked-up in yesterday’s unproductive housing/consumption boom. In fact, the economic effect of this bailout is pretty much the same as dumping the money into the deep blue sea.
Much commentary has focused on what the proposed $700 billion bailout will mean for the U.S. fiscal situation and the bond market. Though clearly federal finances would be a lot better if the government weren’t going to spend all that money, it does look like the government can handle the borrowing, and the bond market might even rally over the longer term (after taking an initial hit). We’ve got lots of problems, but the debt itself is probably manageable.
The two graphs below show the U.S. government’s budget balance and total debt outstanding, both expressed relative to GDP. Note that if you add the assumed $700 billion cost of the bailout (4.9% of GDP) to the likely 2008 federal deficit (2.9% of GDP), you get a total deficit of 7.8% of GDP. This is quite large by recent standards; the highest it got in the 1980s was 6.0% in 1983. It’s nothing next to the World War II deficits, which maxed out at 30.3% of GDP in 1943, but that was a special case, to put it mildly.
Debt levels, though, look a lot more modest. Total debt held by the public is around 37.9% of GDP this year; adding 4.9% to that takes us to 42.8%, well below the recent high of 49.4% in 1993. The gross debt figures are higher, mainly because of the large amounts of Treasury paper being accumulated by the Social Security system. That might be a problem someday, but not for at least a decade or two.
As for the bond market, the only thing approaching a precedent we have for that is the Resolution Trust Corporation, which bought up the bad debts of the S&Ls. It was created in August 1989—almost a year before the cyclical peak. As the graph below shows, yields on the 10-year rose over the next year, and then began a long decline, as the credit crunch and economic stagnation took hold.
Between the cyclical peak in interest rates in September 1990 and the credit crunch low in October 1993, the real total return on bonds was 88% (price plus yield deflated by the CPI). Of course, rates were much higher in those days; the yield on the 10-year was 8.89% in September 1990, for example. So it’s not likely we’ll see a real total return so high in the coming years. But it does suggest that worries about an inflationary spike in interest rates may be overdone. And debt levels were considerably higher in those days: they rose from 40.6% of GDP in 1989 to 49.4% in 1993—in other words, the starting point in 1989 was only 2 points below the projected effects of a $700 billion/4.9% of GDP bailout.
We’ve got a lot of challenges ahead, but we should be clear on exactly what they are.
—Philippa Dunne & Doug Henwood