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Commentary By e21 Staff

The Threat the Obama Budget Poses to American Households

Economics Tax & Budget

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As President Obama acknowledged in a town hall in Nashua, New Hampshire, the deficits proposed in his fiscal year 2011 budget “won’t just burden our kids and our grandkids decades from now. They could damage our markets now, they could drive up our interest rates now, they could jeopardize our recovery right now.” While the President apparently understands the risks presented by his budget, his Administration shows no willingness to confront them. Instead, his Treasury Secretary warns that failing to run a sufficiently large deficit would “risk driving the economy back into recession, causing immense additional harm to middle-class families and making it even harder to fix our fiscal problems.” As early as last March – when the economy was contracting at a 6.4% annual pace – CEA Chair Christina Romer was warning about the risks of reducing the deficit too swiftly.

The supposed “lesson of 1937,” when Congress raised taxes and cut spending in the midst of the Depression, is that the government needs to run massive deficits until the private sector is well into a self-sustaining recovery. But what if creditors stop buying the bonds used to finance these deficits before the self-sustaining recovery comes about?

Depression Deficits Don't Compare to Today's

There are two important distinctions with the 1930s that the Obama Administration tends to ignore. First, the U.S. currently has an external debt (both public and private) of $13.7 trillion or 95% of gross domestic product (GDP). In the 1930s, the country did not depend on external creditors to finance its deficits. Secondly, from 1930-1937, government “gross saving” – roughly equal to the budget deficit – averaged (negative) 1.3% of GDP and reached a peak of 3.5% of GDP in1937 before the government took the contractionary fiscal action Romer criticizes. By contrast, the 2009 deficit was 10% of GDP and next year’s is forecast to be 8.3%. In 2020 the deficit is still expected to be 4.2% of GDP – 20% larger than the 1937 deficit.

Even if one believes that excessive federal spending were the way out of the crisis, the federal government faces constraints on its ability to finance deficits that did not exist in the 1930s. In the past week, both Moody’s has warned that the U.S. is at risk of losing its Aaa credit rating because of rising debt levels. While the U.S. is unlikely to face a full-blown currency crisis because $10.7 trillion, or 78%, of the U.S. external debt is dollar-denominated, the risk of a precipitous decline in the trade-weighted value of the dollar and higher interest rates is very real. What is the likely impact of this scenario on American households?

Trade-weighted Dollar Index

1. Higher Gasoline Prices

The U.S. dollar rebounded dramatically during the 2008 financial crisis as investors sold risky assets to buy dollars, which continued to be perceived as a safe haven, even amidst the U.S. economic and market turmoil. Once the worst part of the crisis subsided, the dollar resumed its downward trajectory. Until concerns arose about a potential Greek sovereign default and its implications for the euro, the dollar seemed destined to retest its lows from 2008.

American households have been impacted by this foreign exchange volatility, whether they realized it or not. Dollar weakness causes the price of globally-traded commodities, like oil, to rise because the prices of these commodities are denominated in dollars. As the dollar loses value relative to other currencies, the global purchasing power of oil exporters declines and oil becomes relatively less expensive for other importing countries. As a result of these two factors, the dollar price of oil adjusts upwards and American households face higher prices at the pump.

The graph below shows the relationship between the trade-weighted value of the dollar and the inverse of the price of a regular gallon of gasoline (because the dollar and gasoline prices move in opposite directions, the correlation is better captured graphically by using the inverse of the gasoline price). While the relationship is not perfect, it’s clear that if the dollar weakens due to concerns about debt levels, gasoline prices will rise. If the dollar breaks through the lows of mid-2008, when gasoline was over $4 per gallon, prices could exceed $5 per gallon.

Gasoline Prices and the Dollar

2. Higher Mortgage Rates

Treasury must issue bills, notes, and bonds to roll-over existing debt and cover new deficits. Eventually, the sheer magnitude of the required issuance will result in higher interest rates. Since all other interest rates are priced based on their “spread” over the Treasury rate, higher borrowing costs for the federal government will mean higher interest rates for corporate and household borrowers. Since 1980, the yields on Baa corporate bonds have been 2.23 percentage points higher than Treasury yields, on average. During the same period, the 30-year prime mortgage rate has been, on average, 1.8 percentage points higher than the 10-year Treasury note. If a downgrade or creditor pressure causes Treasury rates to increase to the historic spread with Aaa corporate bonds (1.1%), mortgage rates would rise from the current 5.03% coupon to 6.65%. This would translate to $3,700 in higher annual interest costs on a $300,000 mortgage. Interest rates on credit cards and other debt obligations would also reset upwards, further compromising household cash flows.

Spreads Over Treasury

3. Higher Taxes

In its budget, the Administration forecasts (tables S.2 and S.3) that the effective interest rate on the public debt will stay below 4% until 2015 and average 3.86% over the ten-year window.This is an exceptionally rosy scenario considering the following: if the effective rate increased by the historic Aaa corporate spread over Treasuries (1.1%), the cumulative ten-year impact of the higher (and more rational) interest costs would be $1.7 trillion.

Higher Interest Increases Outlays by $1.7 trillion

If a modest increase in interest rates added $1.7 trillion to the federal budget, the inevitable shortfall would almost certainly be met with higher taxes. Given that the increase in debt is forecast to come even with the expiration of much of the Bush tax cuts, the tax burden required to finance this increase in net interest costs would be truly staggering.

4. Less Wealth

Finally, it is important to recognize that as the putative “risk-free” rate, Treasury yields are of enormous consequence to the prices and required returns of all other dollar-denominated assets. The more investors earn on Treasuries, the less incentive they have to assume the risks associated with other assets (all else equal). In fact, a well-known model used by the Federal Reserve explicitly links the level of stock prices to the ten-year Treasury bond. The “Fed model” predicts that, at equilibrium, the “earnings yield” on the S&P 500 – the profits of all 500 companies divided by the level of the index – should equal the ten year Treasury yield.

 

Treasury Rates Impact Stock Market Values

If Treasury rates increase by a percentage point due to debt concerns, so too must the earnings yield. Assuming corporate income remains unchanged, the only way for the earnings yield to rise is through a decline in the value of the stock market. Higher Treasury yields would cause investors to sell stocks and buy Treasuries until the “equilibrium” is restored. While sophisticated traders might be able to re-allocate capital across asset classes to protect their portfolio from adverse price movements, households locked into diversified stock portfolios through 401(k) plans would see the value of their holdings fall in response to an increase in interest rates.