The China Syndrome

Big deficits and rising mountains of public debt. Is it a nightmare? No, it’s the fiscal profile du jour of these United States. Or is it both? In any case, assuming Congress keeps current laws and policies intact, the federal budget deficit, as a share of the economy, is on track for fiscal 2010 to be the second highest since World War Two, the CBO projects.

“Under current laws and policies, CBO’s projections show that level climbing to 67 percent by 2020,” the government’s budget watchdog reports. “As a result, interest payments on the debt are poised to skyrocket; the government’s spending on net interest will triple between 2010 and 2020, increasing from $207 billion to $723 billion.” What’s the solution? Everyone knows what’s required, although the details of implementation will be messy, which in Washington means politics, in massive super-sized doses.

Here’s the set-up, once more by way of CBO: “To keep federal deficits and debt from reaching levels that would substantially harm the economy, lawmakers would have to significantly increase revenues, decrease projected spending, or enact some combination of the two.”

Meanwhile, Democratic leader Steny Hoyer in the House of Representatives earlier this week dropped some clues about how the majority is thinking on such matters. “”It seems to me that the only solution that can win the support of both parties is a balanced approach: one that cuts some spending and raises some revenue while avoiding extremes in either direction,” he said via Reuters. Easy to say, tough to do, especial in a mid-term election year.

Spending cuts and taxes on one side vs. rising deficits and the potential blowback for the bond market on the other. Red ink beyond a certain level will go over with the fixed-income set like a lead balloon. But for the moment, all’s calm with bond yields. The benchmark 10-year Treasury yield remains in the 3.6% range, or more or less unchanged this year. Can it last in the face of some ugly choices? The basic alternatives: Raise taxes, cut spending, both, or risk letting the federal deficit surge into uncharted and potential destabilizing territory for the economy and the markets.

As problematic as all this is, it’s even worse in the current economic climate for the simple reason that the outlook for growth is modest, at best. Meanwhile, the demand is exploding for spending on a range of fronts, from Medicare and Social Security to the war on terror to fighting the recession to the pet project du jour. The toxic combination of high spending and low growth threatens to complicate an already sour political atmosphere in Washington. You think you’ve got gridlock now? Brother, you haven’t seen anything yet. History suggests as much. As the book The Presidency and Economic Policy reminds, “When revenues grow at a slower rate than the rate of increase for federal spending, the resulting deficits make it more difficult for politicians to divide up the fiscal pie among competing programs, let alone promise the voters new benefits.”

How does all this factor into the relationship with America’s two largest creditors? Japan and China together hold about 12% of U.S. Treasuries outstanding, according to economist Michael Cosgrove. Writing in an op-ed piece today for Investor’s Business Daily, he advises:

The Chinese can lecture the administration about excessive federal outlays, but nothing would be more effective than dumping Treasuries, even for a short time. Such action would panic investors, and as a result the administration may well agree to constrain spending to placate the Chinese.

No one wants havoc in the capital markets, but the Chinese can do U.S. taxpayers a major favor by dumping Treasuries just as soon as the Chinese can buy their put options on U.S. equities. U.S. equities will quickly recover their lost ground and much more if the administration would agree to constrain federal outlays. Excessive federal spending and regulatory involvement in the economy are holding back equity gains.

The sooner the Chinese dump Treasuries, the better. It is a message that all members of Congress, as well as the Obama administration, need to hear. The Chinese needed to take such action during the Bush years, but that is water under the bridge.

The Chinese can see how the Japanese ruined their economy by growing public debt outstanding to over 225% of GDP in 2010 from 68% in 1991, according to IMF data. The U.S. outstanding public debt to GDP ratio was also 68% in 1991. In 2008 it was 70%. At the end of this year it will be about 94%.

The current Congress and administration seem intent on repeating the mistakes of Japan that in the end will also ruin the U.S. economy.

In fact, the latest numbers show that China’s appetite for Treasuries retreated a bit in December. “”In the current climate, China’s move to reduce its U.S. government debt creates a large propensity for misunderstanding,” said Shi Lei, an analyst with the Bank of China’s Global Financial Markets Department via “Even though China didn’t buy [bonds],” Shi said, “there were still many other countries willing to purchase U.S. Treasury securities.”

If that’s supposed to soothe tortured political souls in Washington, it’s not doing the trick for Eric Anderson, author of China Restored: The Middle Kingdom Looks to 2020 and Beyond. Writing yesterday for The Huffington Post, he explains:

Contrary to popular opinion, Beijing could sell that debt with few long-term consequences for China’s economy…and likely her political reputation. Such a move would cost you and I a fortune the next time we considered shopping for a car or a house…and would further expand an already outrageous national debt. Controversy can breed confusion, but in this case it should simply generate consternation…in every American household and at 1600 Pennsylvania Avenue.

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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