Where there's smoke: fantasists ignoring the fire

IN the words of a veteran investor, watching the US bond market today is like sitting in a packed theatre and smelling smoke. You look around for signs of other nervous sniffers. But everyone else seems oblivious.

Yes, the federal government shut down last week. Yes, we are less than a fortnight away from the point when the Treasury secretary says he will run out of cash if the debt ceiling isn't raised. Yes, bond king Bill Gross has been on TV warning that a default by the government would be "catastrophic". Yet the yield on a 10-year Treasury note has fallen slightly over the past month (though short-term T-bill rates have ticked up).

Part of the reason people are not rushing for the exits is that the comedy they are watching is horribly fascinating. In his vain attempt to stop the Senate striking out the defunding of Obamacare from the last version of the continuing resolution, freshman senator Ted Cruz managed to quote Doctor Seuss while re-enacting a scene from the classic movie Mr Smith Goes to Washington.

Meanwhile, President Barack Obama has become the Hamlet of the West Wing: one minute he's for bombing Syria, the next he's not; one minute Larry Summers will succeed Ben Bernanke as chairman of the Federal Reserve, the next he won't; one minute the President is jetting off to Asia, the next he's not. To be in charge, or not to be in charge: that is the question.

According to conventional wisdom, the key to what is going on is a Republican Party increasingly at the mercy of the Tea Party. I agree that it was politically inept to seek to block Obamacare by these means. This is not the way to win back the White House and Senate. But responsibility also lies with the President, who has consistently failed to understand that a key function of the head of the executive branch is to twist the arms of legislators on both sides.

It was not the Tea Party that shot down the Summers nomination as Fed chairman; it was Democrats such as Senator Elizabeth Warren, the new face of the US Left. Yet, entertaining as all this political drama may seem, the theatre is burning.

The fiscal position of the federal government is much worse today than realised. As anyone can see who reads the most recent long-term budget outlook -- published last month by the Congressional Budget Office, and almost entirely ignored by the media -- the question is not if the US will default but when.

True, the federal deficit has fallen to about 4 per cent of GDP from its 10 per cent peak in 2009. The bad news is that, even as discretionary expenditure has been slashed, spending on entitlements has continued to rise -- and will rise inexorably in coming years, driving the deficit back up above 6 per cent by 2038.

A very striking feature of the latest CBO report is how much worse it is than last year's. A year ago, the CBO's extended baseline series for the federal debt in public hands projected a figure of 52 per cent of GDP by 2038. That figure has nearly doubled to 100 per cent. A year ago the debt was supposed to glide down to zero by the 2070s. This year's long-run projection for 2076 is above 200 per cent. In this devastating reassessment, a crucial role is played here by the more realistic growth assumptions used this year.

As the CBO noted last month in its 2013 Long-Term Budget Outlook, echoing the work of Harvard economists Carmen Reinhart and Ken Rogoff: "The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline.

"Those economic differences would lead to lower federal revenues and higher interest payments . . . At some point, investors would begin to doubt the government's willingness or ability to pay US debt obligations, making it more difficult or more expensive for the government to borrow money. Moreover, even before that point was reached, the high and rising amount of debt that CBO projects under the extended baseline would have significant negative consequences for both the economy and the federal budget."

Just how negative becomes clear when one considers the full range of scenarios offered by CBO for the period from now until 2038. Only in three of 13 scenarios does the debt shrink from its current level of 73 per cent of GDP. In all the others it increases to between 77 and 190 per cent.

It should be noted that this last figure can reasonably be considered among the more likely of the scenarios, since it combines the alternative fiscal scenario, in which politicians in Washington behave as they have done in the past, raising spending more than taxation.

Only a fantasist can seriously believe this is not a crisis. The fiscal arithmetic of excessive federal borrowing is nasty even when relatively optimistic assumptions are made about growth and interest rates. Currently, net interest payments on the federal debt are about 8 per cent of revenues. But under the CBO's extended baseline scenario, that share could rise to 20 per cent by 2026, 30 per cent by 2049, and 40 per cent by 2072. By 2088, the last date for which the CBO now offers projections, interest payments would -- absent any changes in current policy -- absorb just under half of all tax revenues.

The question is what on earth can be done to prevent the debt explosion. The CBO has a clear answer: "(B)ringing debt back down to 39 per cent of GDP in 2038 -- as it was at the end of 2008 -- would require a combination of increases in revenues and cuts in non-interest spending (relative to current law) totalling 2 per cent of GDP for the next 25 years . . .

"If those changes came entirely from revenues, they would represent an increase of 11 per cent relative to the amount of revenues projected for the 2014-2038 period; if the changes came entirely from spending, they would represent a cut of 10.5 per cent in non-interest spending from the amount projected for that period."

Anyone watching the shenanigans in Washington will grasp at once the tiny probability of tax hikes or spending cuts on this scale. It should be clear that what we are watching in Washington is not a comedy but a game of Russian roulette with the federal government's creditworthiness.

So long as the Fed continues with the policies of near-zero interest rates and quantitative easing, the gun will likely continue to fire blanks. After all, Fed purchases of Treasurys, if continued at their current level until the end of the year, will account for three-quarters of new government borrowing.

But the mere prospect of a taper, beginning in late May, was already enough to raise long-term interest rates by more than 100 basis points. Fact (according to data in the latest "Economic Report of the President"): more than half the federal debt in public hands is held by foreigners. Fact: just under a third of the debt has a maturity of less than a year.

Hey, does anyone else smell something burning?