Posted on Thursday, February 17, 2011
I THINK the US will face a financial market backlash against its fiscal outlook when most but not necessarily all of these conditions are present. First, there has to be more progress on deleveraging. Until private sector borrowing returns to more normal levels, there won't be anything for federal deficits to crowd out. Second, foreign central banks would have to materially reduce their purchases of US Treasuries. Third, other developed countries need to make progress in addressing their fiscal challenges. Think of Mohamed El-Erian's line about Treasuries being the least dirty shirt in the laundry. Finally, Washington has to demonstrate it isn't going to make the necessary changes to bring deficits down to sustainable levels. The most likely inference from the behaviour of forward rates (I'm thinking of the 10-year Treasury yield 5 or 10 years forward, going back several years) is that markets at least implicitly assume US policymakers will deal with the deficit when they have to (as they have in the past).
Anyone following the US budget debate over the last several weeks will tell you that you can put a check next to the last factor. The chances that Washington would act on longer-term deficits in advance of a financial market crisis were always low, but they went lower in the last month or so. Republicans made aggressive proposals to cut non-security domestic discretionary spending programmes, a budget category that does not contribute at all to the longer-run deficit problem. Rather than try to broaden the debate to include medium-term entitlement and tax changes, President Obama decided to confine the battle to these same programme areas.
In short, what the economy could use is a debate over medium-term entitlement and tax changes. Instead what it's getting is a debate over near-term non-security discretionary spending. There's a risk the economy gets too little deficit reduction in the longer run and too much in the near term.
My own guess is that the deleveraging of the US economy will not proceed so fast as to produce a budget crisis in financial markets any time soon, possibly until after the 2012 election. But I wouldn't bet a lot on that, and prudent policymaking would try to head off a financial market crisis by putting in place policy changes to take effect a few years from now. And incredible as it may seem, markets are giving US policymakers an enormous benefit of the doubt, such that it shouldn't take much in the way of medium-term policy changes to validate this market assumption, but Washington looks set to fall short of even that
Tom Gallagher, THE ECONOMIST