US Debt Crisis
Content
US Debt Crisis
-Rukun Tarachandani Mukul Aggarwal
Debt Overview
Budget Deficit The amount that the government spends each year in excess of what its tax, tariff, and fee revenues bring in. Government Debt Government debt is the total amount of funds that the federal government has borrowed over the years and not yet repaid. Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders). Governments usually borrow by issuing securities, government bonds and bills. Less creditworthy countries sometimes borrow directly from supranational institutions. The US national debt consists of two components: Public Debt held by the public comprises securities held by investors outside the federal government, including that held by investors, the Federal Reserve System and foreign, state and local governments. Intra Government debt comprises Treasury securities held in accounts administered by the federal government, such as the Social Security Trust Fund. Most economists consider public debt to be the real debt because when the government lends to itself, it hasn't borrowed any new funds. The money that the U.S. Treasury owes to different parts of the government, such as the Social Security Trust Funds and the Highway Trust Fund; it's purely a matter of internal government bookkeeping. The lenders to the government include banks, corporations, pension funds, private citizens, and Government agencies, as well as foreign individuals and institutions. Components of Debt Cyclical Component Spending and revenue that vary in response to economic conditions make up the cyclical component of the deficit. For instance, if business is booming, personal and corporate income both rise, generating higher tax revenue. And with unemployment falling, government spending for unemployment compensation and other social programs falls, so the cyclical component shrinks. However, if the economy is slowing or in recession, tax revenues decline and outlays go up, and the cyclical component of the deficit grows. Structural Component There are some parts of the budget that are not as sensitive to changes in the rate of economic growth. Two good examples are spending for Social Security and interest on the debt, which aren't significantly affected by unemployment and economic growth. Over the past decade, such "structural" items have become more important in the overall budget of USA. Because of this, even if the economy were operating at full employment and spending on cyclically sensitive programs were relatively low; total spending still would exceed total tax revenue, leaving US with a deficit. Debt Instruments 1) Bonds A government bond is a bond issued by a national government. Such bonds are often denominated in the country's domestic currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or
country. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. Government bonds are sometimes regarded as risk-free bonds, because national governments can raise taxes or reduce spending up to a certain point; in many cases (eg. US) they "print more money" to redeem the bond at maturity. Investors in sovereign bonds denominated in foreign currency have the additional risk that the issuer may be unable to obtain foreign currency to redeem the bonds. 2) Treasury Bills and Notes The difference between bonds and Treasury Bills or Notes is that the maturity period of bonds is greater than that of T Bills or Notes. Treasury bills are issued with three-, six-, or 12-month maturities. Notes come due in two to 10 years, while bonds mature in more than 10 years. Sovereign Debt Rating Sovereign debt rating is an indicator of the risk involved in investing in bonds issued by the national government of a country. National governments are different from companies as they can raise (or impose) taxes and undertake a number of other steps to raise money. Therefore, they are rated separately. Sovereign debt ratings are typically higher than those of corporations from the same country, as there is a lesser likelihood of a government defaulting on its payments. Debt Ceiling The debt ceiling is simply a cap on how much money the US federal government can owe. In theory, the debt ceiling is supposed to keep spending in check so that it does not exceed revenues by too much, thus maintaining the balance of power.
US Debt Crisis
Recently the financial markets worldwide were shocked with the news of US debt crisis with the unprecedented downgrading of credit ratings of US sovereign bonds from AAA to AA by S&P fearing of US government’s default on interest payments on debts. This happened for the first time in the country history which was almost unimaginable few days back. Surprisingly the bond yield on the US debt instruments is all time low showing increasing demand and faith from investors. In this article we will discuss what exactly this debt crisis is, what are the causes and what are the implications to the global economy. The crisis started with the political brinkmanship between the republicans and the government over increasing the debt ceiling i.e. $14.3t. US government wanted to increase the ceiling to meet its daily expenditure. This limit is set by US congress. US government has reached the maximum debt limit and in order to borrow more it has to pass a resolution in both houses of congress. The standoff was on whether to increase it or not and the approach which has to be followed. Under US law, an administration can spend only if it has sufficient funds to pay for it. These funds can come either from tax receipts or from borrowing by the United States Department of the Treasury. If the total expenditure exceeds the revenues collected there is a budget deficit, and the only way that the shortfall can be paid for is for the government, through the Department of the Treasury, to borrow the shortfall amount by the issue of debt instruments. In 1917, in order to provide more flexibility to finance the US involvement in World War I, Congress instituted the concept of a "debt ceiling". The US has had public debt since its inception. The debt ceiling has been raised 74 times since March 1962. U.S. Debt Limit Since 1940
In 1940, the debt limit was about $43 billion. It was raised as high as $300 billion during World War II. The debt limit has been increased 140% since 2000, when it was $6 trillion. The US debt has been constantly increasing since its inception. As the fundamental premise of American Revolution were low tax rates so the tax rates were always low in America and to cover the daily expenditure it has to borrow money. Below is the graph showing how the US debt has increased over years and in comparison to GDP.
US debt to GDP ratio since 1940
As we see the US is bridging the budget deficit by borrowing more and more debt which is a serious concern as it is not sustainable for long time. As of May 2011, approximately 40% of US government spending relied on borrowed money. The sources of this debt are public, foreign countries and social security trust funds. According to the Congressional Budget Office (CBO): "At the end of 2008, that debt equalled 40% of the nation's annual economic output (a little above the 40-year average of 37%). By the end of fiscal year 2011, the projected federal debt will reach roughly 70% of gross domestic product (GDP) — the highest percentage since shortly after World War II which is a serious concern. The debt to GDP ratio is also very high almost 98% currently. On august 3 US debt increased to more than 100% of the GDP for the first time after WW2. Let us look at some of the some of the reasons why this debt has been increasing at a fast pace in recent time: US has been recently engaged in two wars – Iraq war and Afghanistan war which is putting a lot of pressure on the budget expenditure. The defence expenditure has increased manifold and contributed majorly in fiscal deficits. President George W bush during his tenure had announced a major tax benefits to the wealthy people and big institutions causing a huge decrease in the government revenues. US has suffered from great recession in 2008. Government has spent a lot of money on bailing out the big financial institutions. It has also released fiscal stimulus to support the economy which caused a huge increase in expenditure. Large scale social programmes like public healthcare, medicare, social security programmes introduced by President Barrack Obama is also putting strains on the finances of government.
Last but the not the least is the lavish lifestyle of an American. US is the largest consumer of products in the world. Trade deficit is increasing day by day which means the imports are increasing at an increasing rate then exports. But the current debt crisis is not only an economic crisis. There is political angle to it also. There was an impasse between the government and the republicans over increasing the debt ceiling. This almost caused the default scenario if there was not a last minute deal between the two parties. The republicans wanted huge spending cuts by government especially in the social welfare programmes of the government in exchange of increase in price ceiling. They were also not in favour of increasing the tax rates to increase the government revenues. These demands were not justified though there is an urgent need to reduce the fiscal deficit by following fiscal prudence. On the other hand government initially wanted to increase the debt ceiling without any spending cuts but finally agreed to reduce the fiscal deficit by $917b over 10 years in exchange of an increase in $900b in debt ceiling.
Solutions to Debt Crisis 1) Raise Taxes and Cut Spending The obvious solution to reducing the growing US Debt would be to raise the taxes to increase revenues and to cut government spending. However some economists feel that since the US is still recovering from recession, a cut in spending and raising taxes would hamper the growth and hence the recovery. Moreover, the slow-growing economy would not be able to generate enough jobs to pull down the unemployment rate. That in turn means US will have to spend even more than expected on unemployment benefits, food stamps, Medicaid and other programs. Cuts in those programs would then become even more painful. With tax hikes likewise tax revenues will be restrained by weak consumer spending and idled labour.The ultra-conservative section of the Republicans, calling themselves the Tea Party have been blocking any efforts to raise taxes to help bring down the deficit. 2) Print more dollars US could more dollars to repay its debt obligations but this is a short-term fix to financial problems, and the downside to doing it is inflation. The more money there is in circulation, the less value a dollar has.
Implications of the crisis
Implications for US The US compromise was crucial, as an acrimonious split in both parties over how to handle the debt crisis had resulted in an impasse. Still there are concerns over whether the deal would be sufficient to fix the problems of the budget deficit. The downgrade would see US borrowing costs rise, further weakening the economy, as well as scaring off potential investors. With unemployment at about 9.2 percent, a credit rating downgrade would worsen prospects of an economic recovery and impede measures by the government to stimulate employment and spending. With federal debt expected to be at about 70 percent by the end of this year, the strain of the demands on government spending is expected to grow. Implications for global economy The deal calls for several key measures, notably spending cuts in discretionary and defence spending;the raising of the debt limit; a call for an amendment to the US Constitution that requires a balanced budget; as well as the setting up of a powerful committee to debate further possible cuts in all aspects. This was to ensure that at least US$2.1 trillion in deficit reduction would be saved by 2021. Although it seems the US is ‘too big to fail’- being the world’s largest economy, its currency the world’s reserve, and its bonds used throughout the banking system as a proxy for cash - its rating being downgraded casts a long shadow. Economists have judged that the current deal ‘falls short of the optimal outcome’ and that a downgraded credit rating would hurt, although how deeply remains to be seen. Some lessons could, however, be learned from the past: in 1998, when Japan lost its AAA rating from Moody’s, the yen fell less than 1 percent, raising the possibility that global markets may be able to accommodate a change in the US credit rating after all. Effect in Asia Already the impact of the debt crisis has been felt in Asia. Currencies such as the Japanese yen have strengthened in turn, as investors looked to the continent as the potential balancer. This is a worry for the Japanese due to fears over the impact on its export sector, leading to Tokyo’s decision to devalue the yen. Billions of dollars were also wiped off the stock markets in the aftermath, leading to some analysts to call it as ‘flashback to the 2008 recession’. Elsewhere, the central bank in South Korea increased the amount of gold it bought for the first time in 13 years, citing the need to diversify away from the greenback and towards ‘an investment class widely considered a safer bet during crises’. In Singapore, Deputy Prime Minister Tharman Shanmugaratnam has warned of a ‘tough 3 to 4 years ahead’ with sluggish growth and possible recession expected. What these events highlight is the persistent inter-dependence of the global economy, with the health of the US economy a critical factor. Japan, still recovering from the consequences of the nuclear fallout in March, can ill-afford to have a trade imbalance to add to its woes. Secondly, the world’s reserve currency has lost credibility, with South Korea’s actions suggesting an erosion of confidence in the greenback, and a need for stability in the market to prevent further landslides. The scenario of a financial domino effect worldwide is threatening to become reality. A crashing US economy would not only hurt other individual economies but also have implications for overall global stability. The question is whether there will be alternatives to stem the tide of possible financial disarray. Impact on India The Indian growth story, unlike other emerging economies, is mainly based on domestic consumption and not on exports to US or Europe. Hence the impact of the debt crisis on India will be limited. However domestic economy is not insulated from the world economy, there will definitely be some tremors here in India. Both imports and exports will be impacted. India’s exports to t he US, particularly IT services, will have an adverse impact. Any slowdown in the US will have an impact on India in terms of our ability to export. Indian exports had declined sharply in the second half of 200809 due to a slowdown in the US economy.
At the same time, there may be higher inflows of foreign institutional investor (FII) funds. This will lead to the appreciation of the rupee, which in turn will help bring down the current account deficit. The RBI has said the country has sufficient liquidity to manage a possible US sovereign debt default. The RBI is prepared for any repercussions in the financial markets arising from any such eventuality. With a reasonably strong financial system in place, India is likely to bear the shocks, as in the 2008 turmoil. Impact on Equities and Gold Prices The downgrade of US debt raised concerns over the growth of US economy. As a result most of the stock indices fell after the downgrade. The shares of companies directly linked to US economy (for example India IT companies) were hit the most. On the other hand fears for an escalation of the debt crisis drove more investors in supposedly safe investments like Gold. As a result gold touched an all time.
-Rukun Tarachandani Mukul Aggarwal
Debt Overview
Budget Deficit The amount that the government spends each year in excess of what its tax, tariff, and fee revenues bring in. Government Debt Government debt is the total amount of funds that the federal government has borrowed over the years and not yet repaid. Government debt can be categorized as internal debt (owed to lenders within the country) and external debt (owed to foreign lenders). Governments usually borrow by issuing securities, government bonds and bills. Less creditworthy countries sometimes borrow directly from supranational institutions. The US national debt consists of two components: Public Debt held by the public comprises securities held by investors outside the federal government, including that held by investors, the Federal Reserve System and foreign, state and local governments. Intra Government debt comprises Treasury securities held in accounts administered by the federal government, such as the Social Security Trust Fund. Most economists consider public debt to be the real debt because when the government lends to itself, it hasn't borrowed any new funds. The money that the U.S. Treasury owes to different parts of the government, such as the Social Security Trust Funds and the Highway Trust Fund; it's purely a matter of internal government bookkeeping. The lenders to the government include banks, corporations, pension funds, private citizens, and Government agencies, as well as foreign individuals and institutions. Components of Debt Cyclical Component Spending and revenue that vary in response to economic conditions make up the cyclical component of the deficit. For instance, if business is booming, personal and corporate income both rise, generating higher tax revenue. And with unemployment falling, government spending for unemployment compensation and other social programs falls, so the cyclical component shrinks. However, if the economy is slowing or in recession, tax revenues decline and outlays go up, and the cyclical component of the deficit grows. Structural Component There are some parts of the budget that are not as sensitive to changes in the rate of economic growth. Two good examples are spending for Social Security and interest on the debt, which aren't significantly affected by unemployment and economic growth. Over the past decade, such "structural" items have become more important in the overall budget of USA. Because of this, even if the economy were operating at full employment and spending on cyclically sensitive programs were relatively low; total spending still would exceed total tax revenue, leaving US with a deficit. Debt Instruments 1) Bonds A government bond is a bond issued by a national government. Such bonds are often denominated in the country's domestic currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or
country. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. Government bonds are sometimes regarded as risk-free bonds, because national governments can raise taxes or reduce spending up to a certain point; in many cases (eg. US) they "print more money" to redeem the bond at maturity. Investors in sovereign bonds denominated in foreign currency have the additional risk that the issuer may be unable to obtain foreign currency to redeem the bonds. 2) Treasury Bills and Notes The difference between bonds and Treasury Bills or Notes is that the maturity period of bonds is greater than that of T Bills or Notes. Treasury bills are issued with three-, six-, or 12-month maturities. Notes come due in two to 10 years, while bonds mature in more than 10 years. Sovereign Debt Rating Sovereign debt rating is an indicator of the risk involved in investing in bonds issued by the national government of a country. National governments are different from companies as they can raise (or impose) taxes and undertake a number of other steps to raise money. Therefore, they are rated separately. Sovereign debt ratings are typically higher than those of corporations from the same country, as there is a lesser likelihood of a government defaulting on its payments. Debt Ceiling The debt ceiling is simply a cap on how much money the US federal government can owe. In theory, the debt ceiling is supposed to keep spending in check so that it does not exceed revenues by too much, thus maintaining the balance of power.
US Debt Crisis
Recently the financial markets worldwide were shocked with the news of US debt crisis with the unprecedented downgrading of credit ratings of US sovereign bonds from AAA to AA by S&P fearing of US government’s default on interest payments on debts. This happened for the first time in the country history which was almost unimaginable few days back. Surprisingly the bond yield on the US debt instruments is all time low showing increasing demand and faith from investors. In this article we will discuss what exactly this debt crisis is, what are the causes and what are the implications to the global economy. The crisis started with the political brinkmanship between the republicans and the government over increasing the debt ceiling i.e. $14.3t. US government wanted to increase the ceiling to meet its daily expenditure. This limit is set by US congress. US government has reached the maximum debt limit and in order to borrow more it has to pass a resolution in both houses of congress. The standoff was on whether to increase it or not and the approach which has to be followed. Under US law, an administration can spend only if it has sufficient funds to pay for it. These funds can come either from tax receipts or from borrowing by the United States Department of the Treasury. If the total expenditure exceeds the revenues collected there is a budget deficit, and the only way that the shortfall can be paid for is for the government, through the Department of the Treasury, to borrow the shortfall amount by the issue of debt instruments. In 1917, in order to provide more flexibility to finance the US involvement in World War I, Congress instituted the concept of a "debt ceiling". The US has had public debt since its inception. The debt ceiling has been raised 74 times since March 1962. U.S. Debt Limit Since 1940
In 1940, the debt limit was about $43 billion. It was raised as high as $300 billion during World War II. The debt limit has been increased 140% since 2000, when it was $6 trillion. The US debt has been constantly increasing since its inception. As the fundamental premise of American Revolution were low tax rates so the tax rates were always low in America and to cover the daily expenditure it has to borrow money. Below is the graph showing how the US debt has increased over years and in comparison to GDP.
US debt to GDP ratio since 1940
As we see the US is bridging the budget deficit by borrowing more and more debt which is a serious concern as it is not sustainable for long time. As of May 2011, approximately 40% of US government spending relied on borrowed money. The sources of this debt are public, foreign countries and social security trust funds. According to the Congressional Budget Office (CBO): "At the end of 2008, that debt equalled 40% of the nation's annual economic output (a little above the 40-year average of 37%). By the end of fiscal year 2011, the projected federal debt will reach roughly 70% of gross domestic product (GDP) — the highest percentage since shortly after World War II which is a serious concern. The debt to GDP ratio is also very high almost 98% currently. On august 3 US debt increased to more than 100% of the GDP for the first time after WW2. Let us look at some of the some of the reasons why this debt has been increasing at a fast pace in recent time: US has been recently engaged in two wars – Iraq war and Afghanistan war which is putting a lot of pressure on the budget expenditure. The defence expenditure has increased manifold and contributed majorly in fiscal deficits. President George W bush during his tenure had announced a major tax benefits to the wealthy people and big institutions causing a huge decrease in the government revenues. US has suffered from great recession in 2008. Government has spent a lot of money on bailing out the big financial institutions. It has also released fiscal stimulus to support the economy which caused a huge increase in expenditure. Large scale social programmes like public healthcare, medicare, social security programmes introduced by President Barrack Obama is also putting strains on the finances of government.
Last but the not the least is the lavish lifestyle of an American. US is the largest consumer of products in the world. Trade deficit is increasing day by day which means the imports are increasing at an increasing rate then exports. But the current debt crisis is not only an economic crisis. There is political angle to it also. There was an impasse between the government and the republicans over increasing the debt ceiling. This almost caused the default scenario if there was not a last minute deal between the two parties. The republicans wanted huge spending cuts by government especially in the social welfare programmes of the government in exchange of increase in price ceiling. They were also not in favour of increasing the tax rates to increase the government revenues. These demands were not justified though there is an urgent need to reduce the fiscal deficit by following fiscal prudence. On the other hand government initially wanted to increase the debt ceiling without any spending cuts but finally agreed to reduce the fiscal deficit by $917b over 10 years in exchange of an increase in $900b in debt ceiling.
Solutions to Debt Crisis 1) Raise Taxes and Cut Spending The obvious solution to reducing the growing US Debt would be to raise the taxes to increase revenues and to cut government spending. However some economists feel that since the US is still recovering from recession, a cut in spending and raising taxes would hamper the growth and hence the recovery. Moreover, the slow-growing economy would not be able to generate enough jobs to pull down the unemployment rate. That in turn means US will have to spend even more than expected on unemployment benefits, food stamps, Medicaid and other programs. Cuts in those programs would then become even more painful. With tax hikes likewise tax revenues will be restrained by weak consumer spending and idled labour.The ultra-conservative section of the Republicans, calling themselves the Tea Party have been blocking any efforts to raise taxes to help bring down the deficit. 2) Print more dollars US could more dollars to repay its debt obligations but this is a short-term fix to financial problems, and the downside to doing it is inflation. The more money there is in circulation, the less value a dollar has.
Implications of the crisis
Implications for US The US compromise was crucial, as an acrimonious split in both parties over how to handle the debt crisis had resulted in an impasse. Still there are concerns over whether the deal would be sufficient to fix the problems of the budget deficit. The downgrade would see US borrowing costs rise, further weakening the economy, as well as scaring off potential investors. With unemployment at about 9.2 percent, a credit rating downgrade would worsen prospects of an economic recovery and impede measures by the government to stimulate employment and spending. With federal debt expected to be at about 70 percent by the end of this year, the strain of the demands on government spending is expected to grow. Implications for global economy The deal calls for several key measures, notably spending cuts in discretionary and defence spending;the raising of the debt limit; a call for an amendment to the US Constitution that requires a balanced budget; as well as the setting up of a powerful committee to debate further possible cuts in all aspects. This was to ensure that at least US$2.1 trillion in deficit reduction would be saved by 2021. Although it seems the US is ‘too big to fail’- being the world’s largest economy, its currency the world’s reserve, and its bonds used throughout the banking system as a proxy for cash - its rating being downgraded casts a long shadow. Economists have judged that the current deal ‘falls short of the optimal outcome’ and that a downgraded credit rating would hurt, although how deeply remains to be seen. Some lessons could, however, be learned from the past: in 1998, when Japan lost its AAA rating from Moody’s, the yen fell less than 1 percent, raising the possibility that global markets may be able to accommodate a change in the US credit rating after all. Effect in Asia Already the impact of the debt crisis has been felt in Asia. Currencies such as the Japanese yen have strengthened in turn, as investors looked to the continent as the potential balancer. This is a worry for the Japanese due to fears over the impact on its export sector, leading to Tokyo’s decision to devalue the yen. Billions of dollars were also wiped off the stock markets in the aftermath, leading to some analysts to call it as ‘flashback to the 2008 recession’. Elsewhere, the central bank in South Korea increased the amount of gold it bought for the first time in 13 years, citing the need to diversify away from the greenback and towards ‘an investment class widely considered a safer bet during crises’. In Singapore, Deputy Prime Minister Tharman Shanmugaratnam has warned of a ‘tough 3 to 4 years ahead’ with sluggish growth and possible recession expected. What these events highlight is the persistent inter-dependence of the global economy, with the health of the US economy a critical factor. Japan, still recovering from the consequences of the nuclear fallout in March, can ill-afford to have a trade imbalance to add to its woes. Secondly, the world’s reserve currency has lost credibility, with South Korea’s actions suggesting an erosion of confidence in the greenback, and a need for stability in the market to prevent further landslides. The scenario of a financial domino effect worldwide is threatening to become reality. A crashing US economy would not only hurt other individual economies but also have implications for overall global stability. The question is whether there will be alternatives to stem the tide of possible financial disarray. Impact on India The Indian growth story, unlike other emerging economies, is mainly based on domestic consumption and not on exports to US or Europe. Hence the impact of the debt crisis on India will be limited. However domestic economy is not insulated from the world economy, there will definitely be some tremors here in India. Both imports and exports will be impacted. India’s exports to t he US, particularly IT services, will have an adverse impact. Any slowdown in the US will have an impact on India in terms of our ability to export. Indian exports had declined sharply in the second half of 200809 due to a slowdown in the US economy.
At the same time, there may be higher inflows of foreign institutional investor (FII) funds. This will lead to the appreciation of the rupee, which in turn will help bring down the current account deficit. The RBI has said the country has sufficient liquidity to manage a possible US sovereign debt default. The RBI is prepared for any repercussions in the financial markets arising from any such eventuality. With a reasonably strong financial system in place, India is likely to bear the shocks, as in the 2008 turmoil. Impact on Equities and Gold Prices The downgrade of US debt raised concerns over the growth of US economy. As a result most of the stock indices fell after the downgrade. The shares of companies directly linked to US economy (for example India IT companies) were hit the most. On the other hand fears for an escalation of the debt crisis drove more investors in supposedly safe investments like Gold. As a result gold touched an all time.
