Tuesday, November 30, 2010

US federal debt may trigger next crisis

Nov 29, 2010

By Sheila C. Bair

TWO years ago, the United States experienced its worst financial crisis since the 1930s. The crisis began on Wall Street, where misguided bets on risky mortgage loans resulted in enormous losses that few anticipated. More than four million jobs were lost in just six months after the peak of the crisis. There is hardly one Main Street in America not still feeling its effects.

Even as work continues to repair America's financial infrastructure and get the economy moving again, urgent action is needed to forestall the next financial crisis. I fear that one will start in Washington. Total federal debt has doubled in the past seven years, to almost US$14 trillion (S$18.5 trillion). That's more than US$100,000 for every American household. This explosive growth in federal borrowing is a result of not just the financial crisis but also government unwillingness over many years to make the hard choices necessary to rein in America's long-term structural deficit.

Retiring baby boomers, who will live longer on average than any previous generation, will have a major impact on government spending. This year, the combined expenditures on Social Security, Medicare and Medicaid are projected to account for 45 per cent of primary federal spending, up from 27 per cent in 1975. The Congressional Budget Office projects that annual entitlement spending could triple in real terms by 2035, to US$4.5 trillion in today's dollars.

Defence spending is similarly unsustainable, and America's tax code is riddled with special-interest provisions that have little to do with broader economic prosperity. Overly generous tax subsidies for housing and health care have contributed to rising costs and misallocation of resources.

Unless something is done, federal debt held by the public could rise from a level equal to 62 per cent of gross domestic product this year to 185 per cent in 2035. Eventually, this relentless federal borrowing will directly threaten financial stability by undermining the confidence that investors have in US government obligations.

Financial markets are already sending disquieting signals. The cost for bond investors and others to purchase insurance against a default by the US government rose markedly during the financial crisis, from an annual premium of less than 2 basis points in January 2007 to 100 basis points early last year, before falling to the current level of 41 basis points.

With more than 70 per cent of US Treasury obligations held by private investors scheduled to mature in the next five years, an erosion of investor confidence would lead to sharp increases in government and private borrowing costs. And while the US enjoys a uniquely favoured status today - investors still view US Treasury securities as a haven during crises - events in Greece and Ireland should serve as a warning. The yields on their long-term government securities have risen from rough parity with US Treasury obligations in early 2007 to levels that are hundreds of basis points higher.

If investors were to similarly lose confidence in US public debt, we could expect high and volatile interest rates to impose losses on financial institutions that hold Treasury instruments, and to raise the funding costs of depository institutions, which can be highly vulnerable to interest rate shocks.

Recent proposals by the co-chairs of the National Commission on Fiscal Responsibility and Reform and by the Bipartisan Policy Centre represent credible first steps towards recognising and addressing the nation's fiscal problem. Both propose to reduce and cap discretionary spending, enact comprehensive tax reform, reduce mandatory spending on health care and other programmes, and ensure the long-term solvency of Social Security.

Fixing these problems will require a bipartisan national commitment to a comprehensive package of spending cuts and tax increases over many years. Most of the needed changes will be unpopular, and they are likely to affect every interest group in some way. The changes will have to be phased in as the economy continues to recover from the effects of the financial crisis.
Establishing a comprehensive plan now would demonstrate a firm commitment to the type of long-term budget discipline that will be needed to preserve America's credibility in the global financial markets and a stable banking sector at home.

The writer is chairman of the United States Federal Deposit Insurance Corp.


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