The Sovereign Debt Waterfall Part 2 - The United States

   In my previous article, I introduced the metaphor of a country's sovereign debt as being like a canoe on a river approaching a waterfall. Greece was described as being perched half-on, half-off the edge of the waterfall, with bailouts from other European countries keeping it from going over the edge, but not pulling it back upstream. In April of 2010, when Greece reached the edge of the waterfall, their national debt was about 140% of the Gross Domestic Product (GDP), and their annual budget deficit was 11%. Austerity measures imposed by Greece have brought their deficit down to 8% of GDP, and this week's European bailout agreement specified that private investors would only get half of their money back on Greek bonds. The result is that Greek debt is now 120% of GDP. So is 120% debt and 8% annual deficit enough to escape the debt waterfall? Probably not, especially when Greek GDP is currently contracting in a recession. To back away from the waterfall, a country's annual GDP growth plus its inflation rate has to exceed its deficit.
   Let's talk about that equation a bit: deficit must be less than GDP growth plus inflation if you want to back away from the waterfall. The first thing to emphasize is that inflation is not a good tool to solve a deficit problem, despite what the equation seems to imply. In the United States, the entitlements which make up most of the government's spending are indexed to inflation. So if inflation increases, that spending area increases just as fast, and no progress is made on reducing the deficit. Inflation also causes stuff to cost more, so all the stuff the government buys costs more and as a result, very little progress can be made on the debt problem by trying to produce inflation. To realistically make the equation work in a country's favor, a country must make its GDP growth rate larger than its deficit.
   Here is a comparison of some countries' debts and deficits. These are 2010 figures except for Greece and the U.S. For the other countries, the situation is a little worse in 2011 but I don't have the latest figures. These figures are from CIA Factbook.
Country            Debt        Deficit
Japan            197%    -7.7%
Greece            120%    -8.0%
Italy                119%    -4.6%
United States        99%        -9.0%
Ireland            96%        -32.4% (not a typo)
Portugal            93%        -9.2%
France             82%        -6.9%
Germany            83%        -3.3%
United Kingdom    76%        -10.2%
Israel            74%        -3.8%
Spain            61%        -9.2%
South Korea        22%        1.2 (surplus)

   Each country in the table has its own unique factors, so the table by itself doesn't tell everything one needs to know. But this can be said: only two countries on this list are moving away from the waterfall. They are South Korea, the star of the lineup, with the lowest debt and an actual surplus. Israel is an example of a country that used to have a debt at 100% of GDP and has run a deficit every year since, but the country's GDP has grown faster than its debt and it continues to do so. I did not put China on the list, because although it looks good, its finances are so opaque that the numbers might be misleading or simply false.
   Here are a few other comments. Japan by all measures should have gone over the waterfall already, but they haven't due to some unique factors. They continue to be able to finance their debt at very low interest rates, but it cannot continue forever. The so called PIIGS (Portugal, Ireland, Italy, Greece, Spain) countries are in trouble for varying reasons. Ireland was doing OK until they chose to bail out their banking system. If they had let it fail, there would have been repercussions to be sure, but by moving their bank's debt onto their national balance sheet they increased the risk to their government balance sheet (this is why their deficit was -32% last year). The healthiest major European country is Germany, but even they are moving toward the waterfall, just at a slower rate and with a bit more distance than the others.
   So can the U.S. avoid the waterfall? I wish we could, but I doubt it. At the current pace, we will catch up with Greece in a little over two years. While one would hope that the Republican majority in the House of Representatives would exercise spending restraint, this year's government spending (fiscal year 2011) was 5.4% larger than last year's. And that was with all the fuss over government shutdowns, debt ceilings, etc. We can't reduce the deficit if we spend a lot more each year than the year before. The reason we spend more each year despite all that is that our entitlement system (mostly Social Security, Medicare, Medicaid) is locked into fixed payments to qualifying people, and the pool of qualifying people is growing rapidly as the population ages.
   The Republican Presidential candidates are not campaigning on specific plans to cut spending, preferring to focus more on exciting tax plans like 9-9-9 or a flat tax. Neither of those will help the spending problem. The Republicans tend to address spending only in the abstract, such as favoring a balanced budget amendment. By the time we ratify a balanced budget amendment, it will be too late. We will have already gone over the edge.
   So my conclusion is that we are headed over the edge of the waterfall. I don't know how long it will take to get there, and suspect that a number of the Europeans will get there first. I would guess it might take three years, but if we slip into a strong recession we will get there more quickly. A strong economic recovery would postpone the day of reckoning. There are a lot of government proposals that are scored in terms of what it means for our budget situation by 2020. I can't imagine we will make it to 2020 before encountering the crisis.