Of Public and Private Virtues and Vices
September 11, 2008
By Joachim Fels & Manoj Pradhan | London
Morgan Stanley acted as advisor to the United States Department of the Treasury in its announced restructuring of the Federal Home Loan Mortgage Corporation (‘Freddie Mac’) and the Federal National Mortgage Association (‘Fannie Mae’).
Please refer to notes at the end of the report. From prudence to profligacy: A very likely consequence of the financial crisis and the related global economic slowdown is that in many countries fiscal balances will deteriorate and the public debt will increase. This would reverse a powerful global trend towards shrinking budget deficits or growing surpluses, which had led to a stabilisation or even outright declines in government debt/GDP ratios in recent years. Should we be worried? Some of it is automatic: To some extent, shrinking budget surpluses or wider deficits would simply reflect the workings of the built-in automatic stabilisers in tax and welfare systems. As demand slows and unemployment rises, tax revenues decline and public spending on unemployment and other welfare benefits increases. This cushions the impact of the economic downturn on private households’ income and spending. Allowing fiscal balances to ‘breathe’ over the economic cycle makes sense as it tends to dampen economic fluctuations. This is why most fiscal rules nowadays aim at balancing the budget (or targeting a certain deficit or surplus) on average over the course of the cycle rather than in each single year. But governments should also become more fiscally active: However, in economic downturns, governments hardly ever just sit back and watch the workings of the built-in automatic stabilisers. Rather, they try to stimulate demand with counter-cyclical measures such as tax cuts or spending programmes. The problem with such measures is that they often come too late because it takes time to realise that a recession is in fact happening, to decide on the appropriate policies, to get parliamentary approval, and finally to implement them. Due to these lags, the economic stimulus often only arrives when economies are already recovering. The swift US action on tax rebates… Yet, if policymakers anticipate a slowdown early on and are able to act quickly, countercyclical fiscal policy can make a difference. The swift tax rebates for US households implemented earlier this year are a case in point: while it remains difficult to estimate precisely how much of the rebates were spent, they very likely helped to stabilise household spending at a time when consumers were hit by soaring energy prices and reduced credit availability over the summer. ...may find followers elsewhere: With the economic slowdown having gone global and monetary policy in many countries constrained by elevated inflation rates, more and more governments are likely to try to emulate the US example of providing temporary tax relief for battered consumers. Thus, budget deficits will likely swell due not only to the built-in stabilisers, but also active countercyclical fiscal measures in many countries, especially if, as we believe, this downturn will be a protracted one that won’t be followed by a vigorous economic recovery (see “A Different Type of Downturn”, The Global Monetary Analyst, September 3, 2008). Bail-outs and rescues pile on public debt: Beyond traditional fiscal policy, some governments have had to step in as lenders of last resort for insolvent or struggling financial institutions. Earlier this year, the UK government nationalised Northern Rock, a mortgage lender, effectively increasing the government’s gross financial liabilities. The US Treasury’s decision this past weekend to place Freddie Mac and Fannie Mae in conservatorship, to insert fresh capital, establish a secured lending facility and start buying MBS in the open market also implies a rise in the government’s explicit and implicit liabilities in the coming years (for details of the plan and its likely economic implications, see R. Berner et al, GSE Rescue Plan: Market and Economic Implications, September 8, 2008). With the financial crisis still in full swing and the unfolding global economic downturn causing additional problems for battered financial institutions, it seems likely that some governments elsewhere will be forced to perform similar rescue operations before the crisis ends. Important longer-term consequences: Against this backdrop, public sector debt in a large number of countries looks set to increase in coming years, both in absolute terms and relative to GDP. This raises two issues: one about the potential inflationary consequences, and another about the longer-term economic outlook. Debt expansion not inflationary per se… On the first issue, it is important to note that rising public debt levels are not per se inflationary. Just because the government expands its budget deficit, or takes liabilities of the private sector onto its own balance sheet, doesn’t create inflation. This is because (in the industrial economies at least) the government doesn’t have access to the money-printing press. As long as the central bank doesn’t monetise the public debt, fiscal policy cannot have a lasting impact on inflation. …as long as central banks don’t monetise: In this context, it is also important to point out that, contrary to some commentators’ views, the US Treasury’s rescue plan for the GSEs should not be equated to the Japanese central bank’s quantitative easing policy earlier this decade. The latter involved a major expansion of high-powered money (cash and bank balances held with the central bank). By contrast, the US Treasury’s injection into the GSEs and the MBS buying will not be financed by the Federal Reserve but will come out of tax revenues or higher debt issuance. Each dollar that the government spends cannot be spent by somebody else (the taxpayer or the buyer of the government bond), so there is no direct inflationary impact. But long-term inflation risks rise: However, it is also worth noting that while there is no direct inflationary impact from the current fiscal easing and expansion of government liabilities, rising government debt levels may lead to pressures on central banks to keep interest rates low and monetise (some of) the public debt at some stage in the future. The big inflations of the past have often been preceded by a rapid deterioration of public finances, which raised the incentives for governments to resort to printing money and thus engineering higher inflation. While the chances of such a chain of events in the near future are very slim, investors need to factor in a higher inflation risk over longer time horizons emanating from rising government debt levels. You borrow more, I borrow less: Another implication of rising public debt levels is that at some stage people should start to worry about the consequences for future taxes, either for themselves or future generations, and will likely start to spend less and save more. Thus, private households may try to offset the rising public sector debt by reducing private debt. Why? An increase in indebtedness on the part of the government means that households will likely have to pay higher taxes in the future. Households that are either liquidity-constrained or have higher preferences for current consumption may disregard this worry, but others may try to reduce their indebtedness as public debt rises. This would likely weigh down on private spending and asset prices. The experience of Germany and Japan over the past two decades serves to illustrate this point. The explosion of government debt in both countries during the 1990s either coincided with (in the case of Japan) or was followed by (in the case of Germany) a peaking out and then a decline of private households’ indebtedness. Thus, the expansion of the public sector balance sheet was mirrored by a contraction in the private sector balance sheet (always relative to GDP). From private to public debt expansion: Intriguingly, the opposite happened in the US and in the UK in this decade: as the public sectors’ liabilities relative to GDP shrank, consumers and homeowners filled the void and took on more debt. But that was then. Deflating house prices, the credit crisis and rising unemployment severely curtail consumers’ ability to take on fresh credit right now. And with government debt levels likely to rise, the private sector should also be less willing in the future to take on new debt because, apart from death, the only certainty in life is higher (future) taxes. Bottom line: Following many years of improving fiscal balances in many countries, public indebtedness is likely to rise in the next several years as governments try to cushion the economic downturn and are forced to serve as lenders of last resort to insolvent or troubled financial institutions. While this should help to prevent a deep recession, it raises two issues. First, rising debt levels raise long-term inflation risks because future generations of central bankers may face more pressure to monetise public debt. Second, rising public debt levels will likely curtail the willingness of the private sector to take on more debt and could thus weigh down on spending and asset prices over the medium term.
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US Budget and Treasury Financing Outlook: Not a Pretty Picture, but Manageable
September 11, 2008
By David Greenlaw & Ted Wieseman | New York
Morgan Stanley acted as advisor to the United States Department of the Treasury in its announced restructuring of the Federal Home Loan Mortgage Corporation (‘Freddie Mac’) and the Federal National Mortgage Association (‘Fannie Mae’). Please refer to notes at the end of the report. The US budget deficit is headed higher – even before considering the impact of the GSE rescue plan. In F2008, which comes to an end this month, we estimate that the deficit will be US$420 billion (or 2.9% of GDP). This is up from US$162 billion in F2007. The big swing factors over the past year were the fiscal stimulus package and macroeconomic factors which led to a slowdown in tax collections from individuals and corporations. Also, defense spending rose at a more rapid pace than in prior years. The outlook for the budget deficit over the next couple of years seems even more uncertain than usual due to a deteriorating US economy and looming political changes. Moreover, a new potential swing factor emerged over the weekend. The GSE rescue plan is almost certain to contribute to a larger near-term budget deficit. However, while the extent of the impact is uncertain, we suspect that it will be smaller than seems to be currently assumed by many market participants. In particular, we believe that there is a great deal of confusion surrounding one particular aspect of the plan – the US$200 billion of potential preferred stock purchases. We have come across some media reports that leave the impression that these funds have already been committed or soon will be. In fact, we see a relatively low probability that any purchases will occur in the near term, and even over the longer run, the amounts involved are likely to be relatively modest. This reflects the fact that the purchases are only triggered if the value of the enterprises’ assets falls below that of their liabilities using GAAP. The CBO recently estimated that the GSEs had combined GAAP-based net worth of US$55 billion. Thus, even if mortgage defaults continue to rise, it will take some time to work through this capital base. In our view, the key aspect of the GSE rescue plan with regard to the impact on the federal budget will be the amount of MBS buying conducted by the Treasury. Obviously, there is considerable uncertainty on this matter since the Treasury has not offered any guidance beyond an indication that there will be an initial US$5 billion purchase of MBS later this month. We are assuming a total of US$75 billion of MBS purchases over the next year or so, but the actual amount could be much greater or much smaller, depending on market conditions and the Treasury’s commitment to driving mortgage spreads tighter. The bottom line is that we look for the F2009 budget deficit to rise to US$540 billion (3.7% of GDP), and in 2010 our estimate is US$450 billion (2.9% of GDP). We show the historical trajectory of the deficit/GDP ratio. The outlook is gloomy – but hardly unprecedented. Also, we provide the details underlying the current budget situation. Here are the important assumptions that are embedded into our budget estimates: • Treasury purchases US$75 billion of MBS in F2009 (with prepayments of about 10% annually thereafter); • Treasury purchases US$25 billion of GSE preferred stock – most of it in F2010; • FDIC net outlays of US$20 billion in both F2009 and F2010 (assumes gross outlays of US$30 billion in each year with accompanying US$10 billion in paydown of working capital); • No additional fiscal stimulus. Such action is possible, but not probable, in our view; and • Extension of AMT fix. Note that our budget deficit estimates for 2009-10 are somewhat larger than those just published by the CBO. This is due to a number of factors. First, our near-term outlook for the US economy is weaker than that of the CBO. Second, the CBO’s estimates do not include an extension of the AMT fix. Third, the CBO assumed only US$20 billion of outlays for the GSEs. Fourth, the CBO’s estimate for FDIC outlays is lower than our own. In the longer run, we expect tax rates for individuals to go up after 2010 regardless of who wins the election. This, together with a recovering economy and a likely flattening out of defense spending, should help to bring the budget deficit back down to US$300 billion or so by 2012. Obviously, the US still faces severe budget pressures beyond that point due to sharply escalating outlays for Medicare and Social Security, but these forces don’t become too drastic until later in the decade. At the August refunding, the Treasury debt managers indicated that they were considering the introduction of an additional reopening of 10-year notes each quarter, together with a shift to quarterly issuance of new 30-year bonds. At present, 10-year notes are reopened once per quarter while new long bonds are issued semi-annually, with smaller reopenings in the subsequent quarter. These changes seem likely to be formally adopted at the November refunding announcement. This should help to meet some of the funding gap that we now see in F2009. At current sizes, the extra 10-year reopenings in F2009 would raise US$36 billion, and bond issuance would rise by about US$7 billion annually. However, the bulk of the new money required in the upcoming fiscal year is actually expected to come from the recent resumption of 1-year bill issuance – probably at somewhat larger sizes than at present. Specifically, we look for 1-year bill sizes to be hiked to US$22 billion by February (versus US$20 billion at present). Also, 3- and 6-month bill sizes are likely to drift higher, with the bill share of outstanding Treasury debt expected to rise from 27% at present to about 30% by 2010. The last time the bill sector comprised that much of the Treasury market was in the early 1980s. However, a relatively large bill sector is consistent with the considerable near-term uncertainty that exists on the budget front. The average maturity of the debt outstanding is expected to slip to 4.0 years over the next couple of years – versus 4.2 currently. The cash raised in the bill sector, combined with the shifts in 10-year and long bond issuance, and slightly higher 2-year and 5-year note sizes, should be sufficient to accommodate the deterioration in the budget picture that we see over the next year or so. The 3-year point on the curve probably represents another potential source of increased supply, but we do not see a clear need for a reintroduction of this maturity at present. Finally, in an interesting twist to the GSE story, CBO Director Peter Orszag is now arguing that the entire operations of Fannie Mae and Freddie Mac “should be directly incorporated into the federal budget”. If this change is made, the revenue of the GSEs would be treated as federal government receipts and their expenditures as federal government outlays – with an adjustment for the manner in which credit transactions (such as a mortgage guarantee) are typically reflected in the federal budget. This proposal is sure to stir a great deal of controversy. For what it’s worth, we don’t really see strong justification for such a change. More importantly, we believe that even if such a change does occur, it should not have any meaningful market impact because it is essentially a definitional change. The supply effect that carries market relevance comes from the MBS purchases by the Treasury and/or preferred stock buying that we discussed earlier, not from rolling all of Fannie and Freddie’s income statement into the overall federal budget. One caveat – it’s conceivable that such a change might generate so much confusion that it would raise concerns about the US government’s credit rating. However, we doubt that the Treasury’s AAA rating will be seriously threatened.
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