On December 5, Standard and Poor’s (S&P) put 15 European sovereign credit ratings on negative watch, citing in part deteriorating budget conditions, anemic economic growth and a lack of political will to deal with these problems. This echoed S&P’s explanation given for downgrading the U.S. in August. More disturbing has been the sharp rise in Italian bond yields. Italian 5-year bond yields were under 3% as recently as November 2010, under 4% as recently as June 2011. Then with frightening speed, yields suddenly spiked, trading as high as 7.75% in November. More disturbing was a lack of any specific catalyst for the spike. There was no Greek-like revelation of a big hole in their budget or some sort of political unrest. It was basically just an erosion of confidence that became self-feeding. This has American investors asking, could the same thing happen here?
The Italian crisis of confidence is indeed a cautionary tale, but the fiscal conditions in Italy, or any other of the troubled European countries, is radically different than what the U.S. faces. The key difference is growth. Italian economic growth has been anemic for a long time, with real GDP only advancing 0.6% since adoption of the common currency. Perhaps more important when considering a country’s fiscal position is nominal growth, or growth levels without considering inflation. By this measure, Italy has grown 2.5% over the same time period.
This compares with 4.2% for the U.S. According to Bloomberg, over the next two years, economists expect Italian real GDP growth at 0%, with nominal GDP growth of around 2%. To illustrate why growth is the key factor in the Italian story, imagine a country with debt/GDP of 100% facing 3% average interest cost. Let’s start by assuming the country grows spending by 4% per year, grows revenues equal to the growth in GDP. We will also assume the country starts with a primary budget that is perfectly balanced, i.e., before considering interest costs, the country is spending exactly as much as it is taking in, with any deficit being caused by interest on debt.
Figure 1. Debt/GDP Ratio Over Time: Vary GDP Growth Rate
Source: Brown Advisory internal analysis
The chart shows that the debt/GDP ratio actually declines mildly even though the country runs a persistent budget deficit. This is because the growth in GDP outpaces the growth in the debt. Mathematically, when debt/GDP is at 100% and the deficit is a function of interest on the debt, if the growth rate is higher than the interest rate, debt/GDP will fall. We see that the situation deteriorates materially if growth drops from 4% (or the U.S.’s historical nominal growth rate) to 2% (the near-term projected rate for Italy). That is because at 2% growth, interest on the debt is compounding faster than the economy is growing. Hence, debt/GDP is growing.
The situation improves modestly if the country adopts an “austerity” budget. Here this is assumed to be where spending growth is matched to GDP growth. Essentially this assures a balanced budget excluding the interest cost of servicing debt.
Figure 2. Debt/GDP Ratio Over Time: Vary GDP Growth Rate (with Austerity)
Source: Brown Advisory internal analysis
Of course, under this “austerity” assumption, there is the potential that cuts in government spending will exacerbate declining growth. In fact, once growth turns negative, the government has a special problem. The decline in GDP will shrink the government’s revenue base and all else being equal, increase the budget deficit. Attempts to cut spending and/or raise revenue would be harmful to growth, at least partially offsetting the austerity measures. For example, if Italy attempts to raise taxes such that revenue collections rise from 40% of GDP to 43% of GDP, yet GDP itself declines, the net result may be little additional revenue.
The exact link between government spending cuts and/or tax increases and economic growth is a hotly debated topic in economics. Some estimates have indicated that the government spending multiplier is around 1.5x, so any 1% cut in government spending would cause a 1.5% drop in GDP. The reality is that the multiplier probably depends on a variety of factors, such as the size of the public sector. But few debate that in the short term, cuts in government spending and/or tax increases result in a decrease in overall growth. This is tolerable when GDP growth is solidly positive. An economy growing at 4% can afford to see government spending decline by 1 to 2% of GDP and still be growing. But an economy where growth is at zero cannot afford such cuts. Just as positive growth compounds into large economic gains over time, negative growth compounds as well. Thus, in the long term, the difference between slightly positive growth and slightly negative growth is huge. In one case, the pie slowly gets bigger. In the other, it slowly gets smaller.
The bond market seems to be expressing exactly this fear about Italy. As investors see Italian growth prospects diminishing, their debt burden becomes more difficult to reduce. Thus, investors demand more and more interest to take a risk on Italy.
The U.S. is in a completely different position. The American economy is still growing. And more importantly, we have our own central bank which is committed to avoiding deflation. Thus, we can say with relative certainty that the U.S. will continue to grow at least in nominal terms. This makes improving our fiscal position relatively easy in the long term. This isn’t to diminish the political challenge of finding the specific spending cuts and revenue sources needed to close our deficit. But the fundamental condition of the U.S. remains plenty strong enough to deal with our fiscal challenge. As long as the U.S. can keep growing the economy at a reasonable pace, relatively small improvements in our fiscal condition will yield a significant improvement in our long-term debt position.
Thomas D.D. Graff, CFA
Fixed Income Portfolio Manager
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