Warnings over US debt: What lessons for the Euro area?
Newropeans Magazine - Warnings over US debt: What lessons for the Euro area?
the U.S. economy benefits from seigniorage, the difference between the face value of money and the cost to produce it.
To become a real international currency, the euro needs to gain some market shares over other currencies as a medium of exchange (oil transactions in euros?), unit of account, and reserves (official and private portfolios), which has already started. But since there is no magic in economics, what is the hidden cost? A European monetary policy tighter nowadays than the U.S. one. Does it seem familiar?
Written by Thierry Warin
Monday, 12 September 2005
Experts warn that heavy U.S. debt threatens the American economy. Figures are sometimes used in misleading ways, and policymakers often look more like Cassandra than Zadig.
As for the public debt, let’s use the OECD’s “general government gross financial liabilities” as a percentage of nominal GDP for comparisons across countries. After a drop to 58.3% in 2000, the U.S. debt rose again to 63.4% in 2004, and up to a forecast of 70% in 2006. In the meantime, the Euro area debt was steady around 77% for the same period, and is expected to decrease.
In terms of public deficit, the OECD figures display a rise in the U.S.: from 3.8% of GDP in 2002, 4.6% in 2003, 4.3% in 2004, and an expected 3.9% in 2006. The Euro area was at 1.8% in 2002, 2.5% in 2003, 2.8% in 2004, and the expected deficit is 2.7% for 2006. While 2.9% of GDP in the Euro area goes to the reimbursement of the debt, this figure is 1.8% of GDP in the U.S.. As a consequence of the debt, the part of fiscal policy used to help the economy adjust to economic shocks is alienated by debt interest payments. There is, thus, a legitimate fear that the U.S. debt will catch-up to the Euro figures. Let’s focus on the U.S. here to try to understand the experts’ warnings.
Why is the rising debt an issue for the U.S. economy? The reasons are at least threefold.
First, U.S. households cannot and do not want to save, hindering the chances to sustain the debt. Back in the 1950s, a generation of Americans saved around 8% of their income. This level moved to 7% during the 1980s, plummeted to 1.8% in 2004, and has moved close to zero in the latest estimate from the Bureau of Economic Analysis. Meanwhile, household debt represents 18% of disposable income (credit card debt alone averages $7,200 per household). Second, the U.S. has twin deficits - trade and public finance - a situation that has to be fixed. The biggest trade deficit in 2004 is with China at $162 billion (U.S. Department of Commerce), partly for exchange rate reasons (an exchange rate situation that effects Europe too); the deficit with Europe (EU15) is the next largest at $105 billion. But the U.S. economy relies more on European trade than Chinese: European exports to the U.S. in 2004 amount to $273 billion ($196 billion for China).
Third, the future seems to be gloomy: the cost of the nation’s three biggest entitlement programs (Social Security, Medicare, and Medicaid) inflates as the population grows and ages. Other things remaining constant, this will increase the public deficit as well as the public debt, leading to higher interest rates, lower investments, etc.
Has the U.S. administration some room to maneuver? The “general government total outlays” measured by the OECD is lower in the U.S. than in the Euro area: 36% of GDP and 48.6% respectively. In other words, although U.S. public spending is lower than in the Euro area, the debt is almost similar. The U.S. administration cannot spend more without further increasing the deficit as well as the debt. An alternative would be to raise taxes. One can see some room to maneuver with “general government total tax and non-tax receipts” (measured by the OECD) of 31.7% of GDP in the U.S., versus 45.8% in Euro area. Yet, households are already heavily indebted, and a rise in taxes would force them to reduce their consumption and lead to a fall in demand. Ultimately, the expected U.S. GDP of 3.6% in 2005 would steadily decrease. Notwithstanding expensive oil, this is why experts believe the debt will eventually strike the American economy.
Can we see some blue sky? Indeed, the U.S. administration can always finance the rise in debt by bonds instead of taxes. But aside from the different temporal effects, the fiscal multipliers, and the rise in interest rates, it may do something quite new to the US economy: reduce the reputation of the dollar.
With the dollar being, by far, the first international currency in the world, whatever the definition is (unit of account, medium of exchange, and reserve currency), the U.S. economy benefits from seigniorage, the difference between the face value of money and the cost to produce it. For a top-rated international currency, an expansionary monetary policy will create seigniorage with fewer inflationary pressures than a low-rated international currency. In this respect, the dollar benefits from a high reputation under the current U.S. macroeconomic conditions. The evidence is that the official reserves (excluding gold) are as low as roughly $65bn for the U.S.; world champion, Japan’s official reserves represent $832.9bn, China is next with $711bn, and the Euro area is around $200bn. Since the amount of reserves indicates a country's ability to pay international obligations, market pessimism about the U.S. debt could lead to a fall in the dollar’s reputation on international markets. This would not only reduce the ability of the U.S. administration to issue bonds to finance the rising debt, but would also reduce U.S. seigniorage, which would have to be compensated by either… new bonds or a rise in taxes. Thus, the room to maneuver seems very thin.
What are the lessons for the Euro area? It does not seem to be in much better shape than the U.S. economy. To differentiate between the US economy though, it is often said that the room to maneuver in the Euro area may come from the fact that European households are less indebted than their U.S. counterparts. The big lesson from the U.S. situation is that aside financing a part of its growth by foreign (official and private) involvement, it also relies on the benefits (direct and indirect) provided by having an international currency. Nevertheless, and although the Euro area policymakers do not seem to see it, the big hope for the Euro area rests on the international future of the euro. By gaining credibility on the international markets, the euro could bring some seigniorage to the Euro area as well as allow the Euro area to use some of its official reserves. This would provide some fresh air to Euro area fiscal policies. To become a real international currency, the euro needs to gain some market shares over other currencies as a medium of exchange (oil transactions in euros?), unit of account, and reserves (official and private portfolios), which has already started. But since there is no magic in economics, what is the hidden cost? A European monetary policy tighter nowadays than the U.S. one. Does it seem familiar?
Thierry Warin
Minda de Gunzburg CES, Harvard University
Department of Economics, Middlebury College (United States of America)
the U.S. economy benefits from seigniorage, the difference between the face value of money and the cost to produce it.
To become a real international currency, the euro needs to gain some market shares over other currencies as a medium of exchange (oil transactions in euros?), unit of account, and reserves (official and private portfolios), which has already started. But since there is no magic in economics, what is the hidden cost? A European monetary policy tighter nowadays than the U.S. one. Does it seem familiar?
Written by Thierry Warin
Monday, 12 September 2005
Experts warn that heavy U.S. debt threatens the American economy. Figures are sometimes used in misleading ways, and policymakers often look more like Cassandra than Zadig.
As for the public debt, let’s use the OECD’s “general government gross financial liabilities” as a percentage of nominal GDP for comparisons across countries. After a drop to 58.3% in 2000, the U.S. debt rose again to 63.4% in 2004, and up to a forecast of 70% in 2006. In the meantime, the Euro area debt was steady around 77% for the same period, and is expected to decrease.
In terms of public deficit, the OECD figures display a rise in the U.S.: from 3.8% of GDP in 2002, 4.6% in 2003, 4.3% in 2004, and an expected 3.9% in 2006. The Euro area was at 1.8% in 2002, 2.5% in 2003, 2.8% in 2004, and the expected deficit is 2.7% for 2006. While 2.9% of GDP in the Euro area goes to the reimbursement of the debt, this figure is 1.8% of GDP in the U.S.. As a consequence of the debt, the part of fiscal policy used to help the economy adjust to economic shocks is alienated by debt interest payments. There is, thus, a legitimate fear that the U.S. debt will catch-up to the Euro figures. Let’s focus on the U.S. here to try to understand the experts’ warnings.
Why is the rising debt an issue for the U.S. economy? The reasons are at least threefold.
First, U.S. households cannot and do not want to save, hindering the chances to sustain the debt. Back in the 1950s, a generation of Americans saved around 8% of their income. This level moved to 7% during the 1980s, plummeted to 1.8% in 2004, and has moved close to zero in the latest estimate from the Bureau of Economic Analysis. Meanwhile, household debt represents 18% of disposable income (credit card debt alone averages $7,200 per household). Second, the U.S. has twin deficits - trade and public finance - a situation that has to be fixed. The biggest trade deficit in 2004 is with China at $162 billion (U.S. Department of Commerce), partly for exchange rate reasons (an exchange rate situation that effects Europe too); the deficit with Europe (EU15) is the next largest at $105 billion. But the U.S. economy relies more on European trade than Chinese: European exports to the U.S. in 2004 amount to $273 billion ($196 billion for China).
Third, the future seems to be gloomy: the cost of the nation’s three biggest entitlement programs (Social Security, Medicare, and Medicaid) inflates as the population grows and ages. Other things remaining constant, this will increase the public deficit as well as the public debt, leading to higher interest rates, lower investments, etc.
Has the U.S. administration some room to maneuver? The “general government total outlays” measured by the OECD is lower in the U.S. than in the Euro area: 36% of GDP and 48.6% respectively. In other words, although U.S. public spending is lower than in the Euro area, the debt is almost similar. The U.S. administration cannot spend more without further increasing the deficit as well as the debt. An alternative would be to raise taxes. One can see some room to maneuver with “general government total tax and non-tax receipts” (measured by the OECD) of 31.7% of GDP in the U.S., versus 45.8% in Euro area. Yet, households are already heavily indebted, and a rise in taxes would force them to reduce their consumption and lead to a fall in demand. Ultimately, the expected U.S. GDP of 3.6% in 2005 would steadily decrease. Notwithstanding expensive oil, this is why experts believe the debt will eventually strike the American economy.
Can we see some blue sky? Indeed, the U.S. administration can always finance the rise in debt by bonds instead of taxes. But aside from the different temporal effects, the fiscal multipliers, and the rise in interest rates, it may do something quite new to the US economy: reduce the reputation of the dollar.
With the dollar being, by far, the first international currency in the world, whatever the definition is (unit of account, medium of exchange, and reserve currency), the U.S. economy benefits from seigniorage, the difference between the face value of money and the cost to produce it. For a top-rated international currency, an expansionary monetary policy will create seigniorage with fewer inflationary pressures than a low-rated international currency. In this respect, the dollar benefits from a high reputation under the current U.S. macroeconomic conditions. The evidence is that the official reserves (excluding gold) are as low as roughly $65bn for the U.S.; world champion, Japan’s official reserves represent $832.9bn, China is next with $711bn, and the Euro area is around $200bn. Since the amount of reserves indicates a country's ability to pay international obligations, market pessimism about the U.S. debt could lead to a fall in the dollar’s reputation on international markets. This would not only reduce the ability of the U.S. administration to issue bonds to finance the rising debt, but would also reduce U.S. seigniorage, which would have to be compensated by either… new bonds or a rise in taxes. Thus, the room to maneuver seems very thin.
What are the lessons for the Euro area? It does not seem to be in much better shape than the U.S. economy. To differentiate between the US economy though, it is often said that the room to maneuver in the Euro area may come from the fact that European households are less indebted than their U.S. counterparts. The big lesson from the U.S. situation is that aside financing a part of its growth by foreign (official and private) involvement, it also relies on the benefits (direct and indirect) provided by having an international currency. Nevertheless, and although the Euro area policymakers do not seem to see it, the big hope for the Euro area rests on the international future of the euro. By gaining credibility on the international markets, the euro could bring some seigniorage to the Euro area as well as allow the Euro area to use some of its official reserves. This would provide some fresh air to Euro area fiscal policies. To become a real international currency, the euro needs to gain some market shares over other currencies as a medium of exchange (oil transactions in euros?), unit of account, and reserves (official and private portfolios), which has already started. But since there is no magic in economics, what is the hidden cost? A European monetary policy tighter nowadays than the U.S. one. Does it seem familiar?
Thierry Warin
Minda de Gunzburg CES, Harvard University
Department of Economics, Middlebury College (United States of America)
posted by Marcel at 2:50 PM
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