Friday, February 22, 2013

UPDATED--"U.S. Facing 'Unmanageable' Debt Situation Over Next Decade, Paper Warns"

In other news, Khloe Kardashian fired from X Factor....

Update below.
Here's the Wall Street Journal:
The U.S. may be facing an economic and financial catastrophe if it isn't able to get government spending under control, a paper written by key economists warns.

The researchers argue the government may soon reach a point where its borrowing levels will set in motion a vicious and destructive surge in financing costs that will get worse the more that gets borrowed. Collateral damage to this dynamic will be the Federal Reserve's ability to provide support to the economy.
"The problems facing the U.S. in the next decade could easily escalate into an unmanageable situation," the paper said.

The paper was written by David Greenlaw, of Morgan Stanley, James Hamilton of the University of California, San Diego, Peter Hooper of Deutsche Bank, and former Fed governor Frederic Mishkin, now of Columbia University. It was to be presented Friday at a conference in New York, held by University of Chicago Booth School of Business.

The paper arrives as U.S. elected officials struggle to deal with a goal both parties say they agree on: deficit reduction. But sharp, nearly intractable divisions on achieving this have left the U.S. lurching from crisis to crisis. Officials are now trying to deal with a series of legally mandated, deep government spending cuts set to kick in on March 1. But even with those spending cuts, the long-term outlook remains worrisome as entitlement spending on a growing pool of retirees threatens large and persistent deficits well into the future.
At the same time, Federal Reserve officials are facing their own set of difficulties. Bond buying aimed at stimulating the economy has pushed the institution's balance sheet to $3 trillion and these holdings will almost certainly grow further. The Fed says no one should fear the inflationary potential of the balance sheet because it can pay banks to keep excess cash on the Fed's balance sheet.

The problem is that this power, employed at a time where rates are rising generally, could become very expensive to wield. The current large profits could turn into unprecedented losses for the Fed, and a breakdown in confidence in the government's fiscal conditions would make this dynamic even worse.
The paper's authors based their cautionary tale on a study of 20 countries over the past 12 years. They found "a significant relation between debt loads and borrowing costs, with a one-percentage-point increase in debt as a percent of gross domestic product being associated with a 4.5-basis-point increase in the yield on 10-year government bonds in a linear specification."

They also find that borrowing costs can start to spiral out of control. "Countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration," they write. In the U.S., the rise in government borrowing costs would be mostly driven by worry over inflation, rather than outright default, the authors said.

Right now, the Congressional Budget Office expects, based on current law, that there will be a few years of falling deficits followed by a return of the rising red ink. Ten years from now, total government debt will equal 77% of GDP and will be set to rise further, testing the limit the paper warns about.

The authors warn the Fed faces future trouble based in large part on the very possible surge in market based rates tied to a loss of confidence in the fiscal outlook. They reckon that by 2017 and 2018, the Fed will be losing "sizable" amounts of money...MORE 
The Financial Times' Money Supply blog has more:
Federal Reserve: QE3, exit strategy and the fiscal crisis
...This is the money chart. Black is the baseline for Fed profit and loss in the coming years. Red is what happens if a fiscal crunch pushes up long-term bond yields (and hence causes losses for the Fed on its portfolio).
Interest rates that are one percentage point higher from 2016 would add $86bn to cumulative Fed losses. Rates two percentage points higher would add $169bn....MORE
See also:
Interest Outlays and Average Maturites of U.S. Debt
Of Debt and Interest Rates: This Ain't No Party, This Ain't No Disco
Geographic Areas to Short When the Debt Bomb Goes Off 
The Economist's Interactive Guide to Government-debt Dynamics