RSS FeedBy M. Isi Eromosele
The global financial crisis has led to vast deterioration in government budgets worldwide, with the International Monetary Fund (IMF) estimating the G-20 fiscal deficits at 5.5 percent of gross domestic product (GDP) above their pre-crisis levels. About one-third of this increase is directly related to crisis related expenditures, with the rest cyclically driven. This could lead to a surge in debt ratios of the G-20 countries of about 40 percentage points by 2014, a level not seen since the Second World War.
In the United States, the extraordinary deficit projection is being driven by a combination of cyclical pressures and secular problems, ranging from the loss of tax revenues during the recession to the long simmering crisis of health care costs and social security entitlement commitments. While the dollar has been weakening, it has supported exports and can be helpful to long-term rebalancing of global growth. To properly manage the deficit levels in the future, countries would need to articulate their plans to restore their fiscal solvency after the global recovery gains firm traction. Otherwise, the negative implications for economic growth, interest rates and world currencies could be substantial.
Investment Implications Of Huge Deficits
Rapidly rising deficits raise the risk of inflationary pressures, rising interest rates, currency weakness and reduced economic growth. A review of the relationship between real long-term interest rates and the budget deficits does find a correlation of 0.40 – meaning the real interest rates have tended to rise when budget deficits worsen. The International Monetary Fund’s work on the impact of deficits on interest rates and growth presents a similar and worrisome picture. According to their calculations, a 10 percentage point increase in government debt ratios would lead to a 0.40 percent increase in real interest rates and a 1.3 percent decline in real GDP. Considering that they have projected a 25 percentage point increase in the debt/GDP ratios of the G-20 countries between 2007 and 2014, this would be a real drag on global economic growth.
Interest Costs Of Huge Deficits
Interest costs on deficits can be affected by both investor concern about the risk of inflation thereby demanding a higher interest rate and a country’s ability to pay the interest without having to issue additional debt. Interestingly, total interest cost on the U.S. budget deficit has only risen from $241 billion in1999 to $253 billion in 2009, while the debt held by the public during this period increased from $3.7 trillion to $5.9 trillion. There was clearly been benefit from a lower cost of debt: a simple calculation of the effective interest rates shoes a favorable decline from 6.5 percent to 4.4 percent over this ten-year period.
Can The Dollar Withstand A Debt Surge
Over the past 40 years the U.S. Dollar has had a clear tendency to weaken during periods of budget deterioration. During periods when the U.S. budget deficit was improving, the dollar gained an annualized 1.1 percent based on the Dollar Index. In the period when the budget deficit was worsening, the dollar fell at a 3.3 percent annualized rate. The ability of the United States to finance its deficits has been helped tremendously by the dollar’s status as the global reserve currency. While there has been much discussion about the need for an alternative reserve currency, the practical reality is that there is really no viable alternative to the dollar in the near future.
As we review the longer-term economic outlook for the global economy, we have a base assumption that growth will be constrained by the negative impacts of increasing deficits.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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