The Latin American region is home to countries with lower levels of public debt, healthy commodity endowment, as well as elevated growth potential. As a result, the large economies currently face little pressure from the bond market (Chart 5), with the exceptions of Venezuela and Argentina which have unique bond market challenges of their own. Mexico has a need for significant fiscal reform leading to less reliance on PEMEX revenue, but due to lower debt/GDP levels (under 40%), Mexican sovereign debt has yet to be punished.
The more typical fiscal challenge in the region is the one currently faced by Brazil, and to a lesser extent Peru. As the throes of the financial crisis spread in 2008, many predicted that Latin American economies would be acutely affected and among the last to recover. We now know that to have been an incorrect prophecy, but that mindset resulted in quite ambitious fiscal packages to head off the crisis. In many places, those packages have now become decidedly pro-cyclical and risk doing much more long-term harm than good. In Brazil, central government expenditures and transfers as a percent of GDP have increased from 19% in March 2008 to over 24% in March of this year (despite GDP growth) and new infrastructure spending programs are still coming down the pike. This year and next are filled with big elections on the South American continent and cutting back on spending will be difficult, especially when capital is still affordable. But, if the Latin American economies are to weather the next storm as well as they did the past one, fiscal consolidation must begin by next year, or in Brazil’s case, the day following the October presidential election.
Chart 5
United States: Pressing Fiscal Problems Need to be Addressed Despite Safe Haven Status
Which brings us, finally, to the U.S. The rally in the bond market since the European crisis unfolded is a reflection of the safe haven status of the U.S. economy, and there still is no threatening message about U.S. sovereign debt from credit default swaps. However, even the U.S. economy cannot continue to function without paying heed to its looming federal deficit and debt problems. The Congressional Budget Office (CBO) baseline estimates of March 2010 point to a lower federal deficit as a percent of GDP in 2010 from the historical high mark of 9.9% in 2009. CBO projections into 2020 indicate that the federal deficit will drop to about 3.0% by 2013 but persist in that neighborhood until 2020. The nation’s federal debt is projected to climb to nearly 68% of GDP by 2020 from 53.0% in 2009. The implications of growing deficits are three fold: (1) it crowds out private sector investment and erodes the future standard living of the nation; (2) it reduces budget flexibility; and (3) it raises the risk of high interest rates.
U.S. fiscal policy is on an unsustainable path and minor meddling of budgetary options is unlikely to solve the problem. In order to avert a major crisis over the medium-term and not jeopardize the well being of the nation, policymakers will have to make stark choices in the quarters ahead. However, it will be politically impossible to implement new policies until the recovery, which is only four quarters old, is fully entrenched. As the economy grows, expenditures due to automatic stabilizers will fade away and the focus on discretionary aspects of spending will be possible. At the same time, the projected costs of entitlements -- Medicare, Medicaid, and Social Security – will have to have to be addressed in the medium term. A key ingredient to change the outlook for the federal deficit is the political will to engage in addressing the causes of the fiscal challenges ahead. The CBO estimates that by 2020, Medicare, Medicaid, and Social Security will make up 47% of total outlays (33% in 2009) and net interest costs will amount to 14% of expenditures (5.4% in 2009). CBO’s computations indicate that Medicare and Social Security are the fastest growing components of federal outlays. The key to the fiscal future is designing ways to cut the rapid escalation of these costs. Forecasts of budgets and embedded economic assumptions are highly uncertain. But the important fact remains that the nation will have to employ a combination of higher taxes and reductions in expenditures to bring back deficit and debt ratios to prudent levels – or risk experiencing the kinds of bond market pressures now afflicting much of Europe.
Copyright (c) Northern Trust
