Nouriel Roubini's Global EconoMonitor

RGE’s Wednesday Note – No Greece in the American Machine

This week’s note draws from a new RGE Analysis, “No Greece in America’s Engine,” which was pre-released to RGE Direct Access clients on Monday and is now available to all RGE clients. The following is a brief summary of some of the macro research included in the piece—the full analysis goes into much greater depth and also includes investment strategy recommendations for clients.

While the global economy is crawling out from the most severe recession and financial crisis of the post-war period, the EZ debt crisis has significantly increased the chances of a double-dip recession in Europe and a global slowdown. Sovereign risk has recently graduated from being an emerging economy (EM) hitch to an advanced economy problem. The Greek debt crisis has occupied center stage of the economic and political debate. It is not just a Greek tragedy – a contagion could spread the virus to Portugal, Spain, Italy and Ireland (See RGE Analysis, The Eurozone’s ‘Bay of PIIGS’). Indeed, at stake is the entire eurozone framework. Yet fiscal sustainability and sovereign risk also loom over other advanced economies like Japan, the UK and the U.S.

A few years back, RGE expressed concerns about the persistence of divergences in the EZ and therefore its long-term success in the paper, Growth Differentials in the EMU: Facts and Considerations. We studied financial integration and channels of interstate risk-sharing and found that since the inception of the EZ, a higher degree of financial integration and cross-county ownership of financial and productive assets has contributed to improved risk sharing in the currency area, though risk-sharing remains significantly lower than in the United States. Going beyond the econometrics, this crisis highlights flaws in the design of the EZ – in this case the lack of political, economic and fiscal federalism, and the absence of a mechanism like those which exist in both the U.S. and Japan to bail out troubled members.

Still, the comparison between U.S. states and EZ troubled members is back in vogue. Projections show that in a matter of a couple of years, the U.S. gross federal debt will exceed GDP and the federal budget will never balance again. This is clearly unsustainable and raises questions about the future of the U.S. ”AAA” ratings. While sovereign risk definitely stalks America, it will not follow the same script of the Greek tragedy. It won’t be an undisciplined state or a group of states that will imperil the U.S. framework of a single currency area and fiscal federalism. No single U.S. state displays the same fiscal vulnerabilities inherent in Greece or other PIIGS (Portugal, Ireland, Italy and Spain) at present.

Mathematics tells a compelling story in this regard. The aggregate fiscal deficit of the U.S. states is estimated to be less than 2.0% of total U.S. GDP during 2008-12, and the aggregate debt of state and local governments is estimated to be less than 20% of GDP during 2008-10 – both far below those of several lagging EZ countries. Let’s zoom into some specific, high deficit states: New York, Illinois, New Jersey and California – the NINCs – and compare them with some vulnerable EU countries – Portugal, Italy, Ireland, Greece and Spain – the PIIGS. The fiscal deficit in the NINCs did not exceed 3.0% of GDP during 2008-09; most countries in the PIIGS had deficits larger than 6.0% of GDP. The debt-to-GDP ratios in the NINCs were below 15% during 2008-09; while this ratio was well above 60% for most PIIGS. The difference is even more marked if we look at the interest payments-to-GDP ratio, which was below 1.0% for the NINCs but above 6.0% for most PIIGS. However, interest payments as a ratio of revenues were around 4%-7% in the NINCs and above 10% in Greece and Italy, indicating that high outstanding debt and interest rates pose debt servicing challenges to both the NINCs and the PIIGS as both face weak economic recovery prospects.

Overall, there does not appear to be a Greece among the U.S. states in terms of fiscal and systemic risks. Yet in the broader RGE Analysis from which this note is drawn, we shed light on increasing fiscal deterioration in U.S. states, led by cyclical factors (housing, manufacturing and consumer downturn) as well as structural factors (lack of fiscal discipline during boom years and a structural rise in spending). State governments, like their federal counterpart, might lack the political will for fiscal reforms yet, unlike their federal counterpart, are required to balance their budgets. Sluggish revenues, political obstacles to fiscal reforms and challenges in servicing debt will increase muni downgrades and yields. However, fiscal federalism—under which the federal government transfers funds to the states—and additional federal stimulus for state and local governments to prevent state deficits become a drag on U.S. economic recovery—will help states partially close their budget gaps. Since states cannot file for bankruptcy and are constitutionally required to balance their budgets, they will cut spending and raise taxes to close the remaining budget gaps. Municipalities can file for bankruptcy and will increasingly do so due to weak revenues and high labor costs. However, transfers from federal and state governments, federal subsidy in the muni debt market and ample room to cut spending will allow municipalities to delay interest payments or restructure debt under bankruptcy rather than default. Thus, implicit and explicit federal backstopping will avert a Greece-like risk of default by U.S. states and an EMU-like domino effect among states and municipalities. Fiscal backstopping will however continue to raise the combined U.S. state, local and federal debt burden and interest cost, pushing the painful fiscal adjustment to the future.

All rights reserved, Roubini Global Economics, LLC. Opinions expressed on RGE EconoMonitors are those of individual analysts and may or may not express RGE’s own consensus view. RGE is not a certified investment advisory service and aims to create an intellectual framework for informed financial decisions by its clients.

Comments are closed.