1 Myles Watts and Doug Young Department of Agricultural Economics and Economics Montana State...

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Myles Wattsand Doug Young

Department of Agricultural Economics and Economics Montana State University

Public Debt & Deficits

February 2012

Links to the General Economy

• Gross Domestic Product (GDP)• Debt• Strength of the Dollar• Aged Dependency Ratio• Housing• Employment

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Economy SizesInternational

Monetary Fund(2010 GDP Trillions $)

Population (Million)

World 63 6,895

USA 14.5 310

Eurozone(17 countries)

12.2 330

Japan 5.5 127

China 5.9 1,341

Germany 3.3 82

Rest of World 24.9 4,787International Monetary Fund, World Economic Outlook Database, September 2011

United Nations, Department of Economic and Social Affairs, Population Division (2011)

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World GDP: Historical Trend

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10

20

30

40

50

60

70

Tri

llio

ns

of

Do

llar

s

World Bank national accounts data

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U.S. and Eurozone GDP: Historical Trend

World Bank national accounts data

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Strength of U.S. Dollar: GDP of Eurozone Countries

Nation GDP Nation GDP

Austria 377 * Italy 2,055

Belgium 468 Luxembourg 55

Cyprus 23 Malta 8

Estonia 19 Netherlands 781

Finland 239 * Portugal 229

France 2,563 Slovakia 87

Germany 3,286 Slovenia 48

* Greece 305 * Spain 1,410

* Ireland 207 GDP in 2010 billion U.S. Dollars

International Monetary Fund, World Economic Outlook Database, September 2011

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Debt as a Percent of GDP (2010)

Net Debt Total Debt

Greece 143 143

Japan 117 220

Portugal 89 93

France 77 82

Italy 99 119

Ireland 78 95

Spain 49 60

USA 68 94

World 64 80International Monetary Fund, World Economic Outlook Database, September 2011

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Aged Dependency Ratio

6420Aged Population65AgedPopulation

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Aged Dependency Ratio1990 2010 2030

Greece .23 .30 .41

Japan .19 .38 .57

Italy .25 .34 .48

Portugal .24 .29 .43

France .24 .29 .43

Ireland .22 .19 .31

Spain .24 .27 .40

USA .21 .22 .37

World .12 .13 .20 United Nations, Department of Economic and Social Affairs, Population Division (2011). World Population Prospects

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U.S. Debt($15 Trillion)

Debt Down Grade

ChangeBps

CostBillions $

20 30

50 75

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U.S. House Mortgages

S&P/Experian Consumer Credit Default Indices

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Case-Shiller10 City House Price Index

BLS CPI Index & S&P Case-Shiller

Employment (2010)

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EducationMedian Weekly

Earnings (2010 $)

Unemployment Rate (%)

No H.S. Diploma 444 14.9

H.S. Diploma 626 10.3

Bachelor’s Degree

1,038 5.4

Doctoral Degree 1,550 1.9Bureau of Labor Statistics/CPS “Education Pays”

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Education Earnings Ratio(College Diploma/High School Diploma)

1980 1990 2000 2010

1.31

1.611.73

1.87

Bureau of Labor Statistics, Current Population Survey

Deficits and Debts

1. The Deficit and Debt Definition

2. The Federal Debt in Perspective

3. How Much is “Too Much?”

4. The Long Term Outlook

5. What Can be Done

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1. Definitions• Deficit = Expenditure – Revenue

– Usually, per year– “The Federal Government’s deficit in 2011

was $1.3 trillion.”

• Debt = Accumulation over time of deficits less surpluses – At a point in time– “The Federal Government’s Debt on January

13, 2012 was $15.2 trillion.”

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Federal Revenues and Outlays(As a % of GDP)

17Historical Budget Data, as presented in Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2011 to 2021 (January 2011).

2. The Debt – How Big is It?(As of January, 13 2012)

• Federal Debt $15.2 Trillion– Held by the public $10.5 Trillion– Held by governmental holdings $4.7 Trillion

• Non-Financial Corporate Business (As of

December 8, 2011)

– Debt = $13.5 Trillion– Assets = $29.3 Trillion

• Household + Nonprofit Sector (As of December 8, 2011)

– Debt = $13.8 Trillion– Assets = $71.1 Trillion

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Federal Debt(As a % of GDP)

Whitehouse Historical Budget Data 20

3. How Much Debt is “Too Much?”

• When lenders worry that the country won’t be willing and/or able to pay it back, so

• Interest rates rise to compensate lenders for:– Default Risk and/or

– Inflation Risk

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When Lenders Loose Faith….

34.4%

12.5%8.2% 6.6% 5.2%

1.8% 1.9%0%

5%

10%

15%

20%

25%

30%

35%

40%

Greece Portugal Ireland Italy Spain Germany U.S.

10 Year Bond Yields Jan 18, 2012

Bond yields from: www.tradingeconomics.com

US Interest Rates Haven’t Risen (Yet)

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As of December 8, 2011 …

• The US Government Debt is NOT “Too Much” in the sense that it Threatens the Economic and Financial System

• But Neither Debt nor Deficits, as Conventionally Measured, Include “Promises” Made to Future Generations

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4. The Long Term OutlookFederal Debt Held by the Public Under CBO’s Long Term

Budget Scenarios (As a % of GDP)

CBO 2011 Long Term Budget Projections 25

Actual Projected

Flat Revenues; Growing SpendingAlternative Fiscal Scenario (As a % of GDP)

CBO 2011 Long Term Budget Projections 26

Actual Projected

5. What Can be Done?

• Cut Spending (from what it would otherwise be)– Health Care– Social Security– Other (Discretionary) Spending

• Raise Revenues– Tax Reform

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Healthcare Expenditure(As a % of GDP)

OECD.StatExtracts 28

Health Care

• Reduce Fraud

• Legal (Malpractice) Reform

• Require minimum deductibles and cost-sharing in Medicare supplements

• Accountable Care Organizations– Salary (v. Fee for Service)– Coordinated (v. Fragmented) Care

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CBO 2011 Long Term Projections for Social Security 30

Social Security Tax Revenues and Outlays, with Scheduled and Payable Benefits

(As a % of GDP)

Social Security• “Freeze” benefits (adjusted for inflation)

today.

• Gradually increase early and full retirement ages

• Increase taxable earnings to cover more earnings (86% today)

• Use the “chained” CPI for inflation

• Cover all new government workers

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Tax Reform-1Lower tax rates and broaden the base

• Reduce the top personal rate from 35% to 23-29%

• Repeal the AMT and phase out of deductions and exemptions

• Tax capital gains (indexed for inflation) and dividends as ordinary income

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Tax Reform - 2

• Eliminate itemized deductions

• 12% tax credit for mortgage interest on principal residence (capped)

• 12% tax credit on charitable donations > 2% of AGI

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Tax Reform - 3

• Cap exclusion of employer-provided health insurance

• Tax interest on new S&L bonds

• Cap exclusion for contributions to retirement accounts at $20,000 or 20% of income

• Eliminate 150 other tax expenditures

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Summary

1. The US government debt is not now at dangerous levels

2. A continuation of current policies for many more years is not feasible

3. Solutions do exist

4. Reform is (Politically) Possible: 1986 Tax Reform, 1993 Budget Compromise, 1996 Welfare Reform

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More Information

Congressional Budget Office

Long Term Budget Outlook

http://www.cbo.gov

National Commission on Fiscal Responsibility and Reform

http://www.fiscalcommission.gov

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Myles Watts Department of Agricultural Economics and

Economics Montana State University

Trends in Agriculture Finance

February 2012

Keys to the Future of Agriculture

• Assets and Debt• Productivity and Demand• Government Programs• Ethanol• Farmer Mac• Basel Requirements• International Competitiveness

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Total Farm Assets - USA

39BLS CPI Index & USDA Economic Research Service

Inflation Adjusted using 2011 CPI

Total Farm Debt - USA

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Inflation Adjusted using 2011 CPI

BLS CPI Index & USDA Economic Research Service

U.S. Real Agricultural Land Prices/Acre

41BLS CPI Index, USDA Economic Research Service & National Agricultural Statistics Service

Inflation Adjusted using 2011 CPI

Real Land Value Appreciation (%)2000-2010

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Productivity: Wheat and Corn Yields (Per Acre)

43USDA National Agricultural Statistics Service

Demographics: Males 17 to 35

Year % of Population

1940 15.91950 14.41960 12.21970 13.71980 16.41990 14.82000 12.82010 13.22020 12.62030 12.4

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Government Programs• Sequestration is about 6% in all

agriculture programs including SNAP

• Current Discussion

• Eradicate direct payments

• Minor reduction in other commodity and resource programs

• About 5% reduction in SNAP45

Overview of EthanolNo

GovernmentCurrent Program

Increased Mandates

Ethanol (B Gal) 8.9 11.0 14.6

Ethanol Price Base 29% Increase 50% Increase

Corn for Ethanol (B Bu) 3.6 4.3 5.5

Corn Price Base 38% Increase102%

IncreaseCorn Price/ Ethanol Price 1.87 2.00 2.53

From James Brown, Master’s Thesis in Department of Agricultural Economics and Economics, Montana State University, October 2011.

Note: Recent corn production is about 12.4 billion bushels46

Farmer Mac

• Secondary Markets including Farmer Mac

– Most mortgages of substantial time length are resold in the secondary market.

– Many are resold through Government Sponsored Enterprises (GSE).

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• Fannie Mae• Freddie Mac• Ginnie Mae• Sallie Mae (until 2004)• Federal Farm Credit Banks• Farmer Mac

GSEs

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• Mortgages are originated by primary lenders such as your neighborhood bank.

• Loans are sold to a secondary entity, some of which are GSEs, and some are very large private corporations.

• Secondary entities may sell or retain these loans.

How Secondary Markets Work

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• Loans are bundled into mortgage backed securities

• These securities may be sold in tranches to multiple buyers through the secondary markets.

• Tranche purchasers are repaid in a hierarchical manner with senior investor paid first.

If these Loans are Sold

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Simplified Hypothetical Tranche ($100 m)

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• Loans must meet certain requirements resulting in somewhat homogeneous loans within a bundle.

• Usually default risk is transferred to tranch investors.

• Ownership of lien becomes confused.

Secondary Market (Tranching) Requirements

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Ownership Retained in Secondary Market

• Loans are purchased from the local bank.

• Secondary market issues bonds or other financial instruments to finance loan purchases.

• Default risk is retained by the secondary market and not transferred to bond investors.

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• Long-term real estate loans are often sold to the secondary market.

• Shorter-term and smaller loans, including operating loans, are less likely to be sold in the secondary market.

Scope of Secondary Markets in Agriculture

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• Liquidity to banks• Diversify risks

• Spatially• Sectorially• Over time

• Facilities credit default insurance• Lower interest rate• Increases credit availability

Benefits from Secondary Markets

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Farmer Mac Overview

• Chartered by Congress in 1987• Provides Access to Secondary Markets

for Rural Borrowers, thereby Reducing Cost of Credit

• GSE that is now Privately Owned (traded NYSE)

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• Board of Directors

–10 Board members appointed by shareholders from financial institutions.

–5 Board members appointed by the President with Senate confirmation.

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Farmer Mac Overview

• Involved in $12 Billion of Loans–50,000 Loans

–600 Lenders

–2/3 Loans eventually to small farmers

–50 States

–130 Commodities

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Farmer Mac Overview

• Helps various agricultural lenders–Farm credit systems–Commercial banks–Insurance companies–Rural utilities

Farmer Mac Overview

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• Farmer Mac is restricted to– Agricultural real estate loans– USDA guaranteed loans– Rural utility loans– Other limited loans

• Widening spread between operating loans and real estate mortgages.

• Secondary markets for agricultural operating loans for all practical purposes are currently unavailable.

Farmer Mac Loan Restrictions

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Bank Regulation:Basel Requirements

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Basel Objectives

• Improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source

• Improve risk management and governance

• Strengthen banks' transparency and disclosures

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Basel History

• 1983: G7 agreed on rules for regulating banks including the 8 Percent Rule

• 1988: Basel Accord amended to use internal models for “off balance sheet”

• 1997: Allowed specific risk models

• 2007: Basel II replaced internal credit risk models with complex risk weighting

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Basel Focus

• Bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress.

• Macroprudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.

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“Three Pillars“ of Basel II

• Minimum capital requirements (addressing risk)

• Supervisory review

• Market discipline

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• Bank Auditing: Capital Ratio and Return on Equity

–Banks are required to maintain adequate capital as measured by their Capital Ratio (or Capital Requirement Rates)

EquityCapital Ratio : CR=

Risky Assets

Minimum Capital Requirements

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8 Percent Rule: CR>.08

• Risky Assets: Calculated as a Weighted Sum of Assets. Various weights for a simplified example

Minimum Capital Requirements

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Asset WeightHouse Mortgages 0.5

Other Loans 1

Cash 0

Most Other Assets 1

Some Off Balance Sheet Varies

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Risk Risky Million $ Weight Value

Assets Cash 3 0 0 Gov't Securities 5 0.2 1 Loans Operating 50 1 50 House Mortgages 40 0.5 20 Buildings 2 1 2Total 100 73

Liabilities Demand Deposits 93Total Liabilities 93

Equity 7

Sold Loans (Service) 35 0.1 3.5Total Risky Assets 76.5

Capital Ratio 0.092

Bank Balance Sheet

Hypothetical I llustration of Capital Ratio

Off Balance Sheet

• ROE, ROA, and Capital Ratio (CR)

ROA AssetROE =

Equity

ROA=Equity/Assets

ROA= Assumes risk weight = 1CR

Minimum Capital Requirements

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Minimum Capital Requirements

ROE and CR (ROA assumed = .01)

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Supervisory Review

• Empowers regulators with tools for the first pillar

• Framework for dealing with residual risk that include systemic, pension, concentration, strategic, reputational, liquidity and legal risk

• Resulted in the Internal Capital Adequacy Assessment Process

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Market Discipline: Disclosure Requirements

• Facilitates assessment by investors, analysts, customers, other banks, rating agencies

• Disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution

• Must be consistent with how the senior management including the board assess and manage the risks of the institution

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International CompetitivenessFinance Example

U.S.Developing Countries

Risk Free Interest Rate Includes Inflation (LIBOR or U.S. T-Bills Based)

3.5 3.5

Bank Margin 1.5 2.0

Inflation or Currency Risk 0 1.5

Default Risk 1.0 8.0

Political 0 3.0

Judicial 0 2.0

Commercial Farmer Interest Rate 6.0 20.0

Small Farmer Adjustment NA 3.0

Small Farmer Interest Rate 6.0 23.073

QUESTIONS

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