"GAME OVER"? Perhaps not...

“During a recession of this severity it is important, as I explained, for the government to step in and fill the hole in demand that was created by consumers and by businesses, to get the economy kick-started.

But the long-term deficit and debt that we have accumulated is unsustainable. We can't keep on just borrowing from China, or borrowing from other countries -- (applause) -- because part of it is, we have to pay for -- we have to pay interest on that debt. And that means that we're mortgaging our children's future with more and more debt, but what's also true is that at some point they're just going to get tired of buying our debt."

- President Obama, speaking at New Mexico town hall meeting, 14-May 2009


SUSTAINABILITY

The Dornbusch model of the sustainability of bond-financed budget deficits is the benchmark for gauging deficit sustainability.

Generally, if the ratio of Fiscal Budget Deficit - to - GDP is less than 5%, the bond-financed budget deficits in mature economies such as the US, Japan, and Western Europe, are said to be "sustainable". That is, they can be perpetually financed by "rolling over" the debt.



In the Dornbusch model, this 5% coincides with the real (inflation-adjusted) interest "lost" on government debt being less than the growth rate of the economy. In other words, as the size of the economic pie grows faster than the interest paid on government bonds, all will be well.


NON-SUSTAINABILITY

Over 5%, well, that's another story. Here the budget deficit becomes "nonsustainable". Domestic and foreign lenders refuse to lend Uncle Sam any more $ -- they refuse to buy any more of our Treasury bonds-- and a mind-numbing inflationary monetization becomes inevitable. Unable to finance its budget shortfall by borrowing, the Government will simply print money. For the non-economists: We then have to print money like crazy and we basically go into hyperinflation.

At that point, our collective ATM dispenses only two words: “GAME OVER”!




THE SITUATION TODAY

So how are we right now in May, 2009? The 2008 deficit/GDP ratio was 3.2%, well under the 5% limit established by the Dornbusch model, but by December 2009, thanks to the massive spending of the Obama plan, we will be at 13% (this estimate directly from the Congressional Budget Office) !

The US has not seen levels like this in 60 years. (war-time deficits, as seen in the graph, are generally temporary, and can be manageable - if your side wins!).


Source: usgovernmentspending.com


REASON FOR HOPE

We're clearly well-past the 5% Dornbusch limit. But wait! Is this the end? How dangerous is this? There is hope---there may be some mitigating circumstances.

This time, with the whole planet in recession, there is no other safe haven. Even at 13% deficit/GDP ratio, the US economy is still the world's most resilient. Where will the Chinese send their savings? Europe? Not likely. Furthermore, US reliance on foreign lenders may be abating, as domestic savings continues to rise.



So as long as global contagion causes the recession to be a worldwide phenomenon, we may dodge the deficit bullet after all, and still manage to confound Dornbusch and be sustainable at 13%.

If I am wrong, buy gold--the real thing, the shiny metal. And a safe.


Dr. Farrokh Langdana, Ph.D.
Rutgers University Business School



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