Twin deficits and fiscal dominance: Are the US becoming more and more like an emerging economy?

The United States treated in the same way as any other emerging economy. This hypothesis, however intriguing and provocative it may be, remains, for the time being, far removed from reality, at least when it comes to the fragility of public finances. This does not, however, mean that there are no points of similarity between the two situations, nor that there are no risk factors creating pressure on sovereign debt yields.

The fact that market participants are preparing for the worst is also demonstrated by a recent study by Schroders, which analysed fiscal dynamics in the United States using the Country Vulnerability Model developed by the investment firm’s economists, drawing on the experience gained in the field during the financial crises that hit emerging markets in the late 1990s. The reasoning behind this is that a high debt-to-GDP ratio is not, in itself, a reliable or unambiguous indicator of an impending crisis; rather, to properly assess the vulnerability of sovereign debt, it is necessary to focus on six early-warning factors.

The result is an overall risk scale with scores ranging from -12 to +12, on which the US stands at -1: a figure that Schroders associates with a phase of ‘blind flight’ and which borders on the -2 to -4 range, which historical analysis links to a very high risk of crisis. The parallels with emerging markets of some thirty years ago stem from dependence on international capital and what is termed ‘external sovereign liquidity’, two of the key factors mentioned earlier. The United States, in fact, has substantial twin deficits (the public deficit combined with the current account deficit) and a negative net international investment position amounting to almost 80 per cent of GDP. According to the study, the country therefore remains ‘vulnerable to changes in sentiment among non-resident investors and to capital outflows’.

And whilst a cycle of ‘unbalanced’ growth – linked, moreover, to the rapid build-up of the imbalances just mentioned – appears to be a potentially equally worrying factor, Washington must, above all, guard against the so-called ‘fiscal dominance risk’, which arises when fiscal sustainability is called into question and the central bank’s interest rate manoeuvres become ineffective or even counterproductive. ‘Without credible fiscal action, it may only be a matter of time before the Federal Reserve is forced to resume large-scale debt monetisation,’ adds Abdallah Guezour, Head of Emerging Markets Debt and Commodities at Schroders and editor of the research.

On the contrary, the high level of liquidity in the banking system, the resilience demonstrated by the private sector and the vital role played by the dollar as a ‘safety valve’ to improve price competitiveness and support the rebalancing of the economy are factors that help shield the United States from potential emerging-market-style crises. The fact remains, as Schroders points out, that at present some countries that were once maligned, such as Brazil, appear to face a relatively lower risk of crisis in terms of debt and public finances.