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The Debt Debate

There is a sharp division over the threat to the economy from public and private debt loads.

Never have so many disagreed so much on such an important issue as whether public and private debt burdens represent a serious threat to America's future economic vitality. On its most basic level, the answer depends on one's view of whether or not robust economic growth is around the corner.

Optimists say recent improving debt trends will continue and that overall debt loads aren't burdensome when viewed on a relative basis. Skeptics, naturally, worry about absolute debt levels, which are extraordinarily high by some measures, and fret that crippling amounts of red ink will flow if the economic recovery stalls.

And despite some positive trends in public and corporate debt, there is a sharp difference of opinion over whether there will be enough improvement to ensure the economy can stay healthy.

Nowhere is this divisive argument more evident than in the debate over tax cuts -- held, of course, in that most divisive of arenas: politics. Supporters of President Bush's tax-cut package, such as the Cato Institute, note the original proposal for tax cuts of $726 billion over 10 years would represent about 0.5% of GDP, based on the Congressional Budget Office's estimates that gross domestic product will be approximately $140 trillion over the next 10 years. (By comparison, President Ronald Reagan's 1981 tax cut topped out at 3.3% of GDP.) The president's scaled-down request of $550 billion would be less than 0.4% of those GDP estimates.

However, the CBO also forecasts the federal government will produce deficits averaging about $310 billion in fiscal years 2003 and 2004, even when using so-called dynamic scoring that incorporates positive economic growth from tax cuts. Economists at Goldman Sachs, among others, believe those deficit estimates are overly conservative and fail to fully incorporate the impact of future tax cuts, military spending in Iraq, and presumed ongoing weakness in equity markets and economic growth.

Last month, Goldman estimated the federal budget deficit would be "at least" $375 billion in fiscal 2003 and $425 billion in 2004, and forecast deficits exceeding $4 trillion for the 10 years ended 2013 vs. the CBO's estimate of $2.7 trillion.

Given that, opponents of President Bush's proposals worry whether America can "afford to indulge in the luxury of tax reform," as Stephen Roach, chief global economist at Morgan Stanley opined Friday. "To the extent that Bush administration policy proposals lead to ever-mounting federal budget deficits, serious new risks might afflict the U.S. economy -- namely, an exploding balance-of-payments gap, a plunging dollar, and rising interest rates. These aftershocks would swamp any hopes for a windfall of economic growth and job creation."

New Dog or Same Old Tricks?

Roach's concern stems partly from America's net private saving rate, which totaled just 4.1% of GDP in the fourth quarter, less than half the average of 8.8% from 1960 to 1999.

However, that 4.1% total is up from 2.4% in spring 2001, a trend that has some hoping a new age of fiscal discipline has dawned.

The optimists' view goes something like this: Chastised by the bear market of the past three years, American consumers and businesses are dramatically scaling down their dependency on debt, aided by historically low interest rates. Household balance sheets, particularly, have been improved by record mortgage-refinancing activity, while record levels of home ownership allowed many Americans to take on "good debt" vs. bad.

Indeed, America's household debt burden -- principal and interest payments -- was 14% of disposable income in the fourth quarter, down from the cycle peak of 14.4% in fourth-quarter 2001, according to the

Federal Reserve


On the corporate front, cash flow for

S&P 500

firms rose marginally in 2002 after falling 2% in 2001, according to Baseline. Improving free cash flow defines corporate America's balance sheet repair to many. Meanwhile, the current ratio -- assets relative to current liabilities -- of S&P industrial firms has risen to over 1.9 currently from under 1.6 in June 1999, according to Merrill Lynch.

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However, some skeptics scoff at what others view as reasons for optimism.

First, the household debt burden is still well above levels seen during the early 1990s recovery, when it averaged around 12.3%. Second, the percentage of households' total amount of liabilities relative to total assets was a record 18.3% in the fourth quarter, according to Paul Kasriel, chief economist at Northern Trust.

"I think consumer household credit is the next potential bomb out there," Kasriel said. "Everyone looks at the Fed's debt-service ratios, which have come down some, but you've got problems out there."

If consumer balance sheets are improving, why are personal bankruptcies and mortgage default rates rising while credit card delinquencies are at record highs? Kasriel asked rhetorically.

"Households have taken out bigger mortgages and paid off some credit cards," he said. "But at the end of the day, the amount of debt outstanding is still bigger and if they lose their job,

most Americans will have a difficult time servicing their debt."

A deteriorating labor market does crimp the bullish view of household debt trends. "The

optimistic expectation is the economy will pick up, and everything will be all right," Kasriel observed. "But if the economy grows at 2% or less, the effective unemployment rate is going to be rising," presumably along with personal bankruptcies, and mortgage and credit card delinquencies. (The official unemployment rate is expected to rise to 5.9% when April's payroll data is reported Friday.)

On the corporate front, Merrill Lynch chief U.S. strategist Richard Bernstein noted the debt-to-equity ratio of S&P 500 industrials has risen from under 45 in mid-2001 to over 55 currently. (The study excluded financials, utilities and transportation companies.)

"Clearly, the trend toward more leveraged balance sheets has yet to be broken," Bernstein commented, suggesting cash levels have been building at an "anemic pace."

In sum, the strategist believes "modest" balance sheet improvements have arisen mainly from asset writedowns and write-offs, and decreases in capital spending, and aren't representative of meaningful long-term repair to corporate America's balance sheets.

A less outwardly bearish view comes from Frank Bifulco, director of research at Orazio Financial Services, a Suffern, N.Y.-based financial planning firm. Most corporations are better off today vs. 12 to 18 months ago, he reckons, but the question is: Will they all be safe if there's another economic downturn?

Bifulco believes otherwise, which could come as a shock to investors who've been gobbling up corporate and -- especially -- high yield bonds in recent months. The

S&P Speculative Grade Index, which mirrors the trend in spreads between high-yield bonds and Treasuries, has gone from nearly 1600 in October to under 1100 as of Monday.

Shrinking spreads between corporate bonds and Treasuries, along with rising stock prices, are market indications that the economy is indeed on the mend, and that debt concerns will pass. In a follow-up piece, however, we'll examine the current account deficit, for which there's little "silver lining," and which some observers believe could trigger a draconian downward spiral of the dollar and Treasuries and U.S. equities.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.