U.S. facing biggest deficit in 60 years: CIBC World Markets report

Mon. December 01, 2008; Posted: 09:00 AM

CIBC (CM: TSX; NYSE) - President-elect Obama can expect to face the biggest U.S federal deficit since the end of WWII when he takes office in January, finds a new report from CIBC World Markets.

Before his administration adds on its own stimulus package, the Treasury market will need to finance a minimum of $1.5 trillion of new debt, if not more, pushing the federal deficit to 11 per cent of U.S. GDP. And this will be before the full brunt of the cyclical deterioration in tax revenues that accompanies a recession, has been felt.

At this level the deficit will be larger, in relation to the overall size of the economy that supports it, than the red ink ran up during either the Korean or Viet Nam Wars. In relation to the size of the economy, it will be bigger than any deficit since 1946.

"Find a strong enough wind and even pigs can fly," says Jeff Rubin, chief economist at CIBC World Markets. "If you force-feed a $14 trillion economy with $1.5 trillion of fiscal stimulus, GDP growth will respond. But what about the trail of record deficits that lay in the wake of such fiscal action? How many years of program spending cuts and tax hikes will it take to whittle down such a massive deficit. Will future taxpayers simply wish we had bitten the bullet for a few quarters and not mortgaged their future?"

Mr. Rubin says that while politicians and financial markets are currently worrying about deflation risks, history has shown inflation to be a far more common dancing partner for massive government deficits. He notes that by monetizing debt by simply selling the bonds and bills to the Federal Reserve Board instead of the public will drive inflation - and that may be a good thing for government.

"The resulting higher inflation allows the government to pay off bondholders with coupons that have less and less buying power every year," adds Mr. Rubin. "And while the bonds mature at par, inflation will have eroded much of their real value. And higher inflation ultimately brings down the value of your currency, which is a huge benefit, if you are the U.S. and can get other countries to lend you their hard-earned savings in your currency.

"That allows you to repay your lenders, like the People's Bank of China, with greenbacks that buy a lot less Yuan than they did when China first lent you the money. And aside from stiffing your creditors, higher inflation is bound to rub off on asset values, like housing prices, for example. That would certainly boost the value of all those mortgage-backed securities that the Fed is now buying."

An area of the economy Mr. Rubin does not think will be saved by a government bailout is the domestic auto sector. While he recognizes that a Chapter-11 reorganization, levered with billions of dollars in taxpayer-funded assistance, may allow the Big-Three to stay in production and win much needed concessions from its unions and creditors, he does not see this resolving questions of long-term viability.

"The issue is not simply the competitiveness of North American auto producers but the size of the market they will serve in the future," notes Mr. Rubin. "A secular rise in gasoline prices and a lengthy period of consumer deleveraging is fundamentally altering both the size and composition of the U.S. auto market. Currently, U.S. car makers are not only making far too many SUVs for customers who want smaller and more fuel efficient vehicles, but more ominously, their production capacity seems grossly oversized for what is likely to be a steadily shrinking North American vehicle market."

The report notes that since gasoline prices hit their peak in June, vehicle sales have plunged 50 per cent, which is larger than the drop in sales after the first two oil shocks. While it took as long as 10 months for sales to recover after the first two shocks, Mr. Rubin is not certain sales will rebound this time. In fact, while gasoline prices have dropped dramatically in the last six months, the decline in auto sales continues to accelerate. The latest monthly sales numbers in the U.S. have dropped below 11 million units, levels not seen since 1983, following the infamous double-dip recession of the early 1980s.

Mr. Rubin thinks two powerful forces will keep sales from rebounding - energy prices and the end of cheap credit.

He notes that oil prices collapsed after the 1982 recession and remained cheap for the next two decades as the oil shocks spawned greater efficiency and new supply from places like the North Sea and Prudhoe Bay in Alaska. While in percentage terms, prices have collapsed as much since the start of summer as they did after 1982, the resulting levels are very different. While $50 per barrel oil is only a third of the peak level of $147 per barrel seen in July, it is a level that only four years ago would have denoted an all-time high price for petroleum.

With the world's new oil supply largely tied to high cost oil sands and deep water wells, many new supply projects are being postponed or cancelled. As a result, there is a very real chance that world supply will contract in the face of depletion rates that every year take out some four million barrels per day of production.

Mr. Rubin believes the end of cheap credit may be almost as important as the end of cheap oil in putting the brakes on future vehicle sales. Over 90 per cent of all new car purchases require financing of some kind. The past twenty or so years not only saw a housing bubble that was fuelled by easy access to credit on favourable terms, but it also applied to automobiles as well. During this period, U.S. vehicle sales reached a peak of over 20 million, and household car ownership rose from 1.9 vehicles per household in the early 1990s to 2.2 in 2007.

"Like today's home buyer, today's auto buyer is finding financing harder and harder to come by," adds Mr. Rubin. "Particularly those looking for lease financing, who until recently had accounted for almost 30 per cent of all new vehicle shoppers. But leasing is a rapidly diminishing source of vehicle financing.

"At a time when there is a growing crescendo of calls for greater infrastructure spending, it is noteworthy that there will soon be fewer and fewer Americans on the road. The shrinking size of the domestic car market suggests that investment in public transit, as opposed to new freeways, would be a far better infrastructure choice."

<< The complete CIBC World Markets report is available at: http://research.cibcwm.com/economic_public/download/snov08.pdf >>

CIBC World Markets is the wholesale and corporate banking arm of CIBC, providing a range of integrated credit and capital markets products, investment banking, and merchant banking to clients in key financial markets in North America and around the world. We provide innovative capital solutions and advisory expertise across a wide range of industries as well as top-ranked research for our corporate, government and institutional clients.

SOURCE: CIBC World Markets

SOURCE: CIBC

SOURCE: Canadian Imperial Bank of Commerce

Jeff Rubin, Chief Economist and Chief Strategist, CIBC World Markets at (416) 594-7357, jeff.rubin@cibc.ca; or Kevin Dove, Communications and Public Affairs at (416) 980-8835, kevin.dove@cibc.ca

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