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By Scott Burns | 11-04-2012 10:00 AM

Three Keys to Deficit Turnaround

Other countries that have stepped back from deficit brinks have faced pressure from the bond market, experienced a change of government, and delivered a mandate to truly deal with fiscal issues, says iShares BlackRock global chief investment strategist Russ Koesterich.

Scott Burns: Can the U.S. work its way out of its current fiscal problems?

Hi, there. I am Scott Burns with Morningstar. I'm joined today with Russ Koesterich, who is the global chief investment strategist with iShares BlackRock.

Russ today you talked at our ETF Invest Conference about what's the landscape that’s facing the U.S. The outlook is fairly glum, but I think you made a great point in that there are ways out of this, and it's not unprecedented. So, can you elaborate on that a little bit for me?

Russ Koesterich: Sure. There is some good news, and the good news is, we've seen other countries really go to the brink with significant problems on their budget, on their debt and come back, and actually, many of them are doing quite well today. One of which is Canada, a country that exited the financial crisis in relatively strong shape. They went through a similar budget crisis in '93. We've seen it in Europe: Ireland. We all forget now with their current troubles that Ireland was a poster child of fiscal rectitude for a long time. They tackled their own issues back in the late 1980s. And there are other examples as well. Sweden in '95.

What they all have in common is that, generally, there is a very consistent pattern leading up to when they finally addressed the fiscal issue. First of all, there was some pressure from the bond market, there was an election, there was a change of government, and there was a mandate to really deal with the fiscal issues. I think, unfortunately, right now in the U.S., many of those conditions are not yet present.

Burns: When you talk about the mandate, who did the mandate come from?

Koesterich: It came in the form of normally a change in government, and the new government really being charged, running on a platform of, we are going to deal with the fiscal problems, and we are going to do it in this manner. I think one of the challenges in the U.S. today is you really have not arrived at a consensus about how to do that.

Both parties are talking about it, but there are very different visions. And leaving the politics aside, economically they have different implications, and we haven't yet got to the point where you can say there is some consensus in the United States--at least among the population, maybe there is among economists--about what needs to be done.

Burns: You talk about the successes, but there are failures out there as well. When I think of the Argentinas of the world and perhaps the Zimbabwes ...

Koesterich: That’s different. We are not going that way.

Burns: That’s a totally different problem. But you think about Argentina: How did that continue to not get better?

Koesterich: Well, I think one of the challenges is, when you use, for example, monetary policy as a substitute for fiscal reform. So, if you do have a situation where rather than deal with the deficit, the issues that would normally come up from a deficit, higher interest rates for example, are masked by central bank intervention.

Now, arguably, that has happened to some extent in the United States. So, for example, if I look at the supply of Treasuries five years and up in maturity in 2011, and look at who is buying that, the market really was dominated by the Fed and by foreign central banks. So, you've had public sector institutions really setting the long end of the curve in a way that helped to mask what might have otherwise been some backup in real interest rates.

Burns: You made a great point, that I wasn't really aware of, about the Fed is keeping interest rates down and the Treasury is printing bonds and the Fed is buying them and then rebating. So the Treasury is paying interest to the Federal Reserve Bank, who is rebating that interest back to the Treasury. How does that whole circle work? And are we really setting ourselves up for a big problem there?

Koesterich: It’s a good question, and it’s something that is hard to answer because we've never been here before. In other words, the Fed has never had a balance sheet this size. We have not seen deficits this high and this persistent outside of a major war. So, this really is new territory.

But I think the point you raise is a really critical one. The Fed insists that they have the ability and the tools to withdraw the liquidity. I think the question that is starting to form for some investors is that as you see this intersection between fiscal and monetary policy, and you have the prospect where changes in monetary policy may make it much more difficult to balance the budget, will we have the Fed acting as aggressively as they otherwise would have given those circumstances? And that’s one thing, and I think it’s reasonable, that's starting to trouble some investors.

Burns: So, just to recap: The other success stories, the other governments that have made this happen, they had three things happen again. So, again there was pressure...

Koesterich: There was pressure the from bond market.

Burns: We had an election.

Koesterich: Yes.

Burns: We have an election coming up.

Koesterich: We do have an election.

Burns: You don’t think that this election is really coming with the third thing, which is the mandate?

Koesterich: I think that's the missing part. So, you have the election, but I think what you are going to be missing is, at least at this point, it doesn't seem likely. Hopefully, you will get into the new administration and whoever is elected, there will be some effort at grant compromise, but right now when you look at the polls, when you look at what polls are saying that people are focused on, it's not clear that the country has arrived at a consensus about how to deal with our deficit.

Burns: Right. So, it’s the, yes deficits are a problem, but I still want my Social Security check.

Koesterich: Or I still want my low tax rate.

Burns: I want my low tax rate.

Koesterich: Generally, you want both, which of course is the root of the problem.

Burns: Well, thanks again for that great insight. And thanks for watching. I'm Scott Burns with Morningstar.

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