Thursday, April 7, 2011

The Trigger Point for a United States Debt Crisis

Updated January 1, 2013

Now that the United States has stared down the fiscal cliff and is facing the prospect of breaching the $16.4 trillion debt ceiling imminently, I thought that it was time to look at whether or not the United States could default on its debt and, if that happened, when it would be most likely to take place.  Many people feel that the United States can just "print" its way out of default and in combination with higher taxes, it can continue to accumulate debt ad infinitum.

Fortunately, an economist by the name of Arnold Kling from George Mason University studied the issue and in August 2010, released a working paper entitled "Guessing the Trigger Point for a U.S. Debt Crisis".  In his paper, he explores the possibility of a default crisis in the market for American sovereign debt.

Mr. Kling opens by noting that many leading authorities on economic matters agree that the current long-term fiscal outlook for the United States is unsustainable.  Between 2010 and 2035, the aging of the baby boomer generation in the United States (and elsewhere for that matter and this means you Canada and the United Kingdom!) will have a huge impact on the fiscal picture.  From 2035 to 2080, the problem is continued growth in health care costs that are expected to grow faster than GDP.  By the year 2080, total federal government spending on entitlement programs will likely exceed total federal tax revenues.

As in the case of all debt, one never really knows when the credit granting organization will disallow accumulation of additional debt.  In the case of residential mortgages, as many Americans know, the point at which the bank declares the mortgage to be in arrears is affected by many factors including your creditworthiness, your past history of making payments, your income situation etcetera.  The credit granting organization must weigh the pros and cons of foreclosure.  As well, there is the complication of individual circumstances.  In the case of two individuals, one may choose to repay their credit because the benefits of repayment outweigh the benefits of default whereas another individual may regard the situation completely differently.  Regardless of the situation, the credit granting organization still holds the legal right to either seize your assets or garnishee your wages to force an individual to pay what is owed.

In the case of sovereign debt, the legal obligations of those holding the debt (the credit grantors) are far different.  In this case, the holders of United States Treasuries have absolutely no legal grounds to force the federal government to repay the principal or interest on their debt.  Any government has options open to it that could solve a credit problem; they can cut services, raise taxes, print more money or default on all or a portion of their sovereign debt.  Cutting services may annoy public employees and those who are counting on entitlement programs, raising taxes will annoy voters, printing more money will have the effect of raising inflation as more money enters the economy and default will cause a crisis of confidence.  The choice made will depend on how the government balances the needs of its constituency  versus the needs of its bondholders.  A debt crisis will arise when bondholders reach the conclusion that the risk of non-repayment outweighs the benefit of collecting interest payments on their investment.

It is very hard to quantify just when bondholders will decide that the risk outweighs the benefit and when governments decide that sovereign debt default is the wisest choice.  Fortunately, observations about the point of sovereign debt default do exist and have been thoroughly examined by Carmen Reinhart and Kenneth Roghoff in their book "This Time is Different".  Here is a summary of their observations:

1.) Middle Income, non-OECD nations:  For middle income, non-OECD nations, the ratio of external debt to GNP for 33 countries that defaulted between 1970 and 2008  ranged from 12.5 percent to 214.3 percent with an average of 69.3 percent.  It appears that non-OECD nations are rarely allowed to post a debt-to-GDP ratio of more than 100 percent without feeling the wrath of the bond markets.

2.) OECD nations:  For OECD nations, the debt-to-GDP ratio can exceed 100 percent, in fact, Japan's debt-to-GDP ratio is just shy of 200 percent, the second highest in the world after Zimbabwe.

3.) Developing Nations: For developing nations, the ratio of external public debt to GDP for defaulting nations between 1970 and 2008 was generally above 40 percent.  Non-defaulting nations had a ratio of less than 50 percent and nearly half had a ratio below 30 percent.

Investors rank sovereign debt based on their confidence level in the regime issuing that debt.  Evaluation is based on political stability and the history of its indebtedness.  In a high-confidence regime, investors conclude that the likelihood of repayment is high so interest rates are low.  In a low-confidence regime, investors conclude that repayment of the debt is less likely so interest rates are high.  A prime example of this phenomenon has recently developed in Europe where the sovereign debts of both Greece and Portugal are now commanding record high interest rates because the bond market views the risk of repayment as high meaning that investors demand a higher return for the perception of risk of default.

A debt crisis occurs when there is a sudden (and not always predictable) shift in perception about the level of confidence in the risk associated with owning any bond investment.  It is at that point, that investors assess that a country's debt-to-GDP level has surpassed their "comfort zone" and will basically force a country to reduce their debt until it reaches a tolerable level.  As noted in the previous paragraph, there is a shift from a high-confidence regime to a low-confidence regime.  In the case of any given country, a high-confidence regime may be allowed a debt-to-GDP ratio of 125 percent by investors, however, if confidence is lost, that same country may only be allowed a debt-to-GDP ratio of 90 percent.  This means that the country will have to find ways to reduce its debt by cutting spending, raising taxes or some combination of the two.  

In his paper, Mr. Kling uses the example of Greece.  He states that when the IMF intervened, they set a debt-to-GDP target for the country over a given period of time as a condition of receiving IMF bailout funds.  This is defined as the Low Confidence Target and the steps that are taken by the government to achieve that target are termed the fiscal adjustment.  In principle, if the government can lower its debt to the Low Confidence Target (the point where bond investors lost confidence in the country's debt), the market will determine that concrete steps have been taken to lower debt to the point that it is manageable and this will result in a drop in bond interest rates.  Lowering the debt of Greece required the government to make massive fiscal adjustments to its budget.

The amount of fiscal adjustment that the electorate of Greece (or any other country) allows before they feel fiscal pain is termed the Pain Threshold.  In the case of Greece, cutbacks that were made at the behest of the IMF led to rioting in the streets and the calling of general labour strikes.  That is why the concept of Pain Threshold is critical to the notion of reaching a certain debt-to-GDP target.  If the government can make massive cutbacks to achieve their Low Confidence Target (i.e. reduce debt-to-GDP) before the public "revolts", the country has a high Pain Threshold; if they can only make small cuts to reach their target, they have a low Pain Threshold.   A prime example of a high Pain Threshold can be seen in the case of Japan.  Japan's debt-to-GDP ratio is approaching 200 percent, the second highest in the world.  The difference between Japan and many other nations around the world is that most of Japan's debt is held by Japanese savers in Japanese banks (and post offices).  This means that the Japanese government is, to some extent, sheltered from a massive shift in confidence.  As a result, the market perceives that the Japanese government could make a large cut in spending without creating unrest in the country.

Now to gather the pieces together.  If the cutbacks or fiscal adjustments that are necessary to reach the Low Confidence Target are greater than the Pain Threshold, it is highly unlikely that the government will be able to take sufficient action to reach its Low Confidence Target and the country will probably be forced to default on its debt.  This appears as though it could well be the case for Greece but only time will tell.

As the author notes, it is almost impossible to determine when a debt confidence crisis will erupt since such crises are often external to the country in question and are related to economic shocks.  There are two types of shocks:

1.) Recessions: these result in lowered GDP which pushes the denominator of the debt/GDP ratio in a downward direction.  As well, the debt numerator also rises due to dropping tax receipts pushing the ratio even lower.  The impact of a recession on the debt-to-GDP is generally considered to be relatively small.

2.) Increase in real interest rates: when interest rates after inflation rise above the growth rate in nominal GDP, the impact on the debt-to-GDP ratio can be quite large.  Over the five year period from 1990 to 1994, the real interest rate over the five year period exceeded the growth in GDP by a cumulative 15 percent and this resulted in an increase in the debt-to-GDP ratio of 15 percent.

Back to the situation in the United States.  The Congressional Budget Office projects that the ratio of debt-to-GDP will rise from 71 percent in 2015, to 87 percent in 2020, to 112 percent in 2025, to 146 percent in 2030 and finally to 185 percent in 2035.  From the author's calculations using a Pain Threshold of 8 percent of GDP per year over a five year period and a debt-to-GDP Low Confidence Target of 60 percent, the United States would barely meet the target by 2020 if fiscal reform was undertaken no later than 2015.  If the debt-to-GDP Low Confidence Target is 175 percent and the Pain Threshold was still 8 percent of GDP per year over a five year period, if fiscal reform were undertaken in 2030, the United States would not be able to lower its debt-to-GDP ratio to meet the Low Confidence Target and a sovereign debt crisis would occur somewhere between 2030 and 2035.

I realize that the author makes many assumptions for his analysis but when all the pieces are fitted into place, it certainly makes interesting food for thought.  I often see newspaper articles and commentaries stating that there is no way that the United States would ever default on their sovereign debt.  It's nice to see that someone is at least attempting to quantify a rebuttal.

I'd like to close with a quote from the last two paragraphs of Mr. Kling's analysis:

" would appear to be quite likely that the United States will experience a debt crisis within the next two decades, unless the path for fiscal policy changes from what is projected by the Congressional Budget Office. However, international capital markets continue to treat U.S. Treasury debt as a fairly safe asset. One way to interpret this phenomenon is that investors expect the United States to take steps to get its fiscal house in order.

The assumption that the United States will have the political will to stabilize its fiscal position is based more on hope than on recent experience. If the political process continues to enlarge the government’s commitments to spend in the future, investor expectations will change at some point. That change in market perception is likely to be swift and severe."

Let's hope that Congress and the President take "swift and severe" action to control both spending and taxes before it's too late.


  1. It's been said "That which is unsustainable tends, in the end, to be unsustained." It was quoted to me in an economics class in business school in London in 2007 by a professor who predicted the latest crisis.

  2. The US is doomed. It has tried to dominate countries around the world and exploit their resources. The big bully is going to fall and fall hard

  3. China could throw the US into a debt crisis any time they want. The US has to continually sell new debt instruments as the existing ones reach maturity. All that would need to happen would be for China to stop buying US debt. This would almost certainly result in the US being unable to roll over existing debt. Even if no new debt was being incurred, this would likely result in the US having no choice but to either default on the debt or print large amounts of money creating massive inflation.

  4. The sad fact is that most representatives of Congress from both parties don't seem to see this as an actual "today" problem!!

    It's almost as if they think that the USA can get itself out of this mess because they still see their country as #1 in all aspects.... Sorry guys but the wake-up call is coming and the financial crisis it will create is hell-bound!!

    P.S. When you start hearing that the US greenback may be changed from being the recognized world currency, you need to start to question why that is... Not just tell yourself it's going to be "ok"...

  5. No one forecasts well out that far. Hundreds of different changes can take place in that time period to alter the forecast. All you can say is that if current conditions hold, and the assumptions are met, this is the likely outcome. And even that is predicated on a careful analysis.

  6. Modern Monetary Theorists claim that governments are special. Their core asset is their taxing power. A government's solvency constraint ultimately lies in its political capacity to levy and enforce the payment of taxes.
    I wonder if the strength of a government's political capacity is related in any way to the percentage of the current budget which taxes support.
    I understand that in the current budget, we borrow 43 cents for every dollar spent. Thus, taxes support 57% of the budget.
    Is there some point, say when taxes support 30% of the budget, in which the political capacity is neutralized and the full faith and credit of the Government is significantly compromised?
    Don Levit

  7. Personally I do think immigration policy should be changed immediately to relieve national debt or economic recession---that is to bring people who have both money and knowledge for immigration.

    Therefore, certain types of family-based immigrants should be cut to avoid chain immigration for job competitions or driving wages down such as siblings' immigration but ONLY allow spouse and kids to immigrate within a family. Then people who have both money and knowledge are welcomed to immigrate to set up companies to create job opportunities in hiring one to five persons for rescuing economic depression. Example is to allow rich (those who are from a family having over one million US cash or assets) foreign US advanced graduates in Science & Medicine to immigrate. It is because this type of immigrants are wealthy enough to set up companies in US to hire people if they can't find a job. Also, this type of immigrants bring inflow of money and knowledge for immigration which uplift both economy (such as buying houses, cars, computers and all kinds of household appliances) and scientific innovations.

    Moreover, this type of immigrants will invite both relatives and friends to visit US and travel visa fees will add monetary income. Also, the sales of airline tickets, hotel reservations, restaurant reservations and all kinds of retail business will be uplifted. These will indirectly create more job opportunities and make the economy booming up.

    Therefore, granting green cards to rich (those who are from a family having over one million US cash or assets) foreign US advanced graduates in Science & Medicine is a good idea for both economy and immigration policy.

  8. No one forecasts well out that far. Hundreds of different changes can take place in that time period to alter the forecast...Thanks...

  9. This is very worth thinking about, but it's also worth pointing out that the valuation of debt is always in relation to all other possibilities for investment. Greece and Portugal's debt is regarded as poor because there are better alternatives: that of stronger countries, most particularly the U.S. If there isn't even stronger debt by comparison with which ours would suffer in a U.S. debt crisis, issued by an economy which isn't likely to be seriously weakened by an American economic crisis (and none comes to mind), I'm not sure that this analysis is useful, at least without adjustment.

  10. the people having great fun at demiose of US should possibly taken a closer look at what will happen with all of us if US as predicted collapses or at least is not able to support world economy and send troops to stop slaughter of civilians everywhere. I can see at least Sourth Korea and Japan getting a bit worried in a process.
    I also think that while indeed China could do some damage to US by requesting repays it would damage itself too.
    As a side observration - US has a very high level of finance 'industry' in general economy which is part of the problem - instead of producing or providing service they do funny thing with money. There seems to be a limit to what country even so big as US can do if whole world is using its currency as global money.
    And final remark: it has been predicted many times that US will collapse and they had quite some troubles in the past yet were able to recover - I wonder why cannot it happen again?

  11. Thank you for your analysis, Mr. Barnard, and for your observations thereon, Commenters. I got here from reading a comment by Mr. Barnard on an Economist article relating to the Portuguese sovereign debt crisis.

    This is an interdependent world. Like it or not, recognize it or not, ignore it or not, know how to deal with this veracity or not, this is an interdependent world.

    As a coach to entrepreneurs and executives, I usually find that failure to adapt to this truth is at the root of my clients' economic problems. Systemically-speaking, I see no instance where the failure to adapt to this is more marked than in the multi-faceted relationships that occur between the financial and real sectors of the econonomy. The sectioning of the actor-principals in any economy into these two is, of course, arbitrary, which is to say that we think the two are sectionable. They can be from the perspective of analysts, but from the perspective of all of us alive today, "we are all in this together".

    Nice to say, warm to feel, but hard to live because what does this mean?

    I think that it means we must regain our sense of the difference between speculation and investment. These terms are often used interchangeably, especially by financial professionals. That conflation of words very much disturbs me as a Wharton Finance Major MBA who primarily but not exclusively interacts with non-financial entrepreneurs and executives. So I have written a paper on the subject. If anyone has the time to read its 10 pages, I would be very pleased. I would be even more pleased if you were able to write me a comment.

    The paper is at:

    Thank you for your attention.

  12. Seems to me this line of thought is missing one key element, which is the intent of other nations. China has no need or desire to force a U.S. debt crisis at the moment. Indeed, almost no one in the world does, and those that might (North Korea, possibly Iran, Cuba) have no ability. In 20 years as the world's power structure and relative fortunes change, that might not be the case. That is, at some point, it might be politically expedient for a China or other major power to force or engineer such a financial crisis. The closer the U.S. is to that tipping point, the more vulnerable it is to such manipulation.

  13. People like Angus Cunningham are part of the problem, not the solution.

  14. Start sheltering your money in anything other than the US dollar, why not your political and business leaders have already done so.

  15. "The US is doomed. It has tried to dominate countries around the world and exploit their resources. The big bully is going to fall and fall hard" - Steve

    We can see where your world view stands Steve.

    Just remember...if the US falls hard, the rest of the countries in the world are going to fall even harder.

  16. A reminder to all claiming US will stand.
    The British Empire was once the strongest and it lost it's way and was manipulated in to dire financial consequences by an up-coming nation with plans to be a world power. The USA. Chinese growth should be seen as the writing on the wall of history.

  17. I'm an American and frankly I'm getting tired of how the leaders are handling the country. I know alot of people rely on the healthcare and medicaid and other things, but we have to cut spending and raise taxes. China still likes us for our buying power, but that might not be there in a decade or two. I really don't want my country to go down the hole all because some stupid politicians couldn't get over themselves and fix some problems.

  18. Buy gold and silver the only real money that exists. Trust no one. Use your Paper money and buy real money that will never default.

  19. You better hope it doesn't get too bad in the States, for it will turn into a good old fashioned "who's got the wealth?" situation and soon our aircraft carriers will be parked off your shores. When people lose everything....they lose it.

  20. Indeed, the way the United States goes, goes the rest of the world. We consume a whopping 25% of the world's natural resources along with everything else. Imagine if suddenly the United States was forced to stop consuming? We have already seen the effects to a small degree but what if the world suddenly has a complete banking collaspe which is not all that far fetched. What if the entire global economy melts down and we have a global depression of Tsunami proprotions? Perhaps the answer lies in letting it all fall apart to such a degree that the slate is wiped clean and we start all over from scratch. Our government has no intention of ever paying all the money back we have borrowed and spent nor can it. 60+ trillion and getting bigger everyday...who are they trying to kid??? Most of us citizens who follow this very closely know this all too well!

  21. Most forecasts seem to miss a huge factor...China, and other emerging nations.

    By 2030 the world might have done a fair amount of re-balancing. These economies should be more affluent and provide a large market for exports from all western countries.

    This would/should provide a huge stimulus for these economies, as is the case for the emerging nations now.

  22. It seems to me, that the US government must start now spending no more than it is collecting of taxes and other revenues. It means a steep increase in taxes, with the resulting fall in demand in the economy, as the increased revenues must be used to balance the books, in other words: Must not be spent! That will lead to a steep increase in unemployment, if nothing else happens. If this would not be enough, the US as an economy must also balance its books in terms of balance of payments with the outer world. In order to lessen the increase in unemployment, which by itself would lead to a downward spiral, real income of all Americans must be cut drastically. That in it self would lead to less government revenue and a downward spiral. The only option open to the US is some kind of default. I´d say that is already happening. The Fed has been printing more than a trillion dollars during the last 18 months and those dollars have entered the economy (quantitative easing). Sooner or later the outer world will realize, that the US is going to inflate its way out of debt, which is a form of default. This will lead to a loss of confidence in the dollar. Were it not for the problems in Euroland, the Euro would already be overtaking the US dollar as the world currency. Which currency will become the world currency remains to be seen. The writing on the wall says that it will not be the US dollar for much longer.

  23. The US doesn't force China to buy its debt. Or Japan. Or anyone else.

    The fact is - if China cannot afford to allow the yuan to rise, they are in no position at all to create a debt crisis in America.

    Besides, the Fed just bought more US bonds than China and Japan hold together.

  24. When Bill was getting a BJ,the USA defaulted...

  25. "The fact is - if China cannot afford to allow the yuan to rise, "

    This is true as long as China remains primarily an all-export driven economy.

    The current turmoils, though, have made chinese leaders way too conscious of the current conundrum they placed their country in, i.e. an almost symbiotical relationship with the USA (and a lot of western countries) that are actually being harmed, in the long run, by it.

    One way or the other, it is gonna end (defaults of OECD countries, denouncement of WTO treaties, a slump of international commerce... ) and they need to insulate the Chinese economy from these posible outcomes the best way they can.

    They already started doing so, by pumping the internal market (though, the resulted, state driven, expansion of the immobiliar market somewhat resembles the early days in the making of the Japanese bubble that burst in the 90's), by slowly using theirs americans "paper" assets to buy "solid" assets around the world (mines in Africa, factories in USA and EU...).

    China can't really expect to keep the Juan down indefinitely. No matter how much it suits the US and Chinese current needs, the rest of the world can't really accept it forever.

    And could not be in their interest in the future... as time passes, this years seems more and more like a reenactment of the 1929 crisis.

    One of the secundary consecuences of the Grear Depression was a resurgence of custom taxes and protectionism that reduced international trade by a rough 75%. If the same is going to happen again, which is possible given the amount of rage against "cheap imports that stole our work" in many countires, China could lose much of its reasons to keep down the Yuan.

    So, future China is going to raise its internal market (already trying, but Chinese really prepare to thrift, preparing for the hard times), dump as much US Dollars reserves as possible (it is trying to, not so simple to achieve without being detected) for solid assets and get ready for a lot less export-friendly world.

    All of these changes are in the making, and they will take quite some years to produce real results. Pretty much like the capitalist turn of the mid eighties...

    ...but the single good thing about non-democratic China is that a good number of the persons handling issues now know they are going to be still around when the situation will get messy, eventually.

    And, eventually, twenty years from now, China could be ready ( or, better, forced by the irresistible forces of the economy) to dump the U.S.A. and the dollars and take over.

    Not that they really want to do it, or the world will like them better than id does the U.S.A. ...

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