A brief article on the Knowledge at Wharton website examines the spectre of a default on United States Treasuries. It gives us an interesting look at background information about America's mounting debt and what could happen to the "riskless" Treasury market in the worst case scenario.
Here is a quote from Founding Father Alexander Hamilton:
"A national debt if it is not excessive will be to us a national blessing; it will be a powerful cement of our union. It will also create a necessity for keeping up taxation to a degree which without being oppressive, will be a spur to industry.”
Let's open with a look at the latest debt numbers. The debt can be broken down into two parts, the marketable debt which includes Treasuries and the non-marketable debt which includes intra-governmental loans, basically, money that is borrowed from one part of government to fund another part. Here is the breakdown:
Notice that nearly 67 percent or $10.887 trillion of the total debt is marketable and just less than half that amount (33.05 percent) or $5.374 trillion is non-marketable. With total debt of over $16.2 trillion dollars, the debt ceiling of $16.4 trillion is likely to be breached by the end of 2012 or early 2013 at the latest.
Fortunately, the average interest rate on America's marketable debt sits at a very low 2.075 percent, down from 2.306 percent in October 2011. Interest on the non-marketable portion of the debt is slightly higher at 3.588 percent, down from 3.932 percent a year earlier. This averages out to 2.560 percent when all debt is included. Here is a bar graph that shows how interest rates on the outstanding debt have changed over the past 24 months and how much cumulative monthly interest has been paid on the debt:
Finally, to put all of this into perspective, the latest GDP figures from the Bureau of Economic Analysis show that the U.S. GDP reached $15.7757 trillion in the third quarter of 2012. This means that the current marketable debt-to-GDP ratio is 69 percent and the current non-marketable debt-to-GDP ratio is 34.1 percent for a total debt-to-GDP ratio of 103.1 percent. This is up very substantially from the 60 percent level reached during the balanced budget years of the Clinton Administration. According to University of Connecticut School of Law Professor James Kwak, the debt-to-GDP could well rise to 200 percent by 2035, a level that is higher than that of all European debtor nations.
Now that we have the latest data in mind, let's go back to the "spectre of default", a subject that is particularly pertinent now that the fiscal cliff is staring us in the face.
As most of us know, if our spending exceeds our earnings for very long, eventually, we will find it difficult to get additional credit and lenders will force us to pay higher and higher interest rates because they will be increasingly worried about default. Unfortunately, such does not appear to be the case for the United States; month after month, we watch Washington's debt rise as interest rates fall to multi-generational lows. As the world's reserve currency, investors regard Treasuries as "riskless" because the government stands behind them with the power of taxation. For a very short time, it appeared that the euro might provide some competition for the power of the almighty U.S. dollar as the world's choice of reserve, however, as we have seen over the past two years, Europe's sovereign debt crisis has removed the euro from the competition. The only currency that could ultimately replace (or accompany) the U.S. dollar, China's yuan, is not quite there yet, however, as shown on this graph, the Asian impact on the world's economy will continue to rise at the expense of the current developed economies, particularly that of the United States:
Just to show you how powerful the U.S. dollar is as the world's reserve currency, at the end of September 2012, foreign nations owned $5.455 trillion worth of Treasury securities or 50.1 percent of the total marketable debt.
Unfortunately, there is no political will to actually reduce the debt. Every suggested remedy is unpalatable to one side of the political spectrum or the other. While the investment community generally regards Treasuries as "riskless" because of the government's power of unlimited taxation, in reality, such is not the case. At some point, no matter what the current perception is, it may be necessary for the government to default when the debt reaches an unserviceable level. Since 1800, 68 governments have defaulted on their sovereign debt with Russia (1998) and Argentina (2002) being the most recent cases. Admittedly, neither of these nations had currencies that were the world's reserve, however, both defaults sent shudders through the world's economy.
What would happen if the United States did elect to default? First, the government may choose not to default on all of its debt; it could choose to delay interest payments and/or extend maturity dates on some or all bonds. The losses on Treasuries would impact Treasury investors, other levels of government, corporations, pension plans, insurance companies and would likely result in dropping stock market and real estate valuations. Interest rates on Treasuries would rise as the risk premium rose and this would push up interest rates for consumers, corporations and municipal and state governments. Credit default swaps on Treasuries, a form of insurance that pays off when a bond defaults, would have to be paid out, likely bankrupting the firms that sold them along with the owners of the swaps.
Since it appears obvious that the debt burden cannot rise forever, Washington has choices to make:
1.) Cut spending.
2.) Raise taxes.
3.) Allow inflation to rise which would both increase tax revenues and shrink the "real value" of older debt. This would have the downside of impacting the value of savings.
4.) Allow the economy to grow at a faster rate than the debt. This would produce bigger tax revenues that could potentially pay down the debt if spending growth was restrained.
Each of these ideas has politically driven weaknesses; no one wants to cut their pet program (i.e. social safety net including Medicare and Social Security and defense and raising taxes is politically unpalatable to conservative Americans. Promoting economic growth has not worked in the past; over the past decade, debt growth has outstripped economic growth, leaving America with a debt-to-GDP level that is up two-thirds from its level at the turn of the century.
The authors suggest that raising taxes, while unpalatable, is probably the most reasonable scenario. Total federal, state and local tax revenue in the U.S. was 24.8 percent of GDP in 2010, the lowest among all G-7 nations. By comparison, taxation as a percentage of GDP was 31 percent in Canada, 42.9 percent in France, 36.3 percent in Germany, 43 percent in Italy, 26.9 percent in Japan and 35 percent in the United Kingdom. As well, 150 nations around the world have a form of national value-added tax. The overall tax rate on goods and services in the United States was 4.5 percent in 2010 compared to more than 10 percent in much of Europe. While increases in income tax revenue generally reduces economic output, such is not the case for value added taxes.
One way or another, Washington has a long way to go before we can be assured that we are going to avoid the spectre of default. Perhaps the national debt has not proven to be the blessing that Alexander Hamilton foresaw.