Tuesday, October 1, 2013

Triggering A Debt Default

An older (2010 vintage) but still pertinent paper by Arnold Kling at the Mercatus Center entitled "Guessing the Trigger Point for a U.S. Debt Crisis" examines a "Made In America" debt crisis and what the trigger point will be.

There are two key aspects to sovereign debt:

1.) The holder of sovereign debt has little or no legal redress in the event of a default.

2.) The sovereign borrower's cost of default is limited to a temporary loss of reputation in the world's credit markets.

There are two options open to nations with serious debt problems.  In the first option, any country with a significant level of national debt can opt to transfer wealth from its bondholders to its constituents through a partial or total default.  This can also be done through the mechanism of increasing the money supply (turning on the printing presses) which will allow inflation to transfer wealth from bondholders to the nation's constituents.  The government can also take the second option; raising taxes and lowering spending, a mechanism that will primarily impact its constituents and have minimal impact on its bondholders.

A debt crisis can occur when a nation changes from being a high confidence regime to a low confidence regime.  In the case of a high confidence regime, bondholders have high confidence in the nation's willingness and ability to pay back its debts.  In the case of a low confidence regime, the opposite is true.  The loss of confidence generally leads to higher interest rates on the regime's debts, making it even more difficult for the debt to be serviced.  This also means that investors will place a lower ceiling on the acceptable debt-to-GDP ratio for that nation.  In the real world case of Japan, investors obviously have strong confidence that the Japanese government will pay back their obligations; this has allowed Japan's debt-to-GDP to rise to over 200 percent.  In sharp contrast, in 1991 when the Russian Federation defaulted, their debt-to-GDP ratio was only 12.5 percent; obviously, they were a very low confidence regime.

Now, let's look at the triggering mechanism for a debt crisis.  

A debt crisis can be triggered by an economic shock.  As you can see on this graph from the Congressional Budget Office's 2013 Long-Term Budget Outlook, the impact of the Great Recession on  America's debt-to-GDP ratio was marked, rising from less than 40 percent of GDP in 2008 to 73 percent in 2012:

The CBO projects that the debt-to-GDP ratio will rise to 100 percent of GDP in 2038, however, you'll notice that they have added no economic shocks to their model, a scenario that becomes more and more likely as the debt level rises, confidence is lost and the economy begins to shrink.  With that in mind, I think that it is highly likely that the debt-to-GDP ratio will be much higher than 100 percent by 2038, particularly because:

1.) Federal spending for health care programs and Social Security will rise to 14 percent of GDP, twice the average of the past 40 years pushing the debt up.

2.) Interest payments on the debt will rise to 5 percent of GDP from their average of 2 percent over the past 40 years pushing the debt up.  The money spent on interest payments will also not be available to help stimulate the economy, pushing economic growth down.

3.) Economic growth will be throttled back by the high federal debt, pushing GDP down.  Increased borrowing by the federal government will reduce private investment in capital because the portion of total savings used to purchase government Treasuries will not be available to finance private investment.  This drop in economic growth will also have an additional impact on the debt-to-GDP ratio as the tax base shrinks, pushing federal tax revenues down and pushing deficits (and the debt) up.

In the words of the CBO:

"The risk of a fiscal crisis—in which investors demanded very high interest rates to finance the government’s borrowing needs—would increase."

Now, back to Mr. Kling.  In his estimation, after an examination of the history of interest rates and their relationship to economic growth since 1979, an interest rate shock represents a greater threat (i.e. trigger point) to a future debt crisis than a recessionary/economic shock.  With current interest rates, both real and nominal, being at multi-generational lows, the odds of an interest rate increase (shock) is substantial, particularly given that the current average interest rate on the debt is just above long-term lows as shown here:

 Right now, the world's bond market is making two key assumptions:

1.) The United States has the political will to stabilize its fiscal position.

2.) The United States has the ability to avoid a default and an ongoing ability to service its debts.

Both of these factors make U.S. Treasuries appear to be a risk-free asset.  Unfortunately, as Mr. Kling's analysis shows, there is a substantial chance that the United States could default on its loans between 2015 and 2030, depending on the federal government's ability to undertake significant fiscal reform (spending cuts) and the willingness of Americans to experience personal fiscal pain (tax increases and reduced services, programs and entitlements).  In fact, if spending continues to rise over the next few decades, this is what the breakdown for entitlements and interest could look like as a percentage of GDP:

If the markets perceive that the American public has a very low pain threshold and cannot live with tax increases and spending cuts, the odds of becoming a low confidence regime rise and the debt-to-GDP debt crisis trigger point drops. In addition, an increase in interest rates could push the United States into the low confidence regime camp.

In today's fractious political environment, the compromise necessary to minimize the risk of a debt default is beginning to look less and less likely.


  1. OMG! Where are we going? (other than down?)

  2. It seems to me the confidence in the full faith and credit of the dollar is based on a sandpile known as the debt ceiling. Raise the ceiling, everything is fine. Do not raise the ceiling - we default, and the dollar is no longer the world currency.
    This seems so foolish to me. That's why I called this type of faith and confidence one that is built on a sandpile.
    Don Levit