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.

The Blessing of a National Debt/The Spectre of Debt Default

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.