Now that the Republicans have come forth with Representative Paul Ryan’s $6 trillion plan to reduce the debt burden on future generations of Americans, 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:
"…it 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 takes "swift and severe" action before it’s too late.
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