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I wrote last month in The Kelly Letter about the growing risk of sovereign debt default, national bankruptcy in layman's terms. Several countries around the world are facing it, the US among them, and one or several such defaults would make the corporate bankruptcies of 2008 look like fallen grass blades before falling redwoods.

In the case of the US, national debt held by corporations, foreign governments, individual investors, and institutions such as pension funds grew just last year from 41% of GDP to 53%. That led the Committee on the Fiscal Future of the United States to issue a warning last week that the US must rein in its deficit. The committee is headed by Rudolph Penner, former head of the Congressional Budget Office, and David Walker, former head of the Government Accountability Office and author of Comeback America: Turning the Country Around and Restoring Fiscal Responsibility.

I think everybody agrees that the US needs to cut its deficit, but it takes only a glance at the federal budget to see that doing so is politically out of the question. Consider that the five biggest gobblers of the US budget are Social Security, Medicare, Medicaid, the Department of Defense, and interest on the debt.

Given how angry people already are about pending health-care reform and its attendant reduction in Medicare benefits, do you think there's a prayer of ruling Democrats announcing on top of it that they will next cut back on Social Security, too, and even further on Medicare? No way. Democrats were already so nervous about the unpopular health-care reforms that they watched the close race for Ted Kennedy's old seat in Massachusetts for signs of what might befall them in the 2010 autumn elections. They lost that seat yesterday. They lack the stomach -- and maybe now, even the numbers -- to get much else changed.

The health-care reform effort itself may yet fall flat, painting in vivid color the rigor mortis afflicting American politics. Everybody agreed that the health care system was broken with prices too high and coverage too low, yet nobody likes the proposed solution that came from nearly a year of debating how to fix it. No wonder. Without offering a single answer to the issue of runaway costs, Congress decided to make participation in the broken system compulsory. There's creativity for you!

Our issue here is not health care per se, but government finances. They're shot, and the health care debacle showed that government is nearly powerless to fix them. It was not able to fix health care, and its bungled attempts have made it impossible to even try fixing the unfunded liabilities of Social Security, Medicare, and Medicaid. If anything, outlays for the latter will only increase now that individual states are going bankrupt and seeking help from the federal government. California, for instance, requested earlier this month $7 billion from Washington to prop up its health and welfare programs.

Moving down the list, what odds are there of reducing defense spending? Zero. Even anti-Iraq-war President Obama made sure to ramp up the Afghanistan war before ramping down the Iraq war, so powerful are the forces of the military industrial complex that President Eisenhower warned against. Here again, corporate forces are in clear control of government action, and show no signs of backing off their demands for government money in light of the deteriorating national balance sheet.

As you can see, not one of the top five financial drains on America will be slowed. Social Security, Medicare, Medicaid, and defense spending will continue growing, and interest on the debt can't be reduced short of default. Which brings us to sovereign debt risk.

Marc Faber of the Gloom, Boom & Doom Report told Barron's last weekend, "The deficit will be above a trillion dollars a year as far as the eye can see. One day, Mr. Bernanke or whoever is at the Fed will have to increase short-term interest rates. When that happens, America's interest burden will go up dramatically. Interest payments could go to 35% of tax revenue in 10 years' time, but that is an optimistic assumption. I'm inclined to think 50% of tax revenue will go toward interest payments on government debt in 10 years. Then you are bankrupt. There is only one way out -- the Zimbabwe way. You will have to print and print and print."

To which Felix Zulauf of Zulauf Asset Management in Zug, Switzerland added, "All federal debt, including unfunded liabilities, isn't 100% of GDP, but 600%. In most industrialized countries, federal-government debt is between 350% and 360% of GDP. Eventually the US will arrive at the point where, as Marc says, interest payments on government debt all of a sudden go to 20%, 25%, 30% of tax revenue. And once you go above 30%, you are done. You go into default or your currency breaks down and your system collapses. The problem you will run into first is a dramatic increase in individual tax rates. You'll see much bigger wealth-redistribution programs than you can believe."

Quietly, my circle of investors and geopolitical thinkers are wondering if a national bankruptcy is just what America needs to finally get corporate bloodsuckers off the taxpayer aorta. Given the political impossibility of reducing costs, will Democrats actually try raising taxes to retain US solvency? Imagine how that would go over as the bankers who caused the latest mess announce their record bonuses courtesy of taxpayer funds. The explosions to come may be the only way through the lobbyist choke-hold on Washington. Pick your poison: bankruptcy or bellicosity.

That's just the US. Other nations face similar financial calamity, which is why the World Economic Forum paid attention to last month's article in The Kelly Letter, and placed national bankruptcies at the top of its list of risks in 2010.

The WEF think tank releases an annual Global Risks report ahead of its meeting in Davos, Switzerland. This year's came out last week, and is available here (pdf file).

Its top three risks are: unsustainable debt levels, underinvestment in infrastructure, and diseases driving health costs up and economic growth down. The US is grappling with all three issues.

John Drzik, Chief Executive of management consultancy Oliver Wyman, was one of the contributors to the WEF report. He said, "Governments, in trying to stimulate their economies, in fighting the recession, are [amassing] unprecedented levels of debt and, therefore, there is a rising risk of sovereign defaults. Debt levels have risen from 78% [in 2007, before the crisis] to 118% of GDP in the G20 ... this is something that could really create much more of a crisis than in the past, and we are already in a vulnerable situation."

He warned that unemployment could rise even more, bringing societal and political unrest. Recent news over Dubai, Greece, and Ukraine captured the attention of global financial markets, showing the risks to be real and raising the specter of such collapses happening among the kings of consumption, America and the UK.

Following the same line of thinking that we followed above, the WEF report showed that both the US and the UK face "tough choices" on the immediate horizon as they try to time a "gradual and credible withdrawal of fiscal stimulus so that the recovery is sustained, but not so late that fiscal deficits cause fear of sovereign debt deterioration."

Figure 1 in the WEF report plots various risks based on their severity in US dollars, from 2-10 billion to more than 1 trillion, and their likelihood, from below 1% to above 20%. Those clustered in the upper-right corner of the chart pose the highest severity and highest likelihood. They are:

Asset Price Collapse: more than $1 trillion, more than 20% likely
Chronic Diseases: about $1 trillion, about 20% likely
Fiscal Crises: about $1 trillion, about 20% likely

Two of the three are precisely what we and others have watched build during the stock market rally that was supposedly happening because the economy was improving. Here are the WEF report's quick overviews of each of the three:

Asset Price Collapse:

The last edition of this report discussed the longer term implications of the financial crisis, exploring the tight interconnections among economic and resource-related risks. The fact that the risk of an asset price collapse remains the strongest risk on the landscape on the severity and likelihood axes illustrates the continuing uncertainty about the resilience of the global economy and the effectiveness of fiscal and monetary responses, governance and regulation. Concerns abound about the decline in the dollar and low interest rates fuelling another bubble, this time liquidity rather than debt-driven.

Experts are also worried about a lag in the impact of the recession in a number of areas. The level of corporate bankruptcies, particularly among small and medium size enterprises remains high. Credit card default rates, which are highly correlated with unemployment, are already at historic levels. The current unemployment rate of more than 10% in the US is considerably higher than the 6.5% unemployment rate that most credit card lending models assume. Finally, though residential house prices have fallen considerably in those markets considered to have been the most overheated, concerns persist about commercial real estate. As illustrated by the events in Dubai in December 2009, debt loads remain high; as refinancing needs arise, which are only expected to peak between 2011 and 2013, further shocks could emerge.

Chronic Diseases: "As a consequence of profound socio-demographical transitions among large sections of the world population, changing physical and dietary habits, chronic diseases including cancer, diabetes, cardiovascular and chronic respiratory disease are continuing to spread rapidly throughout the developed and developing world, driving up health costs while reducing productivity and economic growth."

Fiscal Crises: "In response to the financial crisis, many countries are at risk of overextending unsustainable levels of debt, which, in turn, will exert strong upwards pressures on real interest rates. In the final instance, unsustainable debt levels could lead to full-fledged sovereign debt crises."

On the challenges facing America and other economies with unaffordable social systems:

The difficulties posed by the combination of weak fiscal positions and long-term pressures from current social spending trajectories are considerable. A generational approach that also accounts for the fiscal burden facing current and future generations (accounting mainly for social security and government-supported healthcare) reveals huge fiscal gaps. According to one estimate [Laurence J. Kotlikoff, "Is the United States Bankrupt?" Federal Reserve Bank of St. Louis Review, July/August 2006, covered in last Sunday's Kelly Letter], the United States alone has to reckon with a gap of US$ 66 trillion, a figure more than five times current GDP and almost double the US national wealth. Similar outsized generational debt-to-GDP ratios are obtained for many other advanced economies.

On unemployment: "One risk is that this crisis leaves a legacy of underemployment, where people are constrained to accept part-time jobs or jobs that do not require their level of skills. US Department of Labour statistics show that there are 9 million workers in part-time employment who are seeking full-time jobs. Unemployment can become entrenched as workers lose skills or find themselves with the wrong skills to take advantage of new jobs when they arrive."

The rising likelihood of sovereign defaults, and their residing at the top of the financial severity scale, make this an issue we'll monitor all year. As with so many geopolitical subjects, pinpointing if and when this one will rain fire on the parade is hard to do. It's on the short list of items that could show us a dramatic second leg down in the stock market, however, so we'll pay it the respect it deserves.

Source: Is National Bankruptcy Just What America Needs?