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Does the federal government’s huge debt burden threaten an American debt crisis? This is the second post in a series of three about the damage that might be done by our federal budget deficit and accumulated debt. The previous one covered the risk of inflation. The next will address tax hikes. Today I’m talking about a debt crisis.

The plan is to explain:

1. The classic debt crisis pattern, and possible outcomes
2. Early warning signs of an impending debt crisis
3. Likelihood of an American debt crisis
4. Practical tips for those worried about a debt crisis

Debt Crisis Pattern

The debt crisis pattern can apply to a country, a corporation, or an individual, but we’ll talk about it in terms of countries. A country runs a large deficit year after year. In addition to new borrowing each year, the country must refinance old debt coming due. The country’s creditors start to get nervous about the country’s ability (or willingness) to repay the debt. They demand higher interest rates, and may offer to buy debt only if it is denominated in some other currency.

Recall from our last post that a country can use inflation to reduce the real (inflation adjusted) value of its debt. Creditors know that. They know that inflation typically pulls down the value of a country’s currency on foreign exchange markets. So if, for example, global investors were nervous about Mexico’s debt, they might refuse to buy peso-denominated bonds. However, they might take dollar-denominated Mexican debt. In that way investors are protected against Mexican inflation, though not against Mexican default.

There are three possible resolutions of a debt crisis.

First, the country may pay higher interest rates on its debt, then show fiscal responsibility by cutting its deficit, and thus win credibility with global investors.

Second, a bailout package may be assembled by other countries (perhaps with participation from the International Monetary Fund or another multi-national organization). The other countries will typically require an austerity package of fiscal policy changes, designed to bring the country’s budget back into balance.

Third, a country may not be able to resolve the worries of global creditors. It either repudiates its debt, or simply announces a deferred payment plan. The creditors cannot foreclose on an entire country, but they will decline to lend any new money to the country. Thus, the country has to run either a balanced budget, or a deficit small enough that it can be financed by its own citizens.

The common element is that external creditors impose fiscal discipline on a country, either directly or indirectly.

Early Warning Signs of a Debt Crisis

There are two signs that you are entering a crisis:

1. The interest rate the country has to pay rises

2. Lenders are not interested in bonds denominated in your own currency.

With that in mind, let’s take a look at interest rates on U.S. Treasury Bonds.

RM10

Well, hard to see an impending debt crisis. Here are the results from the Treasury’s last auction:

This 10-year note had a yield of about 3.9 percent. Total bids on the notes were $80 billion, of which $23 billion were accepted. This is an auction, so there were some bidders who did not bid a low enough interest rate to win. Those bids totaled $57 billion. It looks to me like there was adequate interest among lenders. And these were denominated in dollars.

Going forward, those who are worried about a debt crisis will have a challenge interpreting interest rates. Think of three components to the Treasury’s long-term bond rates:

  • The global risk-free interest rate. This used to be measured by the U.S. Treasury bond, but that proves problematic if we are worried about America’s credit quality. The key concept here is that the global business cycle will push the global risk-free rate up or down, as demand for credit from all users increases or decreases.
  • Expected U.S. inflation. Lenders want to be compensated for any loss of purchasing power due to inflation.
  • The U.S. risk premium. This is the spread that lenders demand over the risk-free rate to compensate for the risk of default.

A good early warning system (which I have not set up numerically) would monitor several factors. Start with the interest rates and inflation expectations in major low-risk countries. You can use the IMF’s database to identify advanced economies with positive “fiscal balance” and low current inflation rates. Taking a quick scan, I see Denmark, Finland, South Korea, New Zealand, Sweden and Switzerland seem to fit the bill. The Treasury Bonds of these countries will roughly measure the global risk-free rate. Then add in U.S. inflation by looking at the difference in interest rates between regular Treasury Bonds and inflation-adjusted bonds. Right now that spread is about 2.3 percent. Any increase in U.S. bond yields above changes in global risk free rate and U.S. expected inflation may be due to risk of a debt crisis.

Likelihood of a United States Debt Crisis

I don’t think an American debt crisis is very likely. Call me Pollyanna, but I’m struck by how we reversed a large deficit in the 1980s and actually ran a surplus in the Clinton years. How did that happen? Back in that old time, some Republicans still believed in fiscal responsibility. More importantly, control of the government was divided between Democrats and Republicans, unlike the W. Bush years or the Obama years (so far). The differences of opinion led to gridlock, which many people thought was bad back then. Oh, how we long for some gridlock today. The final issue that helped restrain spending was President Clinton’s scandals. The nation was focused on what happened to that blue dress. On top of the fiscal responsibility was a thriving economy, which boosted tax revenues.

Deficit

Looking forward, our formula for working out of the current deficit pattern would be to have the Republicans regain control of one house of Congress (but not both houses of Congress plus the White House). The economy fully recovers. I’m not ready to forecast surpluses to come, but I can envision the deficits coming down to reasonable magnitudes.

How big is our deficit relative to the supply of funds available to support it? The deficit is (in round numbers) $1.5 trillion. Total world savings is about $25 trillion, so our deficit is a good chunk, but a manageable chunk, of the funds that investors put to work every year.

That’s the annual deficit. What about the accumulated debt? Right now it’s about $8 trillion, to which we need to add about $5 trillion of off-balance sheet liabilities of Fannie Mae (FNM) and Freddie Mac (FRE) and other Government Sponsored Enterprises, for a total of $13 trillion. (We won’t add in the unfunded liabilities of Social Security and Medicare, which are pretty scary 20 years out, when the baby boomers have retired and are big health care consumers.)

The $13 trillion in official debt is getting close to our $14 trillion gross domestic product, but be careful. The debt is often put in terms of GDP, but it’s dangerous to compare a stock variable to a flow variable. Instead, here are some interesting stock variables: net worth of the U.S. household sector is about $54 trillion. Net worth of our business sector is about $18 billion. (The federal government itself does not have a balance sheet! The government does not tally up all of its land, buildings, ships, etc.)

In summary, I am not worried about a United States debt crisis. Don’t take my lack of fear as an endorsement of our fiscal policy of recent years, however. I would have voted against the President’s stimulus proposal. In fact, had I been in Congress, my voting record would have made Ron Paul look like a socialist. (Which is one reason I’ll never be there.) But one does not have to believe that calamity is just around the corner.

Investment Tips for Those Worried About a Debt Crisis

I know that some of you are still not convinced, so here are some investment tips for those still worried.

The simplest way to invest in anticipation of a debt crisis is to avoid U.S. dollar-denominated assets. Buy foreign stocks, bonds and real estate. Those countries with fewest ties to America will be least affected.

One can use the futures market to short United States Treasury Bonds. Here’s a rough rule of thumb: the 10-year Treasury bond has a “modified duration” of about eight years, which indicates that for every percentage point change in interest rates, the value of the bond will decline by eight percentage points. Right now Greece’s bonds are yielding about five percentage point more than German bonds. If you think that the U.S. will have a credit risk at least that large, then there’s a 40 percent gain waiting for you on the short side of the transaction.

Next Up: Taxes

So I’m not too worried about inflation, nor about a debt crisis. I am, however, worried about the impact of the higher taxes that are likely to come. I’ll address that in the next blog post of this series.

Source: Federal Debt Crisis in the U.S.? Nothing to Worry About