Hamish McRae: Defaulting on its interest payments might not be such a bad thing for the US
Economic Life: The US can 'grow' out of its indebtedness: Debt is being accrued there by 300 million people, but in another 40 years there will be 450 million to pay it off
Friday 15 July 2011
There are some questions in finance to which the obvious answer is: yes, of course. Here are a couple. Does it matter if the US Congress cannot agree to an increase in the country's borrowing limit by 2 August – the date, so we are told, that the US hits its present debt ceiling? Would it be bad for the world economy were the US to default on its debt?
Click HERE to view graphic (175k jpg)
Obvious answers, but not necessarily the right ones. As far as the first is concerned there is a little wriggle room, so some delay in increasing the debt limit would not have an immediate effect. Eventually the ceiling would be lifted and meanwhile there might be some delay in Federal payments. The debt ceiling has been increased 11 times since 1996 and there has nearly always been a tussle between Congress and the administration before this has been agreed. A government shut-down happened twice during the Clinton administration, in 1994/5 and again in 1995/6. On both occasions the Federal government had to juggle around with payments, holding some back, while the legislators deliberated. That may well happen again, with the President suggesting that some social security payments might not be paid. However, the general view seems to be that some payments might be delayed, but that eventually a deal will be reached. It just may take a little while.
As far as a default is concerned, that would occur were the US to miss interest payments on its debts. The official view is that this would be a disaster. Speaking on Wednesday this week, the Federal Reserve Chairman, Ben Bernanke, was clear enough. "Failure to [make these payments] would certainly throw the financial system into enormous disarray and have major impacts on the global economy,'' he said.
Clear, but maybe wrong. There would, of course, have to be a downgrading of US debt: the country would inevitably lose its AAA credit rating. The agencies are warning of this already. In the short term, at least, US financing costs would increase as I expect that some foreign investors would dump stock. But if you stand back, the long-term effect of a reasonably lengthy delay in increasing the debt ceiling and a default on interest payments might be really positive. Here is why.
There are two points to be made. First, US levels of absolute debt are not that high by world standards, particularly given the country's demographic profile. Second, the US budgetary process is ill-disciplined and needs to be reformed.
On the first, if you look at net levels of Federal debt relative to GDP, the US is middle of the pack: not great but not dreadful. As you can see from the top graph the US is in better shape than we are. But those figures are just snapshots of debt at the end of last year. They don't take into account the growth potential of different economies, nor the population trends and other demographic indicators. On all these measures the US is in better shape than the rest of the developed world. It has an increasing population and the room for it to go on increasing for many years to come. As a result, though its society is ageing, it is ageing more slowly than elsewhere. The US has also been sustaining higher increases in productivity, even through this downturn. So it does not face the time bomb that much of Europe does; it can, so to speak, grow out of its indebtedness in a way that Italy, for example, can't.
Put it this way. Debt is being accumulated in the US by 300 million people but in another 40 years there will be 450 million to pay it off. In Italy, debt is being accumulated by 60 million but in another 40 years there may be only 50 million people there to pay it.
However, and this is the second point, the US budgetary arrangements are so dreadful that they are undermining this fundamentally sound position. You can catch a feel for this in the second graph. The baseline projections from the Congressional Budget Office are for the running deficit, currently nearly 10 per cent of GDP, to fall back below 3 per cent, a level which would be roughly the same as the potential increase in output of the economy.
That would stabilise debt as a percentage of GDP, though it would not reduce it. This would not create any room should there be another recession. The situation may be much worse than that. Alternative, and arguably more realistic, projections by the CBO suggest that the deficit may get stuck at around 6 per cent of GDP. That would be unsustainable, even for country that runs the only world reserve currency and which its chief trading partner, China, is prepared to finance.
All the experience of the past three years is that countries can flip from solvency to insolvency with savage speed. One month investors are flooding money into you; six months later they are sucking their teeth; and six months after that they will not lend to you at any rate at all. For the moment, the US can borrow at very low rates, but those rates are artificial, the benefit of reserve currency status. That borrowing capacity has meant that the US, unlike European nations, is under little day-to-day pressure to cut the deficit. So, without political change, it will go on rising.
Once you get beyond a certain point, high debt levels inhibit growth. Two highly respected US economists, Kenneth Rogoff and Carmen Reinhart, argue in their book This Time is Different: Eight Centuries of Financial Folly that once debt gets above about 90 per cent of GDP, growth suffers. There are some influential commentators in the US who have argued for the administration to carry on borrowing even now – their argument being that the US economy needs a growth stimulus.
This line of reasoning is being increasingly discredited by what is happening in the rest of the world. However, even if the evidence behind it is thin, the "we should borrow our way out of trouble" approach has a seductive charm for politicians. It was the same line of argument that led to the explosion of credit before the banking crash. Something needs to clonk it on the head before the US really does put itself in a position where it has inevitably to default in some way or other – perhaps by a sharp devaluation of the dollar. That something may turn out to be the debt ceiling.
That is the real case for a serious scare over the debt limit. Were the US to miss a couple of interest payments that would create trouble, of course. But somehow the political process has to reflect the fiscal mathematics. Until the US, and in particular its creditors at home and abroad, can see an effective way to curb its deficit, the potential for a really nasty financial crash becomes all the greater.
It is interesting to see the shift of mood in the markets with regard to Greece. A few months ago default was to be avoided at all costs. Now it is recognised as inevitable. Once that view has taken hold the case for delay disappears. Better get the damn thing out of the way and at least everyone will know the worst. I suspect that a similar shift in mood is starting to take place with regard to the US deficit: that a shut-down of government would actually be better in the long run than the make-believe world where the country thinks it can borrow for ever.
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