PIGS R US: Why the US will default on its debt

Dr Niall Ferguson, CFA, and PhD at Harvard recently wrote a columni in the Financial Times
Niall Ferguson wanted to use the title “Pigs ‘R Us” for one of his recent columns in the Financial Times, but he said that his editor wouldn't agree to it. He ended up titling it A Greek Crisis Coming to America.  Nonetheless, it is a very apt title considering the U.S. and the UK’s debt position relative to Portugal, Ireland, Greece and Spain. In a steady state, the UK and U.S. debt levels as a percent of GDP will far outstrip those of the “PIGS."
Yet even a casual look at the fiscal position of the federal government (not to mention the states) makes a nonsense of the phrase “safe haven”. US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941.

Even according to the White House’s new budget projections, the gross federal debt will exceed 100 per cent of GDP in just two years’ time. This year, like last year, the federal deficit will be around 10 per cent of GDP. The long-run projections of the Congressional Budget Office suggest that the US will never again run a balanced budget. That’s right, never.

The International Monetary Fund recently published estimates of the fiscal adjustments developed economies would need to make to restore fiscal stability over the decade ahead. Worst were Japan and the UK (a fiscal tightening of 13 per cent of GDP). Then came Ireland, Spain and Greece (9 per cent). And in sixth place? Step forward America, which would need to tighten fiscal policy by 8.8 per cent of GDP to satisfy the IMF.
Since the early 90s, tax revenue in the U.S. has not kept pace with spending, which has put the nation in a challenging position of having to borrow the difference. The U.S. is getting to the very scary tipping point of where interest payments needed to service the current debt may soon eclipse the amount of money spent on defense. The guys who we lend to aren't are best friends either.  Modern China, Japan and Saudi Arabia, while they are more or less friendly to us now, could turn downright nasty in the event of default.
Theoretically, there are six ways a country can reduce debt: with a higher growth rate of GDP:

a lower interest rate on public debt; a bailout; fiscal discipline; inflation; or default.

The first three options are the most appealing, but givene the current tax regime not likely.  High debt and high tax burdens slow GDP. Lowering interest rates cannot happen because higher debt ratios warrant higher interest rates.

The U.S. is too big for a bailout, so that leaves three options – and none of them are particularly popular or pleasant: Fiscal Discipline, Inflation or Default. 

Reducing debt through inflation is a fools game because increasing inflation by definition increases the rate you pay as the nominal rate equals the real interest rate plus inflation.  We wrote about it in Myth Busted: Inflation Cannot Cure Government Debt. If all your liabilities are long term it would work, but the US has 55% of their assets due in 3 years or less with 10% inflation protected (TIPS).  That means when you inflate, 35% of your debt becomes cheaper and 65% more expensive.  That's a fools game that Bernanke doesn't seem to get.

Applying fiscal discipline is a very difficult political challenge and by Dr. Ferguson’s estimate, the U.S. would need to reduce its spending by 12.8% of GDP, which is nearly impossible. By his account, only one country was able to apply fiscal discipline to reduce debt and that was the U.K. in the Industrial Revolution. In an era of short-term borrowing, nominal rates can rise ahead of inflation, thereby keeping real rates high and preventing inflation from minimizing debt burdens. 

The message gets even worse when it comes to unfunded liabilities at $104 Trillion, per Fed's Fisher, encompassing medicare, medicaid and Social Security. Which means as much as I am strong on defense, there is no part of the government that could not use a 10% cut.  Cutting earmarks completely would not reduce our expenditures sufficiently for fiscal health. 

The only remaining item on the list is default.  The day of reckoning is near.


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