Financing a confidence crisis
By Svetoslav Georgiev - Chief Market Analyst - Hantec Markets
High level and consistent growth of U.S. government debt attracts more attention and is a cause for concern. The topic of possible U.S. debt default appears increasingly frequently in academic and business publications. What could the economic and financial implications be globally and within the U.S. is a question that intrigues many. Despite the unchallenged safety and seemingly unlimited access to credit, the U.S. government debt financing at low cost is largely dependent on investors’ expectations.
The U.S. public debt has increased from 36% of GDP in 2007 to critical 62% of GDP at the end of 2010. Historically, the U.S. public debt stood at such high levels only in the years of World War II. This poses the question: what debt level is sustainable? The U.S. has the privilege to borrow at low interest rates on international markets due to the unchallenged perceived safety of U.S. bonds. However, rational investors continuously evaluate the debt level to establish if excessive borrowing may lead to solvency problems or if an inflationary route becomes appealing to keep debt at sustainable levels.
Studies have shown (Reinhart & Rogoff, 2010) that debt to GDP ratio of over 90% is generally associated with low growth environment and a value of over 60% is critical. A low growth, especially for an extended period of time, will challenge the “safe debt” status as the debt to GDP ratio continues to deteriorate and solvency problems deepen to reach a point where spending cuts or higher taxation are necessary to maintain the balance. The US debt financing model relies on the unique status of U.S. debt, where perceived safety goes further and allows issue of unbacked debt. Thus, the U.S. government can borrow at rates lower than superior private borrowers. The access to virtually unlimited credit at cost advantage provides numerous social benefits. One being the intergenerational wealth smoothing that allows current investment based on promised future repayment. However, unlimited debt is unsustainable. Some fundamental factors such as budgetary limitations and government’s ability to service its borrowings limit the debt level.
U.S. fiscal policy has been largely dependent on the perceived safety of U.S. Treasuries. The safe debt concept backed by history of strict payments and lack of default (if we exclude a 1979 technical default) allow the floating of unbacked debt, or rather debt backed by the value of security to investors. However, when the debt to GDP ratio approaches unsustainable levels there should be fiscal policy steps that compensate. The decision whether the adjustment comes from spending cuts or tax increases, or a combination of the two, turns out to have major political implications as the recent weeks of frantic negotiations between Democrats and Republicans have shown. A plan that seems to offer a possible end to the impasse was proposed by Mitch McConnell. The plan entails three stages for raising the debt ceiling over the next year. At every stage there should be spending cuts at least equal to the amount of the debt-ceiling increase.
There are two main concerns associated with a debt model based on perceived safety. The first is related to the fiscal implications during periods of low economic growth and the ensuing cost to society-a scenario currently unfolding in the U.S. The second refers to investors’ confidence and the ability of a debt issuer to maintain the “safe debt” status of its bonds. A deep confidence crisis holds a potential for an international financial calamity. Rational investors explore policies and may question debt repayment, even if a country has no history of default. They will also question the appeal of inflationary policy, which for now seems to be off the table given the weight of short term debt in the U.S. debt composition (Blanchard, 2010). Although it is difficult to time changes in expectations, these can be sudden and dramatic. On the other hand, many will say that the U.S. government is too big to fail and default is unthinkable, as the Federal Reserve will provide a bailout.
Nevertheless, a confidence crisis scenario, triggered by debt financing problems or solvency concerns, if realized will lead to investors’ expectations of high interest rates, expansionary monetary aggregates, and a likely loss of value for the U.S. Dollar. The implications for the international financial system may be dire. Expectation from rational investors of higher rates on US debt will bring down the existing refinancing model of U.S. debt and could lead to lasting solvency problems followed by defaults. Expansionary monetary environment will likely be associated with a lasting drop of the U.S. Dollar in international markets. This scenario may lead to reevaluation of the reserve currency status of the U.S. Dollar, which would cause flight to alternative safety assets and would further weigh on the supply side, deepening the drop of the U.S. currency.
The U.S. enjoys the unique benefit to finance its debt based on a “safe debt” status at privileged cost levels. This model of debt financing has ensured easy servicing of debt payments and availability of credit to the U.S. borrower. However, the excessive use of the privilege may unleash a torrent of problems for the U.S. economy and the international financial system. Unsustainable debt level may be associated with extended periods of low economic growth and may translate into substantial cost to society in the form of fiscal austerity. More dramatically, solvency problems can trigger shifts in investors’ expectations and a confidence crisis. This scenario can jeopardize the existing debt financing model, but even more critically can trigger an unprecedented international financial crisis. With so much at stake and negotiations for the increase of the U.S. debt ceiling continuing, the reality of the unthinkable U.S. debt default becomes more tangible.
