Default Lines

Article excerpt

Inflation, austerity, or debt repudiation awaits America.

COULD THE U.S. default on its national debt? That the question is even being asked should give us pause. A few years ago, the idea of the federal government failing to repay what it owed investors seemed like a prospect so farfetched as not to be worth discussing. But as the national debt has rocketed above 90 percent of gross domestic product - the "line in the sand" identified by Carmen Reinhart and Kenneth Rogoff as the default danger zone - the possibility is no longer remote.

A few numbers put the question in perspective. Since 2001, the debt "held by the public," which includes the debt held by non-U.S. central banks and investors, has nearly tripled, from $3.3 trillion to over $9.5 trillion. The total national debt that most media accounts cite - which includes the "intragovernmental holdings" of the Social Security Trust Fund and other agencies - has more than doubled, from $5.7 trillion to over $14 trillion, roughly 97 percent of GDP

This is comparable to the levels of debt that burden the much smaller economies that triggered the Eurozone's recent crisis, including Greece (130 percent), Ireland (93 percent), and Portugal (97 percent). Skeptics of default are quick to note, though, that the sheer size of America's economy and dollar's role the world's primary reserve currency put the U.S. in a category of its own. Yet the debt's fearsome growth has brought the specter of default to Uncle Sam's doorstep. The Government Accountability Office recently declared the trajectory of federal deficits exceeding $1.5 trillion a year "fiscally unsustainable."

Deficits of this magnitude, fully 11 percent of annual GDP, far outpace economic growth, which typically meanders between 2 percent and 3 percent annually. And these numbers are related: Reinhart and Rogoff found that nations with debts exceeding 90 percent of GDP saw their growth rates cut in half. Nations rarely grow their way out of rapidly rising debt

These once astounding but now routine federal deficits have added $5 trillion in debt just since 2008. Official projections for radically reduced deficits in 2012 and beyond are a fantasy. If anything, rising spending on demographically driven entitlement programs such as Social Security and Medicare will drive up spending even as recently passed tax cuts lower federal revenues. Perhaps nothing screams unsustainable quite as loudly as the imbalance of tax receipts and spending. Tax revenues are around $2.3 trillion; spending is about $3.8 trillion. The $1.5 trillion gap is borrowed, adding to the national debt.

As if the official debt weren't worrisome enough, there are other "off-balance sheet" obligations that could end up adding to the debt: the many federal guarantees issued during the financial crisis, for instance, and federal obligations to the ailing mortgage giants Fannie Mae and Freddie Mac.

The Dynamics of Default

How do crushing national debts trigger default? As investors see debts climbing to unsustainable levels, they demand higher yields on bonds to offset a rising risk of default. The subsequent spike in interest rates adds to the government's interest payments. This crimps other spending, forcing the government to borrow more, increasing both the debt and investors' fear of default.

This is a positive feedback loop: rising debt triggers higher interest rates which lead to more borrowing which pushes rates even higher. At some point, the government can no longer issue new debt, or roll over old debt, because investors refuse to buy its bonds or soaring interest payments are consuming most of the state's tax revenues.

Since servicing debt detracts from economic growth, the indebted nation suffers from another positive feedback dynamic. As interest payments skyrocket, either taxes rise or the government provides fewer services. As the economy slows, tax revenues decline and the government has to borrow even more to meet its interest and entitlement obligations, increasing the drag on growth. …