Budget

For Certain Is Debt for the Born

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I'm here to create entitlements, and spend taxpayer money. And I'm all. Out. Of. Taxpayer money.

Is the U.S. on a certain path toward a debt crisis? And if so, at what point will it strike? Economists disagree on the details, but the best answers we have to these questions right now are: "It sure looks that way," and "sooner or later…probably." Some countries, like Japan, manage to survive with extremely high debt to GDP ratios. Others, like the Russian Federation, which defaulted in 1991 with a debt load equal to just 12.5 percent of its GDP, crash under far less debt pressure. The wide variation has allowed folks like Paul Krugman to argue that our current debt trajectory is, if not ideal, perfectly manageable.

In a new paper, the Mercatus Center's Arnold Kling attempts to describe just how uncertain the workings of debt markets—sovereign and otherwise—actually are:

The trigger point for a debt crisis is not quantifiable. This is often true even in the case of private debt, such as a credit card balance. What should be the trigger point at which your bank disallows use of your credit card? If the limit were based solely on your theoretical ability to pay, then the upper limit on your credit card balance would equal the present value of all of your future earnings. However, you clearly are not going to work solely for the purpose of paying the outstanding balance on your credit card. Your willingness to pay is much less than your ability to pay. This presents the bank with a problem in psychological guesswork. The bank has to estimate the maximum amount that you can borrow and still be willing to repay.

If you are a credit card borrower with a large outstanding loan balance, your decision to default depends on the costs and benefits of default. The costs might include various legal penalties as well as reduced access to credit in the future. The benefits of default would include the ability to devote more of your future earnings to consumption, rather than to repaying the debt. If your perception is that the costs of default are less than the benefits, then you will choose to default.

However, another borrower in similar circumstances might evaluate the costs and benefits differently and choose to repay the debt.

The fact that different people may respond differently under similar circumstances poses an analytical challenge for the bank. In addition to assessing the borrower's financial characteristics, the bank must guess how they are likely to behave under financial distress. The circumstances surrounding sovereign debt are, if anything, even murkier. The holder of sovereign debt has little or no legal redress available in the event of default. For the sovereign borrower, the cost of default is pretty much limited to (temporary) loss of reputation in credit markets.

Kling admits up front that there's no way to preemptively pinpoint the exact trigger point for a debt crisis. But after laying out a number of the important factors, concludes that if one accepts the Congressional Budget Office's alternative fiscal scenario as the most likely fiscal path going forward, the U.S. will likely experience a debt crisis within the next two decades. No surprises there; the CBO has described the country's fiscal path as unsustainable, Moody's recently cautioned that the U.S. had inched closer to losing its platinum credit rating, and earlier this year, the International Monetary Fund told the U.S. that it needed to generate a "credible, medium-term" plan for bringing down its debt level.

Congrats! You're already deeply in debt!

Yet despite the warnings, Kling notes that "international capital markets continue to treat U.S. Treasury debt as a fairly safe asset." Why? In his paper, Kling suggests that it may be that "investors expect the United States to take steps to get its fiscal house in order," an assumption, he says, is "based more on hope than on recent experience." In other words, investors simply presume that the U.S. will eventually get its fiscal house in order. But given the political disincentives to making the sort of policy moves necessary to stabilize our debt, it's not the safest assumption.

Yet the folks on the pro-spending side of the equation—in particular, those who wanted to see a bigger stimulus last year and those who want to enact more stimulus measures now—are using the signals from international capital markets as a sign that all is basically well, and that increasing our debt load may not be all that big a problem. But that's like seeing smoke rise up from the floorboards of your house and responding that, "Well, if there's anything dangerous going on, the fire department will show up." Well, yes, eventually the fire department will roll in, sirens flashing—but often enough by that point, the house is already burning. As Kling puts it, if we continue forward without seriously addressing our national debt load, "investor expectations will change at some point. That change in market perception is likely to be swift and severe." So sure: In theory it's possible that we could coast along for decades without a debt crisis. But just because all the emergency sirens aren't blaring  quite yet doesn't mean we shouldn't worry.

NEXT: Tony Washington and the Scarlet I

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  1. “Yet the folks on the pro-spending side of the equation?in particular, those who wanted to see a bigger stimulus last year and those who want to enact more stimulus measures now?are using the signals from international capital markets as a sign that all is basically well, and that increasing our debt load may not be all that big a problem”

    Hey, my credit card cleared. The bank loaned me the money. How could I possibly have a debt problem?

  2. Three words: Why find out?

  3. Japan can support huge debts because of its very high savings rate and a financial and legal structure that actively discourages consumer borrowing. People don’t have much choice but to save and that gives lots of capital for politicians to borrow. The Russians by contrast crapped out because they have a very low savings rate. Who can blame them, would you put your money in a Russian bank, especially in 1991.

    America lays between those two extremes in savings culture. Our wasted borrowing will catch up to us much quicker than Japan’s but not as quick as Russia’s.

    The real question in paying off debt is productivity. If a country’s productivity is growing, they can sustain high levels of debt because the county’s future wealth will be much greater than it was when the money was borrowed. Right now, our productivity growth has been slowing down and the Democrats appear to be waging war on the economically productive and seem hell bent on driving every vestige of material production out of the country.

    Unless we can pay off our debts with interpretive dance, aroma therapy and “awareness” I think we’ll be in serious trouble if this continues.

    1. Well, we’ll be good at digging and filling holes…

    2. If we just froze spending and had a no shit 4 or 5 percent recovery, we would be running a surplus in no time. And the debt as a percentage of GNP would crash. It really isn’t that hard to avoid this.

    3. Unless we can pay off our debts with interpretive dance, aroma therapy and “awareness” I think we’ll be in serious trouble if this continues.

      I’m not so sure that we can’t. Well, mostly sure, it’s confusing. I’m a young supposedly productive member of society who has been sold a lie that I could have a fun job selling “awareness” and still get all the neat itoys that I have become used to.

      It’s really depressing to face econmoic realities on a personal level. Maybe America doesn’t want to come off the Prozac. Have you seen the suicide rate in Japan?

      1. We have some serious market distortions that hurt us. The government over invested in higher education. We now have a shortage of tradesman and an overage of over educated who can’t do much. The government also created a housing bubble which caused over investment in housing. All that wasted effort and money makes growth harder to obtain.

        1. an overage of over educated who can’t do much

          Things they can do: serve me coffee, complain on facebook about how hard it is to find a job.

        2. Not quite. We’re really bad at directing students to pursuits that are needed. Lots of intellectual trades are in very high demand: doctors, chemical engineers, etc.

          Sadly, getting a Masters in English Lit leaves you as essentially unskilled labor in this market.

          1. No shit.

            And I talk from experience. Reading Old English doesn’t pay for much.

            That’s why I started a an organic fertilizer company.

  4. “investors expect the United States to take steps to get its fiscal house in order,”

    In God we trust… or maybe the magic money machine that has been the american economy for the last 100 years. We got through the 30s and 70s. We must be able to right the ship again and re-start the wealth-making machine.

    Right?

    Right?

  5. Yet despite the warnings, Kling notes that “international capital markets continue to treat U.S. Treasury debt as a fairly safe asset.” Why? In his paper, Kling suggests that it may be that “investors expect the United States to take steps to get its fiscal house in order,” an assumption, he says, is “based more on hope than on recent experience.”

    Or maybe investors see similar problems in every other country, giving them no viable options.

  6. The whole idea that nation that can force people to use it’s currency and creates a demand for said currency through forcing people to pay taxes and fees and demands they pay only in that currency needs to borrow money is ridiculous.

    IF I was a sovereign country with legal tender laws and a myriad of taxes and fees that must be paid I’d just print money.

    Cut the oligarch debt investors right out.

    Of course, to keep the value of the money stable, I would peg the currency value to the price of gold so if the currency lost value I’d un-print(destroy) or hoard some and if it gained too much value I’d put more out there via spending.

    Now I could use short-term bond issues and calls to manipulate the base amount of currency to keep it where I want it. This though would not be borrowing to spend the money but rather to get more money to flow back to the nest and get it out of circulation until more needs to get pumped out again.

    All that would be if I was a sovereign nation, since I’m an ancap I’m all for competin’ currencies.

    no homo

  7. As Kling puts it, if we continue forward without seriously addressing our national debt load, “investor expectations will change at some point. That change in market perception is likely to be swift and severe.”

    A few people see it coming and take the right steps in advance, others note their lead and follow, the trend builts until it is general knowledge and then the panic starts. By the time it is general knowledge, however, it is too late to do much.

    Knowing the ‘right steps to take’ is also tricky. One of the things that is forestalling a US currency crisis is that there is no clear alternative place to put your money.*

    *If things get really nasty, the gold bugs may find a reimplementation of the 1933 ban on private ownership with all holders of bullion being ordered to turn it in at an “official” rate within 30 days or face confiscation.

    1. The war on gold will be slightly less successful than the war on drugs.

    2. That’s why people have been investing and guns and ammo instead. It will feel much more rewarding to use the former to return the latter in the event of a government kleptomaniac spell.

  8. Who’s this “we” that you’re referring to, Peter?

    If you’re referring to American consumers’ debts as a collective problem, then the solution is either going to be paying them down or penalties/foreclosures x however many millions.

    If you’re referring the the debt being carried by the Federal government, OTOH, I had no part in taking the debt on, and have no responsibility for paying it off, which makes it a “they” problem.

  9. Yet despite the warnings, Kling notes that “international capital markets continue to treat U.S. Treasury debt as a fairly safe asset.”

    Right up until they don’t. The Treasury market is starting to smell like a bubble. The Chinese are quietly shrinking their Treasury holdings, for example.

    One of the things that is forestalling a US currency crisis is that there is no clear alternative place to put your money.

    Interesting thing is, that recent currency crises elsewhere (I’m thinking Argentina) saw people converting their paper into hard assets of any kind, and not necessarily gold or silver. The new safe haven asset of choice may well be oil. Should I point out that the Chinese have quietly been using their gargantuan dollar reserves to buy hard assets (mines, etc.)?

    The one variable that people seem to underestimate is that, right now, our debt service is as low as it can possibly be, which means it can only get worse. When the market starts to demand higher rates to clear Treasury auctions, our debt service is going to skyrocket, and even if we cut spending as John suggest, we will still be fucked.

    Regardless, if this kicks in, what you see is crushing inflation in assets, which pushes its way down the chain to consumer inflation in short order.

    1. “When the market starts to demand higher rates to clear Treasury auctions, our debt service is going to skyrocket, and even if we cut spending as John suggest, we will still be fucked.”

      They can only demand higher interest rates on new money we borrow. The debt that is being issued now will be paid back at the current rate. The people that get fucked by rising interest rates will be the holders of the debt not the government.

      When the market starts demanding higher interest rates, that will make it harder to run a deficit not service our existing debt.

      Sometime RC I really think you are hoping for hyperinflation and a debt default. You seem to invent ways for it to happen.

      1. “They can only demand higher interest rates on new money we borrow.”

        You do realize the US Treasury doesn’t issue long term bonds anymore, right? They are continually rolling over short term debt. So when the market clearing interest rates in Treasury auctions starts to rise, the cost of debt service will increase.

        1. There seems to be a lot of long term debt out there. You can still buy 30 year bonds.

  10. Can someone pls explain heading? I sense there’s an SF reference there I’m missing.

      1. Gods fucking dammit I am done with this place today.

        It’s from the Bhagavad Gita:

        For certain is death for the born
        And certain is birth for the dead;
        Therefore over the inevitable
        Thou shouldst not grieve.

        Why do I always fail at being an asshole?

  11. The holder of sovereign debt has little or no legal redress available in the event of default. For the sovereign borrower, the cost of default is pretty much limited to (temporary) loss of reputation in credit markets.

    The author misses a huge point: that defaulting on debt is massively pollitically damaging to incumbents.

    1. i.e.:
      1) it would result in economic disruption, and a likely large recession.
      2) US holders of national debt would take a large hit and not be happy (mom and pops, insurance companies, money mkt funds (although mostly corporate paper), pension funds).

      Also, what are the mechanisms for a national default? would congress have to vote? would soaring debt prices simply price us out of the new issue market for t-bills?

  12. I’m here to kick ass and chew gum… and I’m all out of ass.

  13. Just a brainstorm here. What if we started an online petition along the line of, “I’m a young American, and I plan on defaulting on America’s debt.” If we get enough young Americans to sign it, perhaps bond buyers will stop enabling Congress’s irresponsibility.

    1. I’m not-so-young, and have every intention of defaulting on “America’s debt” – can I join?

  14. The wide variation has allowed folks like Paul Krugman to argue that our current debt trajectory is, if not ideal, perfectly manageable.

    Krugman is so full of shit.

    Yes it is manageable. That is if we actually manage it. ie cut spending.

    If we do what he wants, spend trillions more, we are fucked.

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