U.S. Defaults on Debt!
by Satyajit Das Jul 22, 2008

On October 30, 1938, the American Radio Drama series Mercury Theatre aired Orson Welles’s "The War of the Worlds". Adapted from the novel by H.G. Wells, the first half of the broadcast was scripted as a series of dramatic news bulletins of a Martian invasion. Listeners who had missed or ignored the opening credits assumed that the invasion was real. People fled their homes in panic. Police were deluged with panicked phone calls. 

The financial equivalent of this broadcast today? "We interrupt regular programming to announce that the United States of America has defaulted on its debt!"

Default is the failure to honor contractual obligations; in the case of debt, it’s non-payment of interest or principal payments due the lender. The financial impact of default is the lender’s loss. 

Those who have made loans to the U.S. government have suffered significant losses - not because of non-payment, but because repayments have been made in a badly debased dollar. 


Assume a Japanese investor bought 30-year US Treasury bonds in 1985, when the exchange rate was US $1 = Yen 250. Based on a current exchange rate of US $1 = Yen 105, the investor loses 58% of his investment. But the investor can take comfort: At the previous low of US$1=Yen 84, he would’ve lost 66%. 

European investors who bought US government bonds would also suffer significant losses: Based on the highest US$/ Euro exchange rate (1 Euro = US $0.85) and the current trading levels (1 Euro = US $1.56), the investor would have lost as much as 46%. 

These losses are comparable to those incurred in a sovereign default, in which the investor typically loses 50% to 80%. Despite official "strong dollar" policies, a case can be made that the US is in the process of defaulting on its obligations via a systematic devaluation of its currency. 

The US national debt stands at $9.4 trillion as of March 2008 (that’s 12 zeros to the right of the decimal). That’s the equivalent of $30,000 per person, or a little more than $60,000 per member of the U.S. working population. The national debt has grown by $3 trillion (50%) since 2000. In 2007 alone, it grew by $500 billion, from $8.7 to $9.2 trillion. In 2005, it was 67% of U.S. GDP, up from 51% in 1988. 

The Office of Management and Budget projects that total debt will rise to $12.3 trillion in 2013.

Of the $4.7 trillion in private hands, $2.4 trillion (51%) is held by foreign investors. Japan holds around $600 billion (24%), China holds $500 billion (around 20%) and the U.K., Brazil and oil-exporting countries own about 6%. 

Middle Eastern and Russian holdings may be higher, since oil-exporting countries wishing to avoid disclosure may be using Belgium, Caribbean Banking Centers and Luxembourg (8%) as vehicles for investment. 

As James Fallow noted in the Atlantic: "Every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China." 

The debt figures also omit "off-balance sheet" liabilities: The $5 trillion-plus in debt and guarantees carried by the government-sponsored enterprises (GSEs), Fannie Mae (FNM) and Freddie Mac (FRE), which are supported by modest levels of capital (about $81 billion). 

In July 2008, these obligations became a de facto part of the US national debt with astonishing speed. Any problem with the solvency of either institution may have implications for the AAA credit rating of the US.

The national debt’s maturity is also shrinking. In December 2000, the average length of US public debt held by private investors was 70 months. As of March 2008, this had declined by 24%, to 53 months. 71% of this debt is due in less than 5 years; 39% is due in less than a year. 

In the Clinton/Rubin era, the Treasury stopped issuing 30-year bonds (a decision reversed by the Bush administration). The ostensible rationale: Projected budget surpluses would allow the government debt to be retired. 

Shorter dated bonds took advantage of lower, shorter interest rates to reduce the interest cost and boost surpluses. The Treasury Secretary would’ve been aware of this variation on the "carry" trade from his investment banking days. 

The US must now "roll over" significant amounts of debt in the coming years.
High levels of debt are compounded by the "twin deficits": The 2008 budget deficit forecast is $380 billion (2.4% of GDP) and the current account deficit is expected to exceed $700 billion (4.6% of GDP). 

The US savings rate is also extremely low. US consumers have relied on asset appreciation (primarily housing and also stocks) instead of saving. In recent years, borrowing against asset values to fund consumption has reduced even this meager form of “saving.” 


One mainstay of the US economy has been its financial system: "Financial" engineering has long outstripped "real" engineering. Lawrence Summers, a former Deputy Secretary of the US Treasury, proudly extolled the merits of the US financial system in a 2001 speech at the London Stock Exchange: "The United States is the only country in which you can raise your first US$100 million before you buy your first suit." He gave short shrift to critics who felt that US financial sophistication was synonymous with financial instability: "[That belief] is observed in inverse proportion to knowledge of these matters."

The US financial system has been badly affected by losses on subprime mortgages and by the current credit crisis. Losses are in excess of $250 billion, and in all likelihood losses will increase. 

The banking system needs additional capital, despite having raised over $200 billion to date. The Federal Reserve already bailed out Bear Stearns, and further bailouts are possible. 

The Fed has provided over $400 billion in funding support to the financial system - and the US national debt statistics set out above don’t take borrowings required to support the financial system into account.


Confidence in US financial markets has suffered. The unregulated growth of the securitization network and off-balance-sheet vehicles (the "shadow banking" system) now threatens the financial system - a fact that perplexes foreign observers. 

Byzantine GAAP accounting practices (especially off-balance-sheet debt, mark-to-market and derivative accounting) and the failures of rating agencies (a distinctly American phenomenon) have also affected confidence. 


The veracity of economic information has also been questioned. Bill Gross of PIMCO, among others, argue that the official measure of "inflation" significantly understates actual levels because of statistical adjustments made over the past 25 years. 

Mohamed El-Erian, Co-CEO of PIMCO summed it up on 25 June 25, 2008: "What has suffered most is the credibility of the most sophisticated financial systems in the world." 

In a 1998 speech during the Asian financial crisis, Lawrence Summers preached the merits of American-style "transparency and disclosure" - something of which the U.S. is now sorely in need. And John Gapper, a columnist for the Financial Times, observed: 

"If anyone doubts the problems of US infrastructure, I suggest he or she take a flight to John F. Kennedy airport (braving the landing delay), ride a taxi on the pot-holed and congested Brooklyn-Queens Expressway and try to make a mobile phone call en route. That should settle it, particularly for those who have experienced smooth flights, train rides and road travel, and speedy communications networks in, say, Beijing, Paris or Abu Dhabi recently. The gulf in public and private infrastructure is, to put it mildly, alarming for US competitiveness." 

The factors identified are well known. Lawrence Summers once observed: "In this age of electronic money investors are no longer seduced by a financial dance of a thousand veils. Only hard accurate information on reserves, current account and fiscal and monetary conditions will keep capital from fleeing precipitously at the first sign of trouble." 

Why haven’t the "electronic herd" abandoned the US? It seems facts don’t matter - until they do.

High levels of debt are sustainable provided the borrower can continue to service and finance it. To date, the US has had no trouble attracting investors: Warren Buffett (in his 2006 annual letter to shareholders) noted that the US is still a wealthy country with lots of stock, bonds, real estate and companies to sell, and as such is well able to fund its budget and trade deficits.

In recent years, the United States has absorbed around 85% of total global capital flows (about $500 billion each year) from Asia, Europe, Russia and the Middle East. Risk-averse foreign investors preferred high quality debt: This included US Treasury and AAA-rated bonds like asset-backed securities, or ABS, and mortgage-backed securities (MBS). A significant portion of the money flowing into the US was used to finance government spending and (sometimes speculative) property rather than more productive investments.

The real reason the US has yet to experience a sovereign debt crisis: It finances itself in its own currency. This means that the US can literally print dollars to service and repay its obligations. 

The special status of the US derives, in part, from the fact that the dollar is the world’s major reserve and trade currency - a status which derives, in part, from the gold standard. The dollar’s relationship to the value of gold, as well as its full exchangeability, is long gone. 

The aura of stability and a safe store of value based on the strength of the US’s economy and military might has continued to support the dollar. When Saddam Hussein was captured in 2003, he had $750,000 with him - all in $100 bills. 

Many global currencies are pegged to the dollar, sometimes at an artificially low rate (as in the case of Chinese renminbi) to maintain export competitiveness. This creates an outflow of dollars via the trade deficit, which is in turn driven by excess US demand for imports based on an overvalued dollar. 

Foreign central bankers are forced to purchase US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flow back to the US to finance the spending. 

This merry-go-round is the single most significant source of liquidity creation in financial markets. Large, liquid markets and investments in dollars are both a result and facilitator of this process, and help to maintain the dollar’s status as a reserve currency.

That dominance may now be coming to an end. There’s increasing discussion of re-denominating trade flows -- including the price of such commodities as oil -- in currencies other than US dollars. Exporters are beginning to invoice in Euros or Yen. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Others are considering such a move.


Foreign investors, including central banks, have reduced investment allocations to the dollar. The dollar’s share of reserves has fallen from a high of 72% to around 61%. Foreign investors’ demand for US Treasury bonds has weakened, and low nominal (negative real) rates on interest and dollar weakness are key contributing factors. 

Foreign investors may not continue to finance the US. At minimum, the US will at some point have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. 

This would expose the US to currency risk; but more importantly, it would no longer be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors. 


For the moment, the dollar is hanging on - barely. This reflects structural weakness in the Euro and Yen based on deep-seated problems in their respective economies. The artificial nature of the Euro is also problematic. 


The dollar benefits from the "too big to fail" philosophy: Foreign investors, especially central banks and sovereign investors in Russia, East and South Asia, and the Gulf, have substantial dollar investments that would show catastrophic losses if the US were to default. 

The International Monetary Fund (IMF) estimated that the Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Qatar and others) may lose $400 billion if they decide to stop pegging their currencies to the dollar.


Every lender knows Keynes’ famous observation: "If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours." In this, the largest Ponzi scheme in history, foreign creditors must keep supporting the US. As the old observation goes: "The only man who sticks closer to you in adversity than a friend is a creditor."

Does any of this matter? Walter Wriston, then-chairman of Citigroup (C), opined: "Countries don't go broke." In 1982, shortly after this statement, Mexico, Brazil and Argentina defaulted, inflicting near-mortal losses on Citibank. 


Sovereign debt crisis, especially in emerging markets, are characterized by high levels of debt, especially foreign borrowing, poor fiscal policies, persistent trade deficits, a fragile financial system, over-investment in unproductive assets and a sclerotic political system. 

Arturo Porzecanski, in Sovereign Debt at the Crossroads, noted: 

"Governments tend to default specifically when they must increase spending quickly (for instance, to prosecute a war), experience a sudden shortfall in revenues (because of a severe economic contraction), or face an abrupt curtailment of access to bond and loan financing (e.g. because of political instability)...[And] governments with large exposures to currency mismatches and interest rate or maturity risks are, of course, particularly vulnerable." 

The status quo can’t continue. The US must ultimately pay the piper. So what can be done to remedy the problem? In 1989, John Williamson described certain economic prescriptions for nations wracked by crisis -- the so-called Washington Consensus -- which became the "standard" reform package recommended by the IMF. 

This controversial, much criticized package includes: fiscal policy discipline; redirection of public spending from subsidies; tax reform; market determined and positive real interest rates; competitive exchange rates; trade liberalization; liberalization of inward foreign direct investment; privatization of state enterprises; and deregulation. 

Resolution of the problems facing the US requires adopting many elements of the standard IMF economic reform package for emerging markets. Some elements, such as fiscal and monetary discipline, are politically difficult, if inevitable. Reform of farm subsidies must also overcome deep-seated resistance.

Markets are restless; they do not wait. The US dollar has weakened and is likely to fall still further. This helps exporters and tourism, and will ultimately attract foreign investment, which has lately been slow. Weak economic growth and concerns about the US financial system have offset the effects of a lower dollar. 

Despite this, the "closing sale" of US assets has already begun. Belgian firm InBev has acquired Anheuser-Busch (BUD), brewer of Budweiser, the quintessential American beer. Abertis Infraestructuras, a Spanish infrastructure company, submitted a winning bid of $12.8 billion (in partnership with Citigroup) for the right to lease the Pennsylvania Turnpike for the next 75 years. 


Increasing foreign investment is politically sensitive in America. Surveys show that most American would prefer key businesses to remain in American hands. Public concern about investment by Sovereign Wealth Funds (SWFs) reflects this financial xenophobia. 

But the "adjustment" may be well under way. The dry, measured economic prose of the Washington Consensus doesn’t capture its human elements. It will require reductions in American real wages and living standards on a scale that those who haven’t experienced it firsthand can’t begin to understand. Just ask the average citizen of many Asian countries (post the 1997-1998 monetary crisis), Argentina or any other country that has taken the IMF "cure." 


In the 20th century, the US and the dollar overtook Great Britain and the Pound Sterling as the preeminent global economic power and currency. A similar epochal tectonic shift in global economic order may now be commencing. 

The shift isn’t inevitable. There’s much to admire about the US. It remains wealthier than other nations, including those new titans - China and India. America remains a science and technology powerhouse. It accounts for 40% of total world spending on research and development, outperforming Europe and Japan. 

For example, between 1993-2003 America’s growth rate in patents averaged 6.6% a year, compared with 5.1% for the European Union and 4.1% for Japan. America's relatively fast-growing population, secure property rights and well-developed financial markets have long been attractive to investors.

However, as Warren Buffett observed in his 2006 annual letter to shareholders:

"Foreigners now earn more on their U.S. investments than we do on our investments abroad … In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay ever-increasing amounts of interest on interest. …. no matter how rich you are, borrowing on top of borrowing is not a great long-term financial plan. I believe that at some point in the future, U.S. workers and voters will find this annual 'tribute' (of interest payment on the debt) so onerous that there will be a severe political backlash … How that will play out in markets is impossible to predict – but to expect a 'soft landing' seems like wishful thinking." 

The US must now reestablish its economic credentials. Without drastic and radical action, America’s ability to continue to borrow from foreign investors to meet its financing requirements is likely to become increasingly difficult. 

The mass hysteria and panic that followed the broadcast of Orson Welles The War of the Worlds played on Cold-War fears about foreign invasion. It’s interesting to speculate whether a broadcast on default on the US sovereign debt would play on the secret fears of global markets, triggering a similar panic: "We interrupt regular programming to announce that the United States of America has defaulted on its debt!"

Back to Dollar Hegemony