The United States will probably default on its debt one day. There, I said it. Did I get your attention?
Well, actually, I didn't say it. Scott Mather, head of global portfolio strategy for the bond giant PIMCO, said it in an interview for the Fiscal Times. To be clear, he wasn't predicting that the Treasury would walk away from its debt, the way homeowners in "strategic" foreclosures are doing every day now. That is not going to happen.
He had another kind of default in mind. "There is more than one way to default," Mather points out. You can simply refuse to pay the dollars you owe, or you can pay with dollars worth much less than when you borrowed. That's what Mather has in mind: "The U.S. "is probably going to inflate its debt away."
What's that mean? Unlike your run of the mill deadbeat -- say, Nicholas Cage -- Uncle Sam is in the unique position of being able to print the currency with which it pays its vast and growing obligations. Printing more money is politically a lot more palatable than raising taxes or cutting services, the only other known way of paying off government debt. Unfortunately, that makes the printing press a constant temptation for Washington. At some point in our debt-swamped future, it could be an irresistible one. "I'm pretty discouraged," economist Steven Happel of Arizona State University told me last weekend. "I think stagflation is a real possibility."
Credit market newsletter guru Jim Grant in his annual tongue-in-cheek prospectus for U.S. Treasuries-his version of what the Treasury would say if it had to write an SEC prospectus for its bonds, the way corporations do for theirs-noted these five "risk factors," among others. Despite the lawyerly prose Grant affects here, this is scary stuff:
1. The Government's financial market interventions since the start of the financial crisis -including guarantees, loans and direct outlays-have totaled $8 trillion, or 55% of GDP. Says Grant in prospectus-style understatement: "It is unlikely that private risk can be continuously transferred onto public balance sheets without eventually impairing the creditworthiness of the Government." No kidding.
2. The entitlements gap-or the difference between the present value of our future Social Security, Medicare and Medicaid promises and that of the money we'll have to pay for them-was $46 trillion last winter. As of now, there is no plan to pay for shrinking that gap.
3. The U.S. is fighting two wars and has other expensive foreign commitments. "Throughout history," writes Grant, "the financing of military conflicts has led to significant stresses on sovereign finances." As economist Carmen Reinhart points out in this CBS MoneyWatch video, sovereign default was often the result.
4. Credit rating agency Moody's has twice warned that unless fiscal policy improves, the U.S. Treasury bond could face a downgrade, which would likely devastate the price of the bonds.
5. Unfortunately, there doesn't appear to be much danger that fiscal policy will improve. In Grant's words, "Elected officials may not take necessary steps to ensure long-term debt sustainability and may take actions counter to the interests of bondholders." In plain English, faced with a choice of raising taxes and slashing government services on the one hand or inflating the dollar on the other, politicians will choose inflation.
Now while higher U.S. debts are guaranteed, inflation is not a certainty. Nothing in the financial markets is. Even PIMCO's Mather thinks that in today's struggling economy, deflation is the more immediate threat. Economist like Brad DeLong think that inflation is highly unlikely any time soon. (I'll summarize their arguments in a future post.)
Then again, it was once unthinkable that the credit quality of U.S. Treasuries would ever become a factor for investors, but it clearly has. Bond investors refused to absorb a couple of massive Treasury bond auctions last week without higher rates (over all, yields on the 10-year Treasury jumped a sixth of a point last week). Also last week, the U.S. passed a $940 billion health care bill that no serious person believes will lower the deficit. And for the first time in my memory, Bloomberg reported that supposedly default-proof Treasuries traded for higher yields than bonds issued by corporations like Procter & Gamble (PG), Johnson & Johnson (JNJ), and Berkshire Hathaway (BRK-A).
That might not be because investors are literally afraid of a Treasury default-by-inflation (or by any other means) at any time soon. But it certainly wasn't because investors believe that credit risk in Treasuries is unthinkable. They're thinking. So should you.
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