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Generational Dynamics Web Log for 1-Feb-2009
Can a country go into default on its debt? Can the US?

Web Log - February, 2009

Can a country go into default on its debt? Can the US?

Investors are increasingly betting that the answer is 'yes'.

I've mentioned the possibility that the US government will default on its debt many times. Countries like China and Japan have trillions of dollars worth of long-term Treasuries in their portfolios, and that number has been growing exponentially for years, and is currently at over $3 trillion.

It's thus been clear that these long-term Treasuries would not be redeemed in the normal course of events, and that some kind of major international crisis, including a possible US default, would have to occur to resolve these debts. For that reason, for years I've recommended to web site readers to stay away from long-term Treasuries, but to maintain assets either in cash or in short-term (6-12 month) Treasuries, which can be obtained online with no fee from http://treasurydirect.gov .

I've received numerous e-mail criticisms for these recommendations, usually in the form of "You don't know what you're talking about. The Treasury can 'print' as much money as it wants to pay off debt, so the US Government cannot default, and will never default."

I've always regarded such comments to be in the same airhead category as "There's no such thing as a real estate bubble," or "It's impossible to have deflation since the government can prevent it just by 'printing' money" or "We can never have a new Great Depression."

As I've been saying on this web site for six years, we're headed for a new Great Depression, as can be seen simply by applying to the Law of Mean Reversion to the 'real value' of the stock market. This is not rocket science, and every prediction I've made based on this observation has turned out to be true, or is trending true. There is no web site in the world with anything approaching the predictive success of this web site.

So now, the same people who believed that a real estate bubble was impossible, or that a new Great Depression is impossible, are telling us that the US Government can never default, because it can 'print' all the money it wants.

If the people who say this were capable of actual thought, then they would soon realize that if what they claim were true, then it would mean that the US Government would have an unlimited credit card with no need ever to pay off the debt. People who believe that are the same people who believed that no subprime mortgages would ever default. It's the same kind of airhead thinking by Boomers and Gen-Xers who apparently never have been capable of any kind of thinking EXCEPT airhead thinking.

And if their claim were true, then why wouldn't we just do it? Why don't we just 'print' $3 trillion, and pay off all those long-term Treasuries, if only to shut people like me up?

When I put it that way, anyone can see how absurd those claims are. Today Washington is debating about a Christmas tree $800 billion fiscal stimulus bill. No one is even discussing using $100 billion of that to pay off Treasuries. Just the opposite -- everyone realizes that the Treasury debt can only go up, continue its exponential climb to $4 trillion or $5 trillion. There's never a "good time" to pay off debt, unless you're forced to. (See "One, Two, Three ... Infinity.")

Stein's Law: If something cannot go on forever, then it won't.

So the question is not, "Can the US Government default?" The answer to that question is, "Of course it can." The actual question is, "How long can America's debt grow exponentially before it defaults?" And more importantly, "Are we now close to the point of default?" And, "What exactly does default of the US Government mean to the US and the world?"

Iceland and beyond

I've heard analysts, including economics "experts," in the last couple of weeks say something like, "Who knew any of this could happen? Who knew that Iceland would have to be bailed out? Everyone was surprised."

Well, I'm not a psychic, and I'm not a Rhodes scholar, but I can read the news. In February, 2006, there was a spate of news articles about the sudden collapse of Iceland króna, and I wrote an article about it, and that the government bond ratings for Iceland were revised from "stable" to "negative."

So none of this surprised me at all. It was obvious to me, reading the news in February, 2006, that Iceland was on a trend to national default, and that the factors causing that trend would not change.

So, in March of last year, when Iceland's banks were in trouble, and "experts" were saying, "Omigod! Who knew?", I wrote "Country of Iceland may be close to financial default" as the next step in that trend.

The point I'm making here is that you have "experts" like Krugman or at the Wall Street Journal or on CNBC, and they keep getting caught by surprise because they don't read the news about their own areas of expertise. Or else, they read the news, and they reject the news as just more crap written by Boomers.

Now, other European countries are traveling down the same road. On January 9, Standard & Poor’s lowered the outlook on Ireland’s bonds from "stable" to "negative," the same rating change that occurred to Iceland in 2006. At the same time, the ratings of Spain, Portugal and Greece were lowered even further.

Defaults of several European countries is now considered a real possibility by analysts. I heard one TV pundit say, "The difference between Ireland and Iceland is one letter and six months."

Credit default swaps on government bonds

Since last March, investors have become increasingly aware that a country's bonds can default, and they've been increasingly "betting" on defaults.

The way that an investor "bets" on the default of a country's or company's bonds is to purchase a credit default swap (CDS) on those bonds. The CDS is a kind of insurance policy. Just as you can buy an insurance policy that will pay you when your house burns down, you can buy an insurance policy (a CDS) that will pay you when someone's bonds default. There are companies (such as MBIA, Ambac, FGIC, ACA) that have been in the business for many years to sell these insurance policies, and these companies all faced financial disaster last year.

Anyway, you can still buy CDSs on pretty much any publicly available bond, including any country's government bonds. According to an article by Bespoke Investment Group:

"As shown, Argentina and Venezuela have the highest default risk, followed by Iceland, Kazakhstan, Russia, and Egypt. While the UK and US have relatively low default risk compared to most other countries, their CDS prices are getting worrisomely high. At the start of 2008, it cost about $8 to insure $10,000 of UK and US debt. It now costs $135 to insure UK debt and $75 to insure US debt. Japan has the lowest default risk of all of the countries highlighted, followed by Germany and France."

The following tables show the CDS prices for sovereign debt (country debt) for various countries. The the CDS prices represent the cost per year to insure $10,000 worth of sovereign debt for five years. These CDS prices are set in the open market, and so the represent the opinions of investors about the probability of default of these countries.

CDS prices for country debt for various countries, as of January 23, 2009 <font size=-2>(Source: Bespoke Investment Group / Seeking Alpha)</font>

CDS prices for country debt for various countries, as of January 23, 2009 (Source: Bespoke Investment Group / Seeking Alpha)

The above charts show various interesting things:

The leftmost "current" column shows the current CDS prices for various countries -- the price to insure $10,000 in debt. The higher the price, the more likely the country is to default. In the recent past, "normal" CDS prices used to be less than $10 for the developed countries, but now the lowest is Japan - $45.

According to investors, Argentina and Venezuela have extremely high chances of default -- it costs around $3,000 to insure $10,000 of debt. Iceland is next, at just under $1000.

The USA is still considered to be among the safest countries, with CDS prices at $75 per $10,000 worth of debt. However, if you look at the next three columns, you see a dramatic change: The cost was $67 just three weeks earlier (the end of 2008), and at the start of 2008 was just $8!

If you look at the chart on the right, you see an extremely dramatic trend. This chart shows the trend -- the changes in price of CDSs for different countries. The top countries are Ireland, Belgium, Spain, Portugal, Slovakia, Germany, UK, and France, with Greece close behind. What we're seeing is the CDSs prices on almost all the European countries increasing rapidly, indicating that investors believe that one or mor major European defaults are near.

This has caused much alarm among some analysts:

"A sharp rise in sovereign spreads suggests [that default] could be an alarming possibility.

On January 9, Standard & Poor’s announced that Greece, Spain and Ireland were on review for a possible downgrade, indicating that a Eurozone country could default. If financial crises have taught us one thing, it is to take such “black swan possibilities” (as Nicholas Nassim Taleb would describe it) seriously. A sovereign default by a small country could wreak havoc on the markets for credit default swaps (CDS) and might even destroy financial institutions in other Eurozone countries. It could trigger panic rise in bond yields and the threat of contagion could turn into a self-fulfilling prophecy. A far more serious threat would be a cascading series of defaults that would eventually include one or more of the Eurozone’s large countries. The 10th birthday of Eurozone seems to be holding out ominous portents."

These widespread concerns have forced Jean-Claude Trichet, the President of the European Central Bank (ECB), to defend the euro on several occasions.

"I do not see the euro at stake, certainly not the solidity of the euro area. What is at stake is the judgement of the market at the moment on the sustainability of fiscal polices."

One can only say that this is a boilerplate response that Trichet would give in any circumstance, and that one cannot assume that it provides you with any information whatsoever.

What is clear, though, is that trend is clearly in the direction of default. Economic trends have been just as dismal throughout Europe as they have been in America in recent months, and there's no reason to believe that they'll improve in the foreseeable future.

The strengthening US dollar

When any organization goes into debt, and can no longer borrow by ordinary means, it can hope that someone will bail it out; if not, the organization goes bankrupt. Bankruptcy means making some sort of agreement with its creditors; for example, they might agree that the bankrupt organization will pay 50 cents on every dollar it owes.

When a country goes bankrupt, it has pretty much the same choices. Iceland was able to arrange a bailout from the IMF last year, but if several European countries default, then IMF bailouts may not be an option.

A country does have one more option: It can 'print' new money, and pay off the debts with the new money. For most countries, this has the same effect as defaulting in the sense that the country now owes the same debts in an inflated currency, so its effective debt is a fraction of what it previously owed.

Among world currencies, the US dollar is unique for two reasons:

The dollar is the world's reserve currency, and many, many trillions of dollars are held by people, businesses and governments around the world. This effectively means that it's politically impossible to inflate the currency to reduce the debt.

There are hundreds of trillions of dollars in credit derivatives contracts and other structured finance securities (including mortgage-backed securities) in portfolios around the world. The values of the assets continue to be written down, reducing the amount of money (dollars) in the world.

What these factors indicate is that the US dollar is, in a sense, disconnected from the US government. The amount of dollars in the world can be influenced but not controlled by monetary and fiscal actions taken by the US government. In a sense, it can be said that the US dollar has become an international currency with a life of its own.

What does a US government default mean?

For several years it's been apparent that the US government would eventually default on its long-term Treasury debt, and for that reason I've recommended that readers stay away from long-term Treasuries. However, I've never been able to form a strong opinion on what this would mean to the country and the world, and of any such opinion would be speculation anyway.

My view was influenced very strongly in October, 2007, when I posted the article "The bubble that broke the world," describing a book by that name written by Garet Garrett in 1931-32.

Garrett's book is still the best I've seen for understanding today's mood, since it captures the mood at the beginning of the Great Depression, before other writers provided descriptions of that mood distorted by later wars and ideologies. If you haven't read "The bubble that broke the world," now would be a good time to do it.

As I explain in the article I wrote describing the book, I expect the international community to try to find a way to "bail out" the US, just as the international community tried to bail out Germany in 1932. This is all speculative, of course, but what might be the nature of this bailout?

The Generational Dynamics forum has some of the smartest people on the internet as contributors, and one contributor has posted an analysis that references some recent statements by Russian Prime Minister Vladimar Putin blaming the international financial crisis on the United States.

Putin's statements have been supported by a proposal by German Gref, a former Economics Minister who is now CEO of Russia's largest bank, state-owned Sberbank. The proposal was that, in the absence of any serious competitors to the dollar, he advocated international control of U.S. monetary policy.

This proposal is being taken as a joke, and indeed it's a move of desperation by the Russians, who are collapsing economically as the price of oil fell from $147 per barrel to $40 per barrel. In fact, if you look at the CDS charts near the beginning of this article, you'll see that Russia is near the top of countries viewed as likely to default. Putin and Gref are just doing what all politicians do -- finding someone else to blame for their problems.

But the proposal shows the way to a possible scenario. As the US government debt increases exponentially, the Russian proposal may gather steam, and it might turn into "Give the international community control of the dollar, and we'll forgive you all your debts." If the situation becomes sufficiently desperate, this may become a viable scenario.

The above is just speculation, so let's return to what we know for sure. From the point of view of Generational Dynamics, the trends are clear and unstoppable. There will be an increasing financial crisis that will be worse than the Great Depression. This financial disaster will destabilize poor populations around the world, leading to the Clash of Civilizations world war. Beyond that, the exact scenario cannot be predicted.

(Comments: For reader comments, questions and discussion, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (1-Feb-2009) Permanent Link
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