Don’t be surprised if the US defaults on debt

September 13th 2008 - On October 30, 1938, the American Radio Drama series Mercury Theatre aired The War of the Worlds, directed by Orson Welles. Adapted from H G Wells’ novel, 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 and phone calls swamped police.

The financial equivalent of this broadcast today would be an announcement: “We interrupt regular programming to announce that the United States of America has defaulted on its debt!”

Lenders to the US government have suffered significant losses .The losses have not been from non-payment but because repayments have been in a constantly debased currency - the dollar.

Assume a Japanese investor bought 30-year US Treasury bonds in 1985 when the $/yen exchange rate was $1 = yen 250. Based on a current exchange rate of $1 = yen 105, the investor has lost 58% of the investment, though he can take comfort from the fact that at the low of $1 = yen 84, he would have lost 66%.

European investors who bought US government bonds in recent years would also have suffered significant losses. Based on the highest $/ euro exchange rate (1 euro = $0.85) and recent trading levels (euro1 = $1.56), the investor would have lost (up to) 46%.

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.

As of March 2008, US national debt stood at $9.4 trillion. This equates to over $30,000 per person in the US or a little over $60,000 per head of the US working population. The US national debt has grown by $3 trillion (50%) since 2000, when it was $6 trillion. In 2007 alone, it grew by $500 billion, from $8.7 to $9.2 trillion. In 2005, it was 67% of US 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%) and China holds $500 billion (around 20%). Oil-exporting countries probably hold another 10-14%.

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.”

In September 2008, the $5.4-trillion-plus in debt and guarantees of the government sponsored enterprises — Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) — became de facto parts of US national debt.

US national debt is also shortening in maturity. In December 2000, the average length of US public debt held by private investors was 70 months. As at March 2008, the average length had shortened to 53 months (a decline of 24%); 71% of this debt is due in less than 5 years and 39% in less than 1 year. 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).

A mainstay of the US economy has been its financial system - “financial” engineering has long overtaken “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 in the following terms: “… the United States is the only country in which you can raise your first $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 the current credit crisis.

Mohamed El-Erian, co-chief executive of Pimco, summed it up on 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, Summers had preached the merits of American-style “transparency and disclosure”. It is the US that now needs “transparency and disclosure.”

There are other dimensions to the malaise.

John Gapper, a columnist for the Financial Times observed on May 8, 2008: “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. To quote Summers again: “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? Facts, it seems, don’t matter, until they do.