The Specter of Default: How Safe Are U.S. Treasuries?Published: June 06, 2012 in Knowledge@Wharton
The soaring United States debt -- about $15.6 trillion -- is financed through the sale of Treasury securities, and these enormous offerings make the U.S. dollar the go-to currency for governments, businesses and investors who need to store reserves with the utmost safety. But the debt cannot continue growing forever, or borrowing costs will deprive the government of money it needs for other purposes. Economists and policy makers -- from right and left -- agree on that.
So, just how solid are Treasury bonds, long considered a "riskless" investment? Is a default possible? Desirable? Unthinkable? And what are the options for reducing the annual government deficits that cause the debt to grow?
Those and other questions were the subject of a recent Wharton conferencetitled, "Is U.S. Government Debt Different?," organized by Wharton finance professor Franklin Allen, University of Pennsylvania Law School faculty members Charles Mooney and David Skeel, and Anna Gelpern, a professor at American University's Washington College of Law. The conference was set up in the wake of last summer's debt-ceiling showdown in Washington, which highlighted the risk of a default on government bonds. Now, a similar showdown may be in the offing, given that the ceiling will need to be raised by the end of this year.
Conference participants' short answers to the key questions: Treasuries have a unique role in world finance; default would be catastrophic, and the only practical ways to curb the growth of U.S. debt are to tackle entitlement programs like Medicare or to raise taxes, or both -- solutions that seem almost impossible given the Republicans' opposition to tax increases and cuts in military spending, and the Democrats' defense of spending for the poor and elderly.
Since the financial crisis that began in 2007 and 2008, the national debt as a percentage of gross domestic product has skyrocketed, according to conference panelist James Kwak, a professor at the University of Connecticut School of Law. "The federal government ran annual deficits well above $1 trillion in 2009, 2010 and 2011 ... the largest deficits since World War II" as a percentage of GDP, he wrote in a paper delivered at the conference. By 2035, the debt could double as a percentage of GDP, to 200%, he noted during his presentation.
The U.S. could handle its debt with a combination of economic growth, tax increases and spending cuts, but it would take substantial political will that currently does not appear to exist, Kwak said, observing in his paper that "proposals that would increase tax revenues are effectively off the table in Washington," while "the prospects of significant reductions in future spending are also relatively bleak."
Over time, U.S. government debt has waxed and waned as federal budgets have swung back and forth between surpluses and deficits. The debt, an accumulation of annual deficits, is expressed in dollars, but its size as a percentage of gross domestic product provides the most convenient way to see when it is getting out of hand.
The current $15.6 trillion in debt includes $10.85 trillion held by the public, such as bonds sold to domestic and foreign investors, and $4.74 trillion in intra-governmental debt, such as obligations from one agency or fund to another. The public debt equals about 70% of GDP, the intra-governmental debt about 30%.
The total of 100% of GDP is less than the record of 112.7% just after World War II. From that time, the debt gradually declined to less than 40% of GDP in the early 1980s, then rose steadily to just under 70% in the late 1990s. Several years of budget surpluses then drove the debt down to about 60% of GDP in the early 2000s, when the sharp rise to today's 100% level began.
That was caused by spending on the wars in Iraq and Afghanistan, reduced revenues from the tax cuts pushed by President George W. Bush, weak revenues from the recession after the financial crisis, economic stimulus spending in recession and growing Medicare and Medicaid expenditures, including the prescription drug benefit that took effect in 2006. Most projections show annual budget deficits continuing to grow, causing the debt to soar in coming decades.
In the summer of 2011, Congressional Republicans and Democrats were locked in a standoff over the relatively routine process of raising the debt ceiling. The current ceiling, $16.4 trillion, is likely to be reached late this year.
Borrowers who get in over their heads typically find loans harder and harder to get, and are generally forced to pay ever-higher interest rates as lenders worry about potential default. But U.S. Treasuries operate in a world of their own. Because the government stands behind them with its taxing power, investors consider Treasuries to be very safe -- virtually the only type of bond that is free of default risk. (Like other bonds, Treasury prices can rise and fall as they are traded. Prices, for instance, fall when investors perceive a greater risk of inflation, which undermines the value of fixed-interest earnings. Prices of existing bonds can also fall when a rise in prevailing interest rates makes older bonds with low yields less desirable than new bonds with higher yields. The term "riskless" refers only to default risk, not interest or inflation risk.)
Worldwide demand for a riskless bond is enormous, and Treasuries really have no rivals. Gold was long used to store reserves, but this ended after World War I because gold supplies simply did not grow fast enough, said conference participant Richard J. Herring, a Wharton finance professor. After World War II, the dollar, which is owned through Treasury purchases, became the unquestioned reserve currency. Treasury holdings have no storage costs, can be bought and sold instantaneously and provide an excellent vehicle for intervening in foreign-exchange markets to influence exchange rates, Herring noted.
"It takes an awful lot to diminish the demand for dollars in foreign exchange holdings," he said, adding: "There was a huge hope that the euro would be an alternative ... but it didn't catch on in a major way." Someday, the Chinese yuan may compete with the dollar, Herring suggested, but probably not for many years.
Many countries, including China, use Treasuries to store reserves. About $4.5 trillion in U.S. debt, nearly half the debt held by the public, is owned by foreigners. Demand is especially high when financial turmoil or uncertainty drives investors to safe havens in a so-called flight to quality.
Asset managers also use trillions of dollars worth of Treasuries to store money safely, and no other asset class is large enough to serve this demand, said Zoltan Pozsar, a visiting scholar at the International Monetary Fund. In recent years there was some speculation that private markets -- the "shadow banking system" -- might offer a substitute, but the financial crisis derailed that hope. "The lesson of the crisis is that you cannot do that by private means," Pozsar said. "Private money creation is always going to end in tears."
Because of this high demand, the U.S. government is able to borrow at extraordinarily low interest rates despite the widely held view that the country's debt is too large. The 10-year U.S. Treasury note, for example, pays less than 2%.
Most experts expect yields to rise over the next few years, as major economies get stronger. Demand for Treasuries could slacken as other investments, such as stocks, get more attractive, forcing the government to pay higher yields to compete for investors. In addition, growing economies will spark worries about inflation, which will drive bond investors to demand higher yields.
Rising rates would cause severe problems for the U.S. government. The bulk of Treasury bonds in circulation have maturities of less than five years, which will require existing debt to be refinanced with new debt at higher interest rates. That will increase the government's debt-service costs.
In theory, it would make sense for the government to refinance short-term debt by taking out long-term debt -- bonds with 10, 20 and 30-year maturities -- while interest rates are low, just as a homeowner replaces a high-rate mortgage with a new low-rate loan. But it's very difficult for any borrower, including the government, to bring itself to replace a low-rate short-term loan with a long-term loan that charges more. Two-year Treasuries yield only 0.3%, compared to 2.84% for 30-year treasuries. In addition, there might not be enough investor demand for larger sales of long-term bonds, as many investors will not want to tie up their money at low rates when higher rates are just around the corner.
No Good Remedies
While just about everyone recognizes that the debt poses a serious problem, every potential remedy is distasteful.
At the extreme, the government could default -- simply refuse to pay investors what it owes. This occurs fairly frequently when corporations that issue bonds go bankrupt, and about 68 governments have defaulted on sovereign debt since 1800, Herring said. The most recent cases involved Russia in 1998 and Argentina in 2002. Some governments have chosen to default when they find it worthwhile to repudiate the actions of a previous regime, Herring added, noting that others have opted for default rather than face a bout of high inflation, which is politically perilous.
While none of the conference panelists advocated a Treasury default, they did explore the legal and practical implications of such an event.
A legal justification for default might be made, depending on one's reading of the 14th Amendment. It could be argued that provision would permit something short of a total default, such as a delay in paying interest, a decision to pay on some bonds but not others, or the option of extending maturities, which are the dates on which the government must repay investors' principal.
But even if a legal justification for some type of default could be found, the results would likely be catastrophic, predicted panelist William Bratton, a professor at the University of Pennsylvania Law School. "A default would represent a substantial tax on all investors," he said, paraphrasing U.S. Treasury Secretary Timothy Geithner.
Trillions of dollars of losses would roar through the world economy like a tsunami, damaging Treasury investors, including governments, corporations, pension and insurance funds, individual investors and people who own mutual funds. Panic would undoubtedly harm other types of investments as well, including stocks and real estate. And if the government wanted to borrow in the future, as it most likely would at some point, it would have to pay much higher yields to attract investors. As higher rates worked through the markets, state and local governments, corporations, homebuyers and other consumers would face higher rates as well.
In addition, prices of riskless Treasuries are key when assessing values of other types of bonds, helping guide hedging strategies and providing collateral for financial transactions. They are the main tool banks use to manage liquidity, Bratton said, adding that there is no viable substitute.
To underscore how the markets view a potential Treasury default, Richard Squire, a professor at Fordham Law School, noted that the market for credit default swaps on Treasuries is "very thin." These are a form of insurance that pays off if a bond defaults, and they constitute a very large market covering many types of debt around the world. The CDS Treasury market is tiny, in part because the markets consider default so unlikely. But also, said Squire, they think a Treasury default would be so devastating that the firms that had sold the swaps might be wiped out and thus unable to pay the swaps' owners. He compared it to buying insurance against a nuclear attack while knowing that all the insurers were based in Washington, D.C., and would be destroyed.
If default is out of the question, and the debt burden cannot be allowed to grow indefinitely, the government will have few options other than to raise taxes or to cut spending.
Some politicians argue that the country can grow its way out of the problem, with economic growth producing bigger tax revenues that could pay down the debt if spending growth is restrained. But it is difficult to believe the economy could really grow fast enough for that to happen, said Deborah Lucas, a professor at MIT's Sloan School of Management.
Another option is to allow inflation to rise. That, too, would increase tax revenues, while the "real" value of older debts would shrink. But high inflation can be very damaging to the economy, undermining the value of savings and taking an especially hard toll on older people on fixed incomes.
Cutting federal expenditures could free up money for paying down the debt. But, as the tug of war between Democrats and Republicans shows, it is impossible to find enough money to make a difference without going after cherished expenditures like defense, Medicare, Medicaid and Social Security.
That leaves tax increases -- another option with many opponents, especially conservatives. But if the political will could be rallied, the United States does have plenty of room to raise taxes, suggested University of Michigan Law School professor James R. Hines, Jr.
Total tax revenue in the U.S., a combination of federal, state and local taxes, equaled about 24.8% of GDP in 2010, the lowest level among the G-7 countries -- the world's high-income nations, Hines said. Levels were 31.0% in Canada, 42.9% in France, 36.3% in Germany, 43% in Italy, 26.9% in Japan and 35% in the United Kingdom.
A key difference: The U.S. does not have a national value-added tax, a form of sales tax introduced in more than 150 countries since 1966. Though many states have sales taxes, the overall tax rate on goods and services is low in the U.S. compared to most other countries -- 4.5% in the U.S. in 2010 compared to more than 10% in France, Germany and the U.K., for instance.
In general, said Hines, every $100 in increased tax revenues reduces economic output by $50, but the value-added tax is less damaging because it does not discourage business investment. "We have significant untaxed revenue ability. Could we pay of all the debt if we wanted to? Yes, over 20 years we could." For now, though, lawmakers have failed to rally around a strategy.