Debt and the dollar’s demise, a compendium of concerns

Here’s a stark reminder of the ticking time bomb that is the US’s federal debt — now at an $11,900bn, or $38,000 per citizen.

Ratings agency Standard & Poor’s is now warning that the US will have to officially — and imminently — raise its federal debt limit:

The U.S. government is moving closer to its $12.1 trillion debt ceiling. On Sept. 30, 2009, public debt subject to the limit totaled $11.9 trillion, leaving $250 billion headroom. Standard & Poor’s Ratings Services expects Congress to increase the limit this quarter. However, the required legislation may become enmeshed in other current political debates, which will raise uncertainty in the government debt markets and may disrupt some government functioning. Nonetheless, we do not believe that the debt ceiling issue will prevent timely service of U.S. federal government debt. Our rating of U.S. government debt remains ‘AAA’ with a stable outlook.

The U.S. is unusual among the 123 sovereigns that Standard & Poor’s rates in that it sets a statutory limit for nominal debt outstanding and more particularly has its legislature vote on the limit most often apart from the approval of the budget. The bifurcated process can thus allow a lawmaker to vote for higher spending or lower taxes while later posturing against the government debt that is engendered by fiscal deficits. We consider that this process is not best practice and is a weak point in an otherwise strong budgetary framework.

As a reminder, Congress has raised the US debt ceiling by varying amounts 76 times since 1960. Most of those times, Congress raised the debt ceiling before it was hit, but other times — such as in the last occurrence — the debt crisis of 1995/1996 — it reacted only after debt reached its statutory limit.

That $240bn, incidentally, is about two months worth of government financing operations — which means the US will have to act relatively soonish — either by officially raising the debt ceiling or creating some additional headroom viz some clever accounting manoeuvres.

So what can the US do to create a bit of breathing space? Here are S&P’s suggestions:

In these instances, the U.S. treasury must engage in some legerdemain to create additional headroom. One possibility is to withdraw government debt holdings of the Government Securities Investment Fund (G Fund), a defined contribution plan for Federal employees. The government makes the withdrawal with the understanding that it will replenish the G Fund with interest when the debt ceiling is increased. On Dec. 31, 2008, $113 billion of government securities were in the G Fund.

Another potential source of headroom would be suspending payments to and redeeming government securities held by the Civil Service Retirement and Disability Fund. The amount of headroom that this approach can add varies with actuarial assumptions, but currently represents roughly $3 billion a month.

A third source of headroom could come from selling part of dollar holdings on the Exchange Stabilization Fund. On July 31, 2009, there was $16 billion available from this source.

A fourth source would be for the federal government to cease providing state and local governments with non-negotiable U.S. federal debt for escrow accounts.

A fifth source of headroom would be for the U.S. treasury to sell its holdings of Fannie Mae and Freddie Mac debt, which totaled $165 billion as of Sept. 30, 2009. However, if the Treasury were to liquidate these fiscal assets, the sale could disrupt the very markets the original purchases had intended to calm.

These are all interesting sources of potential fiscal headroom but we’ve already seen cold water poured on many of them by analysts.

Deutsche Bank’s fixed income team, for instance, are pretty clear in their latest research note:

Back in 1995-1996, when the most serious dispute over the debt limit occurred, there were substantial disruptions to the Treasury issuance process and the Administration was forced to undergo various accounting maneuvers to keep the government in operation. In all, the conflict between the Democratic Administration and the Republican Congress lasted for almost 5 months. The first action in October 1995 was to suspend bill auctions and issuance of SLGS and foreign add-ons, followed by regular Treasury coupon auctions. The Treasury then diverted funds headed toward the government employee retirement funds and the Exchange Stabilization Fund. The battle finally ended in March 1996 with an increase in the debt ceiling, after Congress backed down.

One concern is that these same accounting maneuvers, when applied today, will not be able to stave off a government shutdown (or possible suspension of bond payments) for long. Today, the financing needs of the government are so much higher, that diversion of these funds would not last more than a couple of months, and probably far less. Total debt raised, marketable and nonmarketable, including intra-government issuance, has been running at about $130 bn/month for the last 6 months. Most of this amount, $125 bn, has been for marketable issuance to the public. In this context, the traditional measures are only brief delaying actions. For example, SLGS gross issuance was only $53 bn for all of FY2009, and in fact there was a net paydown in SLGS of some $44 bn; thus stopping the issuance of SLGS would have little impact in the larger picture. About $200 bn of non-marketable Government Account Series bonds are rolled over daily, but it’s unclear to us how much of these issues the Treasury Secretary could suspend from rolling over.

In other words the team thinks the US will end up having to raise the limit:

On the other hand, the politics are somewhat more encouraging this time around. The Administration and both houses of Congress are controlled by the same party. The House has already passed a debt limit increase, based on the so-called “Gephardt rule”, which automatically increases the debt limit after the annual budget resolution is passed. The Senate is another matter. But the obstacles to passage in the Senate are not insurmountable, given the Senate Democrats’ theoretical ability to break filibusters, if the party stays united. The 1995-1996 episode showed that there was little politically to gain by trying to shut down the government. We think there is a possibility that regular bill issuance might be affected, with cash management bills filling the gap; there is an even lesser possibility that coupon issuance would be affected in December. In the end, we think the Senate will raise the debt limit without undue drama, even though the political debate might be intense at times.

Fine, but what would an increased debt limit actually mean for the US exactly?

Well, for a start it effectively `kicks the can’ of the debt problem to the next generation.

But it could also have more near-term implications — namely a massive effect on the US dollar — a currency already under pressure from the Federal Reserve’s unconventional monetary policies and journalists from The Independent.

Here’s Charles Stanley’s Jeremy Batstone-Carr on the link between the two:

Critically, the dollar weakness story is not about inflation or deflation as both assume that the dollar will survive the instability created by mountainous levels of debt. So far, US policy shows no sign of addressing the real cause of the problems in that economy; gigantic and excessive levels of debt. The problem has now got so bad that it now looks impossible to put the genie back in the bottle. There is no way back for the US currency and devaluation is inevitable.

Wow. He goes on:

There are only two ways of getting rid of unsustainable levels of debt; deflation and inflation. Prevailing US policy makes it entirely clear that deflation will be prevented at all costs (in order to avoid a debt deflationary spiral into depression). The country’s biggest banks (too big to exist) have been preserved on the official basis that they are, in fact, too big to fail. The US government will seemingly go to any length, with complete disregard for public debt levels or future budgetary requirements, to preserve the current situation but can it work?

It could work if the dollar were devalued significantly as that would reduce the value of debt in real terms after prices, wages and asset values rose to accommodate the dollar’s reduced purchasing power. The US government could manage a far higher public debt if each future dollar used to service the debt were comparable, for sake of argument, to $0.33c today. A lower dollar might enable the preservation of bank balance sheets and simultaneously bring the ratio of total debts and liabilities, in real terms, closer to sustainable levels relative to GDP. Put differently, the process of monetary inflation would be massively accelerated.

Whether accelerated inflation would prove more destabilising than deflation is not clear. The obvious risk is that the Federal Reserve might miscalculate the level of inflation (as may have been the case in the past) and lose control, crashing the dollar as well as the entire US economy. Whilst the very term “hyperinflation” conjures very negative images it remains to be seen just how significant a threat it poses in the context of such huge debt levels.

Although the dollar is periodically regarded as a “safe haven” currency by investors seeking any port in a financial and economic storm, this view is fraught with risk. The dollar’s continuing trade weighted decline on the foreign exchanges might be regarded as a positive indicator of reviving risk appetite. We suspect that there’s more to it than that. In part the currency’s latest slide reflects the growing shift away from the dollar, both as the world’s reserve currency and as an international medium of exchange. The emergence of the dollar carry trade has only heaped more pain on the beleaguered greenback.

Of course the dollar’s slide could be arrested quite easily, by reducing federal spending and raising interest rates. The inevitable consequence of these policy options would be, of course, greatly to increase loan defaults and to unleash the deflation associated with rising bank failures, consumer retrenchment and a dive back into “double dip” recession. Raising interest rates would accelerate the process of excessive debt purge, eventually paving the way for a more stable economic environment. Policy measures such as these, mentioned openly in the current climate, would surely doom such advocates to being burnt at the stake for heresy!

Prevailing policy favours the inflation implicit in maintaining bank balance sheets. Thus the total debt and liability levels continue to go unaddressed. These high debt levels will inevitably result in a severe impediment to a revival in economic activity. Bank balance sheets are expected to continue crumbling under the weight of mortgage, credit card and commercial property loan default. Mortgage backed securities, regardless of how they are valued for accounting purposes, would be unlikely to become liquid for a considerable time, possible / probably years. On this basis it is legitimate to question whether the prevailing policy measures can work for anything other than the shortest of time periods. On balance and considering all the apparent options there seems no fundamental way to prevent the inexorable slide in the dollar towards its inevitable date with destiny.

The dollar, by the way, now looks like this:

Trade-weighted USD - Charles Stanley

Related links:
The debt limit: History and recent increases – 2008 CRS report for Congress
Making the case for a weaker dollar – FT
Misguided monetary mentalities – Paul Krugman (for an alternate view)

Copyright The Financial Times Limited 2019. All rights reserved. You may share using our article tools. Please don't cut articles from and redistribute by email or post to the web.

Read next:

Read next:

FT Alpha Tweets