Tuesday, September 21, 2010

U.S. Debt: Just How Big?

Morgan Stanley's London office has issued a new publication, Sovereign Subjects, which focuses on sovereign risk in advanced economies. The question addressed: how likely is it that the western nations will restructure their debt? Any such action will penalize the holders of sovereign bonds.

So far investors in U.S. Treasury bonds seem unconcerned. They have been relentlessly bidding up bond prices since last spring. The yield (which moves inversely to price) on the ten-year bond has gone from 4% to well under 3% in a matter of months--and seems headed to 2% or less. Indeed, there has been talk of a "bubble" in bonds.

By one measure, the debt-to-GDP ratio (lefthand column in the table above), U.S. Treasuries appear to offer a safe haven relative to the bonds of the Club Med nations, or PIIGS. But debt-to-revenue ratios (righthand column) suggest that, absent any tax increases, the U.S. is in a poor position to service its debt.

Add in future liabilities not now captured in national accounts, and you end up with some pretty ugly-looking balance sheets:

A government with negative net worth, in the words of Morgan Stanley's Arnuad Mares, "is insolvent. In other words, some or all of its stakeholders must suffer a loss: either taxpayers (through a higher tax burden), or beneficiaries of public services (through lower expenditure) or bond holders (through some form of default)." Continuing:

"Against this background, it seems dangerously optimistic to expect that sovereign debt holders can be continuously and fully sheltered from partaking in the loss of wealth and income that has affected every other group. Outright sovereign default in large advanced economies remains an extremely unlikely outcome, in our view. But current yields and break-even inflation rates provide very little protection against the credible threat of financial oppression in any form it might take."

Mares does not believe that sovereign bondholders are being adequately compensated for the risk that they are taking on. Once that perception gains traction in the investor community, there will be a stampede to the other side of the boat. Then watch what happens to the federal deficit when interest rates spiral upward.

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