Betting against the US default

CNN Money reports that investors are betting on a US default. This isn't unusual as bets like these were already in place during August 2011, when the chances of default by reaching the debt ceiling were even higher. Today, the total payout in case of a default could run up to $3.4bn, while back then they could have paid out around $5.6bn. How does this scheme work? How does one "bet" against or on a debt default? CNN Money explains: 

"Financial institutions can buy what essentially amount to insurance contracts that protect against a government default. These securities, called credit default swaps or CDS, cost a 0.34% premium to insure against the government defaulting in the next year. That means an investor pays about 34 cents for every $100 of potential payout they would receive in the event of default."

But as always in the world of finance, it's not as simple as it seems:

"First, these contracts are only available to institutional investors. Second, credit default swaps on U.S. debt are usually priced in euros, because if the United States defaults, who wants to be paid back in dollars? Third, there are far less lucrative payouts if other scenarios occur. For example, the government could elect to partially pay its debt. Even the definition of "default" is murky. ...

In the CDS market, a true "default" happens only if the U.S. were to stop paying principal and interest to Treasury bondholders, or if it refuses to acknowledge its bond contracts or restructure its debt." 

How realistic is it for the US to default? One would say almost impossible, as the US government bonds were widely considered to be essentially a zero-risk asset for a long period of time. This has a lot to do with the fact that the US is printing the world's reserve currency, and when your domestic debt is denominated in dollars over which you have control of, there is nothing to be worried about, right? Wrong. The moral hazard implication is huge here. Such a comfortable position around accumulating debt is what got the US on the brink of a fiscal cliff in the first place. 

The debt sustainability problem is huge according to CBO's latest debt outlook report. It predicts that public debt is likely to reach 100% by 2038, and go over 200% around 2076, while interest on debt repayment (which are currently around 8% of budget revenues) are predicted to take in huge portions of future budgets if things carry on the way they have so far:

"The increase in debt relative to the size of the economy, combined with an increase in marginal tax rates (the rates that would apply to an additional dollar of income), would reduce output and raise interest rates relative to the benchmark economic projections that CBO used in producing the extended baseline. Those economic differences would lead to lower federal revenues and higher interest payments. . . . 

At some point, investors would begin to doubt the government's willingness or ability to pay U.S. debt obligations, making it more difficult or more expensive for the government to borrow money. Moreover, even before that point was reached, the high and rising amount of debt that CBO projects under the extended baseline would have significant negative consequences for both the economy and the federal budget."

CBO's range of scenarios are also quite pessimistic. Only two scenarios assume deep spending cuts and tax hikes that would shrink the debt, while most others see the debt increasing between 77% and 190% by 2038. The 190% figure isn't that unrealistic at all since it implies that politicians simply carry on doing what they have before, raising expenditures more than revenues. 

So once again, how likely is it for the debt ceiling to be breached and the US thrown down a downward spiral of loss of confidence, investor panic and reemergence of a worldwide recession? 

The US public debt is suppose to reach it's debt ceiling by mid October this year (see graph below). It has been close several times before, but every time the politicians raised the bar, amid some controversies, and stabilized the markets for a short period. This is a typical short-termist solution that offers only temporary relief, whilst pilling up risks only to make it even worse the next time around. Such a strategy of dealing with debt simply cannot carry on infinitely.  

Source: The Economist

The situation is very tricky. If on one hand the debt ceiling doesn't get raised, and the US actually does reach the unlikely scenario of debt default, we are in for another long and painful recession (has the current one already ended?). On the other hand, if the debt ceiling does get raised as it has many times before, then we're just allowing the long-term debt unsustainability to continue, which will eventually burst and cause a deep recession. One can say that current budget quarrels and debt ceiling issues are the seeds of a future financial meltdown. The solution needs to be reached immediately via a reform of the entitlements system (read some of my previous proposals and ideas here, here, here, here and here) and pro-growth policies removing the restrictions on businesses to invest and hire. A welcomed change would be to overtake the entire crony political establishment in order to reinstate the proper US values and high levels of social mobility in order to return the country back on its path to prosperity (and avoid things like these happening in the future). But that's an institutional issue and a topic of another post. 

And finally, to end on a somewhat positive note, the investors betting against the US are a minority, as far more still have confidence in the US claiming that a default is not likely at all. In other words they do believe that Congress and the President won't send the country into another recession and will raise the debt ceiling once again. So they expect more of the same - short-termist policies and lack of long term vision. They all need to be reminded on the most important lesson of economics.