The Sovereign Debt Waterfall Part 3 - Over the Edge

   It's hard to make predictions about the economy, because the economy is the sum of an enormous number of factors, not all of which can be known or understood. However, I think the idea that the United States is approaching the sovereign debt waterfall is a safer prediction than most. The reason is that the current in the river is so strong that it will overwhelm everything else that happens. In this metaphor, the river's current is the greater than $1 trillion annual deficit the United States is running, along with the difficulty of doing anything that can meaningfully reduce it. I still guesstimate that it will take a few years to get there, but on the timing of the prediction I have no confidence at all.
   The U.S. funds its budget deficit with auctions of Treasury Bills and Bonds. These are government IOU's ranging from 3 months to 30 years. The buyer of a 3 month Treasury Bill is loaning the government money for 3 months. The interest rates are low, since the U.S. government is presumed to be a safe borrower - 3 month interest rates as of October 31, 2011 are 0.01%, 30 year interest rates are 3.25%, while 1 year, 2 year, 10 year, etc. rates are somewhere in between. The U.S. Treasury auctions this debt weekly usually on Tuesday, Wednesday and Thursday, and usually auctions about $60 billion a week. This is enough to cover the U.S. deficit, along with rolling over previous U.S. debt that comes due.
   Interest rates typically rise or fall based on several factors, mostly expectations of inflation - investors want their money to earn more than the inflation rate. But when a country approaches the waterfall, the interest rates begin to rise for an entirely different reason - investors begin to fear that the country will not pay back its debt. This can be easily observed in Europe today, since all the countries in the European Union use the same currency, and a Euro is a Euro is a Euro; the value of the Euro and the inflation rate are the same for all Euro countries. A Euro in Greece buys the same amount of gold, or oil, or whatever as a Euro in Germany. However, German 10 year bonds, denominated in Euros, have an interest rate of a 1.7%, while Italian 10 year bonds, also denominated in Euros, are 6.1% (October 31, 2011 figures). The reason for the difference is that investors have a sneaking suspicion that Italy just might default on its debt, and the increased risk causes them to demand a higher interest rate. In March 2010, Greek bonds and German bonds had almost the same interest rate in the 3% range. Then Greece reached the edge of the waterfall and Greek interest rates rapidly shot to the moon, eventually going over 180%.
   This is what I believe it will look like when the U.S. reaches the edge of the waterfall. In a very short period of time - just days or weeks - we will go from smooth sailing as far as interest rates are concerned to completely unmanageable. This is what happened to Greece. It will happen suddenly, because it will be triggered by a panic. We won't be able to undo the panic, because the panic will be for good reason. There are already people who invest in long term government bonds who do not expect the government to honor the debt many years from now, but instead believe they will be able to sell to someone else between now and then. When those people change their minds, they will try to sell and interest rates will shoot up. It is happening in slower motion in Europe, since the European Union is working on all kinds of plans, schemes and devices to try to bail out member countries, and some of the plans will work at least for a little while. The U.S. is too big for anyone to bail out.
   When interest rates hit unmanageable levels, we are at the edge of the waterfall. No government, U.S., Greece, or anyone else, will sell its debt at rates like 50% or 100%, because if it did, interest rates would soon soak up all the money the government takes in. So at this time, business as usual, as we have done it for more than 80 years, will stop. What happens next depends on the government's decisions. Below I will describe what I think is the default case. This is what will happen if the government takes the least action, either out of choice, or a lack of will, or political gridlock.
   The government can't issue debt any more, so the debt stops growing, deficit spending stops immediately. The government can't roll over its previous debt either, so we actually will start paying down the debt. This will give us what Charles called the "draconian Bachmann" solution on steroids. Without new debt, we will be able to service all existing debt (which will still have low interest rates). If we try to pay for all our entitlement programs, we will not have quite enough money to do it. We will then have zero money left over to fund all the rest of the government programs - no money for defense, NASA, pay for any government employees, etc. Of course that won't work, so we will figure out some way to cut entitlements and ongoing programs both and fund them both at low levels. The overall scope of the cutbacks will be much more than the $1 trillion annual deficits we currently run. This will plunge the economy into its worst short term downturn ever, as ripple effects of unemployment, etc. spread throughout. This will be a deflationary event. It won't last forever, but will last for several years and be enormously painful.
   The paragraph above describes the default case, which is what happens if government doesn't do much. However, I suspect the government will find the above scenario intolerable and will inject itself vigorously into the process, changing the situation in ways that are less predictable. The government could decide not to honor its external debt. Can't you just hear it: "Why should our government pay China when it won't pay its own veterans?" This would allow more money to be used to fund ongoing operations, but would harm trade and hurt the value of savings accounts that include U.S. debt. The government could try to print money to fund its operations, although it would have to be done via real printing (you get your money in physical $20 dollar bills) rather than the current fractional lending approach won't work on the waterfall's edge. That could lead to hyperinflation. Or it could try something we haven't even though of. There is no painless solution, though.