A Default By America Is Looking More Likely By the Day

One of the critical planks of a nation built on borrowed money is confidence. Up until recently, that hasn’t been an issue. Faith in America’s future has remained steadfast. Now, though, people are starting to doubt the wisdom, capabilities and ethos of those in charge. They are increasingly nervous about reactive and open-ended moves to fix the system that aren’t working. They wonder if things have moved past the point the point of no return. Some are even asking the question, as the Economist.com’s Free Exchange blog does, “Could America Default?”

Ben Bernanke said [yesterday] that the TARP plan, and any subsequent debt-financed bail-outs, pose no credit risk to America. That is probably true, but it’s a rather remarkable statement.

We have arrived at our current situation due in part to the insatiable demand for American debt. During the savings glut that characterised much of the past decade governments and individuals desired American assets because they viewed them as relatively risk-free. That enabled the government to run up enormous debts, while facing low real rates (especially on longer-dated securities), and made credit a little too easy.

Now America is counting on its assets’ risk-free status to persist. It plans, in fact, to help save the global economy by incurring still more debt. The risk-free perception means that America can borrow whatever it needs for a low cost, and can do so without threatening its risk-free status. This isn’t typically how credit-worthiness works.

The prospect of an American default seems incomprehensible no matter how much debt the government issues. But is it really? Suppose a major creditor nation posed a security risk and threatened to dump all its American debt on the market. In that case default could happen despite American solvency. That situation is improbable, but feasible. After all, many politically inconvenient creditor nations hold substantial American debt. And stranger things have happened.

And there must exist some level of debt that the market views as unsustainable. Yesterday I mentioned Willem Buiter, who believes that Britain reduced its credit rating as a result of its bank bail-out. America has avoided this problem thanks to the dollar’s role as a global reserve currency. But does issuing so much debt ultimately undermine that role?

An extraordinary amount of wealth has been created, all over the world, during the last twenty years. This was largely possible because of the belief that there exist certain assets that pose little risk, and a currency that will always be in demand. The dollar continues to be the world’s reserve currency, albeit with some new competition from the euro. Demand for Treasuries remains strong. That suggests the world wants to maintain its faith in American stability, though to be fair, potential competitors look, if anything, worse at this point. What would it take to change this global view of America?

What do you think?

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