3 November 2008

Government default the rule, not the exception

On the other hand a longer-term examination of debt markets reminds us that, throughout human history, regular default is the rule than the exception. And while sovereign defaults on external, foreign-currency debt are most common, Carmen Reinhart and Kenneth Rogoff demonstrated in a paper released earlier this year that defaults on domestic debt have happened far more often than might have been expected, particularly in times of severe economic duress.

In both the US and UK, budget deficits are poised to explode, for a number of reasons. The recession is hitting tax revenues, while government entitlement programmes should soar in cost. Then there is the steadily increasing bill for the wars being fought in Iraq and Afghanistan. But the really big impact is coming from the rescue packages being thrown at the financial sector. Morgan Stanley recently estimated that the 2009 fiscal deficit in the US would reach 12.5%, over double the previous record of 6%, set in 1983. Under the Bush administration, the US national debt has risen from $5.7 trillion, to over $10 trillion currently. The terms of the recently-passed bailout legislation increased the statutory debt ceiling to over $11.3 trillion.

When measured as a percentage of GDP, the US national debt is expected to pass 70% next year, which, though much higher than recent years, is still short of the record 122% registered in 1946, at the end of the Second World War. Some observers point to this comparison as an argument for the sustainability of the current position.

Yet others argue that government debt must be seen in the context of, and as part of, the overall debt burden on the economy. With the US private debt to GDP ratio at levels never seen before – close to 300%, according to Steve Keen, the Australian economist – the question is surely whether the whole debt pyramid can avoid crashing down via a violent and uncontrollable chain of defaults, dragging the government bond market down with it. If this seems far-fetched, it helps to remember that the Latin root of the word credit comes from credere – to believe, but also to trust. For large sections of the private sector bond market, it is precisely that trust which has disappeared over the last year and a half. To suggest that such “credit revulsion”, to use an old term, might spread to governments’ debt obligations is surely not beyond the realms of possibility

Signs of strain in the US Treasury market are already there, despite the current low yields. Recent auctions have shown poor bid-to-cover ratios, and long tails (the difference between the average accepted yield, and highest yield), both signs of shallow demand. Delivery failures in the secondary market have also hit record levels, a sign of poor liquidity. Market observers should keep a close eye on the progress of future auctions, particularly as the issuance schedule picks up.

How can investors take cover if concerns over government solvency spread? For the early part of any credit-related decline in bond prices, there are obvious hedges, such as credit default swaps, short Treasury bond futures positions and inverse Treasury ETFs. But ultimately a US debt default would have cataclysmic consequences for the financial economy, bankrupting the entire system. So the ultimate safe haven is in the precious metals, which would rapidly regain monetary status in such a scenario.

Paul Amery is European Editor of www.indexuniverse.com

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