US credit interest wall looms nearer 

Nobody wants to say it, but a major reason why corporations are not creating many jobs and expanding in the U.S. is due to increasing systemic risk being created by Washington. The U.S. is supposedly in economic recovery, yet President Barack Obama projects a record $1.6 trillion deficit for 2011 — with years of more trillion-dollar annual deficits and escalating debt ahead.

Government debt is growing by $120 billion a month, three times faster than the $40 billion monthly increase in GDP. What is going on?

The real issue is not the U.S. government’s debt ceiling to accommodate ongoing deficit spending, but rather the wall that we are about to hit. This wall will be raised by foreign governments balking at financing U.S. debt except at significantly higher yields to offset the dollar’s declining value.

Recently, officials from China, Brazil and other countries blamed high food and raw materials prices on Washington — charging it with exporting inflation by degrading its currency through quantitative easing. No surprise here, as most commodities are traded in dollars. The Wall Street Journal notes that some economists attribute dollar weakness induced by Fed policy contributing as much as 50 percent of the price inflation in commodities such as corn, sugar, wheat, coffee, cotton, rubber, metals and oil.

Another related debt wall that looms ahead is the one that arises from declining credit quality. An unsettling report, “The Evolution of Moody’s Perspective on the U.S. Aaa Rating” received little attention when released on Jan. 27 in the midst of upheaval in Egypt and the Middle East. But, coming on the heels of a similar warning from Standard and Poor’s, it has serious implications.

Moody’s states that “recent trends in and the outlook for government financial metrics in particular indicate that the level of risk is rising … and likely to continue to rise in the next several years … ” Furthermore, it continues, “the time frame ... appears to be shortening, and the probability of assigning a negative outlook in the coming two years is rising.”

Moody’s infers that accelerating government spending since the financial crisis of 2008-2009 is the reason for shortening the time horizon for the negative credit watch revision. The report cites specific causal metrics in terms of the federal government’s ratio of debt to revenue rising from 230 to 460 percent between 2008 and 2010 … ” The fact that debt is growing more than four times faster than revenue in the U.S. should be alarming by itself. But the Moody’s report goes further and graphically illustrates the relative condition of the U.S. by comparing it to the other Aaa-rated countries. It turns out that the U.S. is the high ratio outlier — having nearly three times more growth in debt to revenue than the Aaa median, and more than two times times that of Germany, France, the U.K., and Canada — all of which have undertaken austerity measures.

The U.S. government has enjoyed unlimited access to financing because of its role in having the reserve currency and “safe haven” in global financial markets. Thus, the U.S. Treasury bond has been the “risk-free” benchmark. But if the credit rating outlook on U.S. sovereign debt turns negative, the dollar will risk losing its status as the world’s reserve currency because its associated government debt could no longer be considered risk-free. As a result, the demand for dollars would decline precipitously and cause further devaluation.

The important take-away here is the imperative of reducing systemic risk by tying the debt ceiling to deficit reduction. In the longer term, the debt ceiling should be capped at a percentage of GDP.

Without telegraphing the will to radically cut spending, the U.S. will hit a Greek wall of deficit finance and liquidity problems. If that becomes headline news it is already too late. History reminds us that such crises happen faster than most anticipate and almost always before the ratings agencies take action.

Scott Powell is a Visiting Fellow at Stanford’s Hoover Institution who researches and writes on business, public finance and the capital markets. Previously, he spent 15 years working for several Wall Street firms managing bond portfolios.

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Scott S. Powell

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