Trump’s America: the lifting of the US default taboo

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Without Kissinger to negotiate the petrodollar and put the US currency back to the centre of the global game after the shock of Nixon’s announcement in 1971 to halt the convertibility of the dollar to gold, the greenback would never have been the world benchmark since more than 40 years. Will Trump really know how to surround himself with advisers of the same calibre? Also, will he take their advice? Because a shock of the same magnitude is currently in gestation: it is called ‘payment default’ of the US public debt. It is the taboo which was lifted by the election of Trump. So, will it be a self-fulfilling prophecy or healthy debate? A solution or a total disaster?

The unthinkable sovereign default 

If there is a country on this planet banned from defaulting on its public debt, it is definitely the United States. US Treasuries are at the heart of the global financial system, considered the ultimate safe haven and the most liquid bond market in the world. It goes without saying that no one expects the United States to miss the slightest reimbursement of its sovereign obligations. The deflagration that such a default would produce seems, apparently, incomparable with that of the Lehman Brothers bankruptcy, if we refer to the amounts at stake ($600 billion for Lehman, against $20 trillion of US public debt) and to the systemic place Wall Street takes, and more generally the finance on the other side of the Atlantic. The United States, if it wants to hold its rank in the present world order, is clearly deprived of this option, quite common for other countries nevertheless (for your information, over the last 35 years we can count no less than 70 sovereign defaults in the world[1]…).

fig1Figure 1 – Global public debt in default or under restructuring, as a fraction of the global GDP, 1800-2008. Source: Les Crises.

But the United States has never failed in its federal debt. This is undoubtedly a safe bet and so a US sovereign default is really unthinkable. Unthinkable, right? Just like Brexit or the election of Donald Trump!

The certainty crumbles  

For the record, the US Federal State has never failed before. And yet … How could one qualify the 1971’s convertibility of the dollar to gold stopping[2], resulting in a major dollar value loss compared to the precious metal, and along with it the North American debt? Or maybe the similar devaluations of 1933 and 1934 under F. Roosevelt[3]? As we can see, this does not necessarily take the form of a clear non-payment… And since we talk about Roosevelt, does Trump’s “programme”, consisting of an economic revival via infrastructure, not vaguely make us think of the New Deal[4], creating a priori the same temptation to strongly devalue the greenback[5]?

This could be risky speculation if Trump had not himself displayed during his campaign his willingness to renegotiate the US public debt if necessary[6]. Careful though, we do not pretend that the newly elected Trump is doing what he wants on this matter (or on any other, moreover), quite the contrary: he is undoubtedly instrumental on many points of his policy. Nevertheless, the taboo is lifted[7] and it is no longer inconceivable that the United States will, some day, record a default (in one form or another) on its federal public debt, which is already changing everything in the way people think.

Our analyses on this topic in the GEAB, which started many years ago, now take their full meaning[8]

Writing off the debt

What this change in perspective on US debt brings is well summed up by Trump’s phrase: « I would borrow, knowing that if the economy crashed, you could make a deal. And if the economy was good, it was good. So therefore, you can’t lose. »[9]. To be honest, it is difficult not to give him credit for common sense: he would do wrong to deprive himself of borrowing on the markets[10], given that the country can do so at historically low rates. Moreover, we are speaking of the United States, and not Argentina or Greece, and markets would soon forget a US default and lend again to the new economic prospects of this country, (re-)opened by this restructuring. The painful period seems thus reduced to the few months preceding and following the default.

fig2Figure 2 – US 10-year treasury maturity rate, 1975-2017. Source: FRED.

The lifting of this taboo has as first consequence the debunking of the US public debt, which will indeed be necessary if Donald Trump wants, as he promised, to reduce taxes whilst carrying out his plan to support the US economy … There is definitely no question of default right now as the conditions have never been more favourable to borrowings. The official forecasts, which we find very optimistic, show a public deficit growing up to 5% of the GDP over the next ten years.

fig03Figure 3 – Deficits (or surplus) over the next decade in the US, as a share of the GDP, 2000-2027.
Source: New York Times.

We anticipate that the lifting of the default taboo will lead the US to borrow even more than what the current projections claim. According to the growth which the country will be able to generate[11], the public debt should thus increase from its present value of 105% of the GDP to probably 115% to 125% under this first mandate of Trump (see the detail of our calculation in the box below); a sharp increase in just four years. And again, without counting the 17% debt of the local States and governments. In view of the current standards, these are not levels which could automatically lead to bankruptcy, but it is a trajectory hardly sustainable in the long run[12].

Here are the details of a very rudimentary calculation confirming this increase: if Trump achieves the growth target of 4% per year (which we strongly doubt), the GDP of the United States in four years will be of about $22 trillion. But for this to happen, the US will have spent $100 billion per year in its infrastructure plan, and will have lowered taxes by 30% for individuals (Trump’s promise was a drop of 30 – 35%, source: FactCheck, 04/11/2016) and by 50% for businesses (going from a tax rate of 35% to 15%, source: The Atlantic, 23/01/2017); resulting in a shortfall of approximately $620 billion (source: Tax Policy Center). Compared to the current deficit of about $600 billion, the new deficit would therefore be around $1300 billion. Add to this an average debt interest rate which could rise by at least 1%, meaning an additional expenditure of about $200 billion. Overall, the debt in four years would be around $26 trillion, or 118% of the optimistic GDP value at that time. We assume here that the cuts which will undoubtedly be made in the social security budget, will be cancelled out by a military budget increase.

Debt Ceiling  

However, there is one main obstacle standing in the way of a slippage in the US debt; it is the debt ceiling, which re-enters into force on March 15 this year[13] (after a one and a half year suspension). If the ceiling is not raised, the government will be in default before the fall. But who can decently think that the Republicans can oppose a ceiling raise, now that one of theirs controls the White House? They had not succeeded when Obama was in power and threatened not to raise the ceiling only to get counterparts. Of course, a mini-psychodrama is once again to be expected from March 15 on, as it is an opportunity for easy pressure to serve many agendas and to oblige the president to remain within reasonable limits. But our team anticipates, without too much risk, a sustained increase in the country’s debt ceiling, or even a new period of suspension. The Senate seems to have already given up any opposition in this respect[14].

However, in order to avoid the recurrence of this episode too often, and given the high level of indebtedness projected by Trump, the US president could, in our opinion, propose a change in the calculation of the debt ceiling: as for the European countries, it would be more convenient (and somehow much more logical) to express it as a share of the GDP, especially since Trump hopes that his debt policy will generate high growth…

Risk of runaway

The debt ceiling (which has at least the merit of existing and imposing the topic to the public debate!) is therefore not a very serious safeguard against the accumulation of federal debt. Could a president, who has parliament on his side, blow the debt higher? Yes, as we have seen with Reagan or George W. Bush, for example (see note 12). But the difference this time is that the federal debt was low when these presidents entered the White House (respectively 30% and 50% of the GDP)… The difference also is that the world had confidence in America at the time.

The markets, despite their unshakeable faith in the Great America, and despite their recent performance, no longer have the blind confidence they once had[15]. The default of payment no longer seems taboo to them either. Thus, the nearer the maturity of sovereign bonds, the higher their interest rate has increased in recent years, which validates our analysis above; they are not afraid to lend for 10 or 30 years (because the country will quickly recover from a possible default), but become more cautious on short-term maturities.

fig04Figure 4 – US bond interest evolution for 30 years (orange), 10 years (blue), 5 years (red), 2 years (green), 1 year (brown), 6 months (purple), on a 0 basis in 2012. Source: Bloomberg.

The comparison with the German bonds is also eloquent: while these are sinking into negative land, within the United States the movement is contrary.

fig05Figure 5 – Bond interest evolution (orange US and German blue), 2 years maturity, on a 0 basis in 2012. Source: Bloomberg.

If we add to this that foreign central banks, with China in the lead, continue[16] to sell their US Treasury bonds[17], and that serious doubts appear around the liquidity of the US sovereign bond market[18], one can see that the risk of runaway is not completely ruled out, as long as the Fed is hostile to the US President’s policy[19] and continues to raise the rates without a new quantitative easing.

Between real temptation and means of pressure 

In view of the above, on the one hand there is the desire to take advantage of historically low rates to borrow strongly (hoping to generate growth), and on the other hand a risk of runaway and a mistrust at the same time among foreign countries and markets. So what should we think of Donald Trump’s statements about the possibility of a US payment default?

Finally, by caricaturising a little, it looks like an invitation to China to finish quietly, in the next two years, to get rid of most of its US bonds. China obviously looks suspiciously at Trump’s uncertain politics and his sabre-rattling, and sees here the perfect opportunity to get rid of her dollars under the pretext of supporting the yuan, something the United States wants by the way.

But is an American default really credible? Let’s have a look at who owns the debt[20]:

fig06

Apart from draining social security funding, which is possible within a certain limit, there is no visible sense in defaulting on intra-government debt. It is also difficult to touch any North American savings or pension funds. A cascading bankruptcy of US banks or insurers is also not in the country’s interest; and concerning the states, this may be a means of punishing the most recalcitrant, but the room for manoeuvre is limited. All that remains is the Fed[21], and above all the debt held abroad, about 40% of the entire debt. Hence a discount of 25% for example would only bring down the total debt by 10%, which is not an enormous oxygen balloon. And the simplest way to achieve the same result is a devaluation of the dollar, far less complicated than a sovereign default…

So, it’s not a very credible option. A default of overseas debt would nevertheless be a radical solution to ensure protectionism and the retreat desired by the new administration, and also to put an end to the role of the dollar as a reference currency which can be seen as too heavy to bear for a country that can no longer afford it. But it is unlikely that Donald Trump would voluntarily choose a solution that would weaken the US to such a degree on the world stage.

Still, in the hands of an impulsive and unpredictable president who puts the “art of the deal” above everything and integrates in his “crazy strategy” the principles of the game theory[22] (method used by Varoufakis in his negotiations with the Troika in 2015, in which the Minister of the Economy had put in the negotiation the idea that the Grexit was less frightening for Greece than for the Eurozone and was ready to go towards it), the lifting of the taboo and the threat of a non-payment is creating, in front of the foreign countries, a great vehicle of negotiation. An effective tool, certainly, but dangerous as well.

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Notes:

[1]     Source: Les Crises, 04/06/2015
[2]     Source: Wikipedia
[3]     Source: Wikipedia
[4]     All possible resemblances between Trump and Roosevelt stops there, of course…
[5]     We keep saying, and have for months, that contrary to what the media says, the perspective for 2017 is more towards a weak dollar than to a strong one. And we are maintaining this anticipation, knowing the priority which will be given by the G20, in tune with Trump’s programme, to restore of the trade balances; this aim would be better served by a weak dollar. Source: Nasdaq, 10/03/2017
[6]     Source: The Atlantic, 22/06/2016
[7]     The populists have, at least, the merit to lift taboos … for better or for worse.
[8]     We are inviting our readers to go back to our GEAB bulletins n°40 (December 2009), n°42 (February 2010) and n°44 (April 2010), for instance.
[9]     Source: CNBC, 06/05/2016
[10]    We could say the same about the European countries which, if they did not get preoccupied with their public debt levels, could benefit from the negative rates of the bonds to create economic stimuli. Something which Draghi is inviting people to do… Source: Irish Times, 18/07/2016
[11]     For 2016, it was only of 1,6 %, for a public debt raise of about 6% of the GDP. Sources: CNN, 27/01/2017; ZeroHedge, 04/01/2017.
[12]     Again, our estimation is very conservatory if we compare it to the historical figures of certain similar presidents: Reagan, in a way closer to Trump, raised during his two mandates the debt to the level of 186%; George W. Bush, to 101% (without mentioning Roosevelt and his 1048%!). Source: The Balance, 21/02/2017
[13]     Source: USA Today, 09/03/2017
[14]     Source: Reuters, 09/03/2017
[15]     We have already developed this analysis in the GEAB no 108 of October 2016.
[16]     A movement already analysed within the GEAB no 108 and no 110 of October and December 2016.
[17]     Source: CNN, 19/01/2017
[18]     Sources: Bloomberg, 02/02/2015; Bloomberg, 25/01/2016
[19]     Which determined us to say that Trump would drop Ms Yellen on the first occasion, an anticipation we keep, by the way…
[20] Source: The Balance, 27/02/2017
[21] If it accepts a devaluation: we go back to a loss of independence for the US central bank…
[22] An explanation of the « game theory » is offered by the BBC. Source: BBC, 18/02/2015


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