Will the U.S. Default on Its Debt?

We made it through the weekend without a shutdown, as Congress agreed on a plan to keep the government open.

Wonderful. Thank you.

But a far more important showdown is set to take place over the coming weeks as Congress votes on whether to raise the federal debt ceiling.

This is nothing new. The debt ceiling has been raised 10 times in the past 10 years. But raising it in the past has never been an issue. This time around looks to be more contentious as a new political dynamic brought by last fall's election promises to challenge the status quo.

What happens if the debt ceiling isn't raised? The Treasury says it could use a series of short-term tricks to keep current until early July. After that, the United States would default on its debt for the first time in modern history.

Scary. But let's change topics a bit. Say the debt ceiling is raised. That, of course, doesn't mean we're out of the woods. Public debt is careening out of control at a rate that's miles away from sustainable. Some have been wondering aloud how long it will be, even if the debt ceiling is raised, before the U.S. defaults.

One is The Wall Street Journal's Brett Arends, who wrote last week:

The national debts that finally drove Portugal to seek a bailout this week amounted, at the gross level, to 87% of gross domestic product, according to International Monetary Fund data.

The same figure for the United States of America? Try 99%.

The massive budget deficit that finally broke Portugal in the bond market: 8.6% of GDP.

America's 2010 deficit? About 8.9%.

So maybe the question isn't whether the next country in line is Italy or Spain. It's whether it's closer to home.

Sounds nasty.

But there's a missing point here. The history of sovereign defaults makes one point very clear: There's no magic "tipping point" that pushes countries into a danger zone of default. Great Britain survived World War II with debt totaling 240% of GDP. It avoided default. Russia, on the other hand, defaulted in 1998 with debt-to-GDP of just 12.5%. Albania defaulted in 1990 with debt to GDP of 16.6%. The United States exited the second world war with debt equal to well over 100% of GDP. It never defaulted. Japan has the highest debt-to-GDP ratio in the developed world (over 200%), yet can borrow an almost unlimited amount of money at interest rates that round to zero.

Why the discrepancies? As former Citigroup Chairman Walter Wriston once said, "countries don't go bust." It's very, very rare that a country actually runs out of money and literally can't pay its debts. Taxes can be raised, or (more often) money can be printed. Instead, countries choose default because it becomes the least-bad option. Why raise taxes on citizens who vote when you can default on international investors who do not? Defaults usually aren't economic events. They're political ones.

Here's the conclusion of all of this outlined in Carmen Reinhart and Ken Rogoff's book This Time is Different: The most reliable indicator of future default isn't debt-to-GDP. It's past default. The fact that the U.S. has a debt-to-GDP ratio higher than Portugal tells us nothing. Portugal has a history of default. The U.S. does not. The bond market will lose faith in Portugal long before the U.S. And it should. At equal rates of indebtedness, markets will be far kinder to Ford (NYSE: F  ) than they will General Motors (NYSE: GM  ) going forward. Why? Because Ford has shown a willingness to make sacrifices necessary to avoid default. GM has not. Same goes for countries.

Something else to consider: The total amount of national debt isn't what's most important. It's the carrying cost -- the interest paid on the debt -- that really matters. Most countries have never, and will never, pay off their debt in full. It gets rolled over indefinitely. People can't get away with this because we eventually die. Countries keep chugging along. There's no inevitable day of reckoning when everything comes due. Interest payments are the primary concern.

Here, there's good news. While debt has surged over the past decade, interest rates have plunged. Net interest payments as a percentage of GDP are now actually about as low as they've been in the past half-century. Even the projected spike over the coming years doesn't create anything unprecedented.

Source: Office of Management and Budget.

These projections could of course change in a heartbeat. But the situation probably isn't as dire as some make it out to be -- yet. If left unchecked, it's really in the forecasts of 2030 and beyond that the cost of our debt becomes an unimaginable burden.

So will the U.S. default? Financial historian Edward Chancellor has a measured response:

There's a long history of commentators fretting about an impending public debt implosion that never arrives. It's true that several countries, including the US and UK, have large structural fiscal deficits and huge unfunded contingent liabilities. But it's a mistake to extrapolate current fiscal deficits indefinitely into the future and point to "inevitable" bankruptcy. In time, welfare and pension obligations will be reduced and taxes will rise ... furthermore, large industrial economies, such as the US and UK, have in the past carried large public debt burdens without defaulting. They have deep financial markets and domestic banking systems that are capable of absorbing vast amounts of government debt. Most importantly, unlike Greece and other stricken Eurozone members, public debt is issued in their own currency and they maintain control over their central banks and foreign exchanges. Given these institutional characteristics, default is extremely unlikely.

What say you? Sound off in the comments section below.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. General Motors is a Motley Fool Inside Value selection. Ford Motor is a Motley Fool Stock Advisor pick. The Fool owns shares of Ford Motor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (32) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 14, 2011, at 3:19 PM, belseware wrote:

    There is no connection between reaching a debt limit, and defaulting on the debt. Only idiocy would cause a government to prioritize (any) other spending over servicing the debt.

    This is political brinksmanship, they're not idiots (technically).

    If the debt limit isn't raised, we'll have to live on our revenues. What a concept. We can live on our revenues past July--way past July--by spending less.

    It's like an automatic balanced budget amendment!! Even Paul Ryan takes 26 years...this would be NOW.

    Your chart of interest on the debt goes ALL THE WAY out to 2016? Extrapolate that line, would you please...yeah, that one, the nearly vertical one.

    This is journalism??

  • Report this Comment On April 14, 2011, at 3:30 PM, TMFHousel wrote:

    ^As Chancellor notes, extrapolating a problem into infinity is probably the worst thing one can do for long-term budget forecasts.

  • Report this Comment On April 14, 2011, at 3:45 PM, JnthnScttFool wrote:

    Most important sentence in this article.

    "Defaults usually aren't economic events. They're political ones."

    Consider the calibre of our politicians at present, as a class, not just by party.

    'Nuff said

  • Report this Comment On April 14, 2011, at 5:41 PM, xetn wrote:

    I will repeat myself: We do not have a revenue problem; we have an out-of-control congress/administration that has a spending problem. We don't need an increase in the debt ceiling, we need a decrease in spending. And not a phony $38 billion that really doesn't cut anything.

    There is nothing worse than a bunch of lying, cheating politicians (but, again, I am repeating myself).

    It is completely ludicrous to think you can solve a spending and borrowing (debt) problem by increasing spending and borrowing.

  • Report this Comment On April 14, 2011, at 5:53 PM, mtf00l wrote:

    "large industrial economies"

    Is this still true of the US?

  • Report this Comment On April 14, 2011, at 5:58 PM, TMFHousel wrote:

    ^ Yes.

  • Report this Comment On April 14, 2011, at 6:00 PM, mtf00l wrote:
  • Report this Comment On April 14, 2011, at 6:02 PM, mtf00l wrote:

    "domestic banking systems that are capable of absorbing vast amounts of government debt." via tax payer bailout?

  • Report this Comment On April 14, 2011, at 6:07 PM, mtf00l wrote:

    "The US Federal Reserve held between $700–$800 billion of Treasury notes on its balance sheet even before the recession. In late November 2008, the Fed started buying $600 billion Mortgage-backed securities (MBS).[25] By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010. Further purchases were halted since the economy had started to improve. Holdings started falling naturally as debt matured. In fact, holdings were projected to fall to $1.7 trillion by 2012. However, in August 2010 the Fed decided to renew quantitative easing because the economy wasn't growing robustly. Its goal was to keep holdings at the $2.054 trillion level. To maintain that level, the Fed bought $30 billion in 2-10 year Treasury notes a month. In November 2010, the Fed announced it would increase quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011."

    From;

    http://en.wikipedia.org/wiki/Quantitative_easing

    for date reference.

  • Report this Comment On April 14, 2011, at 6:16 PM, mtf00l wrote:
  • Report this Comment On April 14, 2011, at 7:40 PM, cosmictap wrote:

    “People can't get away with this because we eventually die. Countries keep chugging along.”

    Newsflash: countries die, too.

  • Report this Comment On April 14, 2011, at 9:17 PM, ynotc wrote:

    "public debt is issued in their own currency and they maintain control over their central banks and foreign exchanges."

    News flash, several countries are trying to change the reserve currency from U.S. Dollars to some denominated currency.

    As they say in investing past history is no guarantee of future performance.

  • Report this Comment On April 14, 2011, at 9:49 PM, mweems44 wrote:

    One of the reasons that the PIGS are having problems is that they no longer have their own currency that they can devalue when times get tough. It will be interesting how the Eurozone will be able to handle this problem.

    The US and UK still have currencies that they can devaue, and that's what they are doing. Not great but better than the alterative.

  • Report this Comment On April 14, 2011, at 11:40 PM, carpeman123 wrote:

    Well maybe we have not had the United States as a whole fail but what about the following.

    http://www.nytimes.com/2010/12/23/business/23prichard.html?p...

    How Long before this happens to government/state employees all over the u.s.?

  • Report this Comment On April 15, 2011, at 3:58 AM, Tarter539 wrote:

    It is 100% IMPOSSIBLE for the United States to default on its debt.

    To believe otherwise is to misunderstand our monetary system.

    The most intelligent line in this article, which discredits the premise, is:

    "Most importantly, unlike Greece and other stricken Eurozone members, public debt is issued in their own currency and they maintain control over their central banks and foreign exchanges."

    It is IMPOSSIBLE TO DEFAULT on your debt when you have a monopoly on your currency.

    The United States hold ZERO debt denominated in foreign currency.

    When you're Greece and you run out of Euros, or when you're on a gold standard and you run out of gold....you have to go begging or get digging.

  • Report this Comment On April 15, 2011, at 8:50 AM, TMFHousel wrote:

    <<It is IMPOSSIBLE TO DEFAULT on your debt when you have a monopoly on your currency.>>

    Not impossible, just unlikely. Just because a country has a monopoly over its currency doesn't mean it can't choose default. Also, inflation (usage of that currency monopoly) is very much a silent form of default.

  • Report this Comment On April 15, 2011, at 10:00 AM, lctycoon wrote:

    What happens when the interest rates go up (as they inevitably will) and our ability to service our debt? Say the rate goes to 5%. Goodbye, America.

    Will the US default? I don't think so, at least not in the typical way. What will happen? Inflation, and lots of it. There is no way to fix the problem without large amounts of spending cuts and tax increases.

  • Report this Comment On April 15, 2011, at 12:07 PM, Lordrobot wrote:

    It may be worth noting that the Constitution does not make citizens responsible for Gov. Debt. In fact it expressly states the opposite. Yet politicians keep trying to hang this on the taxpayers.

    If the US Defaulted on all debt and cleared its books from the Federal Reserve as well as the Politicians, the country would then have zero debt. It would be a bankruptcy.

    The trouble with defaulting is that the gov is so large now and employs so many and has so many nanny state payments that it is in the banker vernacular, too big to fail.

    At some point one should ask themselves if a gov that behaves like this deserves to survive.

    If the United States wants to be a waring nation then they are going to have to take over conquered territory to fund the war state and nanny state.

    It is gun to your head politics.

    There is no question that gov needs to be reduced in size across the board Federal, State and Local. Entitlements have to be reduced and cut back over time and these long distance protracted wars have to end and the Military must be reduced in size. It is a diet but taxpayers should not suffer the brunt for the stupidity of politicians.

    So I suggest this: The taxpayer has to rise up and demand sharp reduction in gov and start by cutting back on gov jobs and overhead. Gov so far has escaped any of the ravages of unemployment it is time they shared in the process.

    The taxpaying voters should hold a gun to gov head now and seed the Gov default option if politicians do not act now.

    These plans by Ryan and Obama are entirely too small and insufficient. They are both just gaming the system to extend the debt into the future. The cuts have to be immediate and large.

    Afghanistan war is not going well and Iraq needs to stand on its own.

    We have had two back to back presidents that have caused untold damage to the economies because of gov expansion and gov. debt.

    Homeland security needs to be gutted. They do absolutely nothing except grope your children. They have not even reduced a terrorist threat but they have destroyed freedoms in this country.

  • Report this Comment On April 15, 2011, at 2:50 PM, DonkeyJunk wrote:

    If Congress could find a way to monetize stubbornness, ideological claptrap, and ignorance, they could finally put the issue of how to pay for programs and subsidies without raising taxes aside--we'd have a surplus and enough free cash to erect a 20-lane bridge to the moon.

  • Report this Comment On April 15, 2011, at 3:26 PM, CrankyTexan wrote:

    Let me get this straight. The Motley Fool is against personal consumer debt, but they think that trillions of national debt is acceptable? What a bunch of liberal rubbish. I love the USA, but if the USA were a stock, I would short it. Our politicians are corrupt and have no idea how to run a business.

  • Report this Comment On April 15, 2011, at 3:32 PM, CrankyTexan wrote:

    Meanwhile, California is bankrupt from uncontrolled spending.

  • Report this Comment On April 15, 2011, at 3:38 PM, catersi wrote:

    So its agreed, the us government, needs to take out the federal reserve from the picture.

  • Report this Comment On April 15, 2011, at 3:47 PM, mtf00l wrote:

    Lordrobot.

    Eloquently put. What country will institute a no fly zone in the US to protect the tax payers who rise up?

  • Report this Comment On April 15, 2011, at 3:57 PM, TMFHousel wrote:

    <Gov so far has escaped any of the ravages of unemployment it is time they shared in the process.>>

    When I ran the numbers last Oct. (update soon):

    "Year to date, the private sector has added 650,000 jobs. That's slow, but not terrible. Yet the government sector -- even after adjusting for the short-term census hiring and firing -- has shed 224,000 jobs. And the private sector is roughly five times larger than the government sector, so in percentage terms, the plunge in government jobs is more extreme than it looks here."

    http://www.fool.com/investing/general/2010/10/12/the-most-un...

  • Report this Comment On April 15, 2011, at 3:59 PM, buffalonate wrote:

    The interest we pay as a percentage of GDP is historically low right now. In a couple of years if the interest rate goes up that could change.

  • Report this Comment On April 16, 2011, at 10:21 AM, himargin wrote:

    Although the chart (Interest vs GDP) indicates a rising percentage with a mean less than 3%, it seems to me this is much lower than what many of the politicians and doomsday theorist are saying. From a revenue perspective, if the mean interest is 3% of GDP, then our interest payments appear to be just over 1/2 of 1% (.6%) of revenue based on the fact that US revenue has ranged between 15 and 20% of GDP over the past 50 years. While I am concerned with the rate of debt growth and the inflationary pressure created by multiple QE exercises, this debt service as a % of revenue is much less than I have seen publized by several sources and does not seem to be an unachievable load.

  • Report this Comment On April 16, 2011, at 1:22 PM, EAKMF wrote:

    It is hearting to see comments from others who are thinking and concerned about the mess we are in (thanks to our elected people). Given that they are the ones who oversee (saw?) us to this problem, are they to be trusted to do what is necessary? There is no magic bullet. Costs must be reduced and Income increased (tax increases) have to be done! That is the immediate action. Can these people do it?

    For the future, I suggest that a method of eliminating perpetual politicians is term limits. I have seen proposals that make sense.We need to recognize the need and act.

  • Report this Comment On April 22, 2011, at 2:11 PM, nswanberg wrote:

    Cut military spending. Close all our bases in Europe, Japan and the middle east. Since North Korea is just a proxy for China, have them get the kook out of North Korea or stop trading with and exporting our jobs and wealth to China. Then let South Korea deal with the Chinese.

  • Report this Comment On April 23, 2011, at 1:10 AM, drborst wrote:

    Morgan,

    Nice work. You really brought out a few nuts in the comment section with this, very entertaining. My favorites are the ones who don't seam to have read the article.

    But I'm curious about the graph. The rising sections are easy. In the 40's, war. The 80's rise is likely due to the Regan tax cuts (and smaller spending cuts). The rise after about 2003 is either the effect of the Bush tax cuts or the two wars.

    But the big drops I don't get. The long drop in the 90's likely correlates with a growing economy, while the one in 2008 was during a big recession. If the 2008 drop was due to interest rates, then where is the rise due to Volker's interest rate rise in the late 70s?

    Or am I just thinking about the graph all wrong?

    DRB

  • Report this Comment On April 25, 2011, at 2:31 PM, PanzerWatts wrote:

    It seems an odd decision to only show the projected "Interest Payments as a % of GDP" for the next 5 years. The OMB (Office of Management and Budget) does projections for the next 10 years and they project that the % will continue to worsen. By 2020 the % of Debt payments will be at 3.5% and rising.

    http://www.cbo.gov/ftpdocs/119xx/doc11999/12-14-FederalDebt....

    Furthermore, this ignores the very salient fact that historically the US government has revenues of roughly 20% of US GDP. So thist translates to 17.5% of the entire Federal budget dedicated to interest payments alone by the end of the decade.

  • Report this Comment On June 29, 2011, at 10:24 PM, Patriotrodney wrote:

    The U.S. Government defaulted on its' debt in 1933.

    http://spectator.org/archives/2009/01/21/was-there-ever-a-de....

  • Report this Comment On July 28, 2011, at 2:34 AM, Seekr wrote:

    There is lots of discussion out there on what happens to the American economy if the government chooses to default.

    What happens with regards to a flow-on effect to other countries? (I know from the natural disasters in Queensland that long-standing businesses have bankrupted because others who owed them money had to default on their debts because they had no buildings/product/way to make the money to repay the debt.I know the global economy is far more complex than this.)

    I'm not very good at getting my head around economics. I would dearly appreciate someone explaining how the rest of the world will be effected.

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