Many people are finally coming to a realization that should have been evident long ago: Greece’s debts are not going to be repaid. And as discussion turns to who might be next, it seems a good time to revisit the question of whether the United States could some day find itself in similar trouble. I am substantially more optimistic about this than I was a couple of years ago, and here is why.
Let me begin by clarifying that the difference is not, as many other observers have often asserted, the fact that the U.S. debt is denominated in our own currency and therefore could always be repaid just by printing a sufficient quantity of dollars. Reinhart and Rogoff (2009, pages 111-116) documented more than 70 separate historical instances of overt default on domestic public debt. Jesse Schreger, a promising Ph.D. candidate from Harvard, has nicely laid out the theory for why that is. Overt defaults on government debt are costly, but so can inflation be if the government takes the alternative route of trying to monetize the debt. Which course a government takes– outright default or big inflation– will depend on the relative costs of those two options. Schreger does a nice job of demonstrating that a rational assessment of these alternative risks gets priced into the market valuations of sovereign debt around the world.
Instead the core issue comes down to one of sustainability, which is a function of the debt-to-GDP ratio, the interest rate on government debt, the GDP growth rate, and the value of the primary surplus (government revenues less expenses on items other than interest rates) that the public is willing to maintain indefinitely in order to continue to make interest payments to creditors. The math behind this is straightforward and uncontroversial. The only question is what are the values for the relevant magnitudes. An unsustainable path will necessarily eventually lead to some combination of high inflation, overt default, or financial repression.
Two years ago it was unclear to me what would change to put the United States on a long-run path of fiscal sustainability. The graph below plots the interest rate on 10-year U.S. government bonds that the Congressional Budget Office projected in their February 2013 Budget and Economic Outlook. Although the 10-year rate was under 2% of the time, CBO was expecting it to return to more normal historical levels relatively quickly. When those anticipated higher rates began to apply to a U.S. net debt burden that had doubled as a percent of GDP since 2007, the result was a tripling in the government’s anticipated interest expense. This, in combination with the huge fiscal challenges associated with an aging population, created some reasons for concern.
Ten-year yields ended up rising in the spring of 2013 much faster than the CBO had anticipated, but just as quickly they came back down, and today are lower than they were two years ago. This development is factored into the latest CBO projections released two weeks ago, which now call for a slower rise in yields than anticipated in 2013 and ending at a lower plateau. That will end up saving the U.S. Treasury over a hundred billion dollars annually by 2018.
But things right now look even more favorable than that. The CBO report was released on Jan 29 and was assuming a value for the 10-year yield of 2.5% for 2015:Q1. But last week it fell all the way down to 1.83%.
And an expectation that we’re headed significantly up from here doesn’t appear to be priced into longer term bonds. If you simultaneously sold a 1-year bond and bought an 11-year bond you could lock in a rate that you could earn on the combined holding that in effect amounts to a 10-year bond that you don’t pay for until a year from now, known as a forward interest rate. If ynt denotes the yield on an n-year bond purchased at time t, you can use formula (2.4) in Svensson (1994) to calculate the forward rate on a 10-year bond that you will purchase at date t + h from
The red dotted lines in the figure above plot those 10-year forward rates implied by the current yield curve using the estimates developed by Gurkaynak, Sack, and Wright. These show a much more modest rise in rates than is built into the CBO projections. Note that these forward rates do not make any adjustments for risk premia. But this usually works in the direction that a rational forecast of the future 10-year rate would be lower than the 10-year forward rates plotted above; see for example Kim and Orphanides (2007). Perhaps there is an unusual negative term premium at the moment arising from current and planned large-scale asset purchases by central banks around the world or from the flight to dollars as a safe haven from some of the turmoil outside the U.S.
Or perhaps markets simply have it wrong, and current holders of 20-year bonds will suffer the kind of capital loss that the CBO’s Jan 2015 projections imply. Personally I think that’s fairly likely. But in any case, there is no missing the fact that the accumulation of U.S. debt since 2007 has not put any of the pressure on the federal budget so far that some of us had been anticipating. Moreover, with control of the White House and Congress now separated between the two parties, it is less likely that we’ll see significant changes in either spending or taxes that increase the deficit over the near term. My expectation of solid U.S. growth for 2015 will be another factor increasing near-term revenues and decreasing some spending items.
Hence my conclusion: Greece has a big problem right now with its current debt load. The U.S. does not.