The inevitability of a U.S. debt crisis

A debt crisis in the world's largest economy is coming and it can no longer be avoided.

A recent issue of The Boeckh Investment Letter lays out the case for the inevitability of a sovereign debt crisis in the U.S. Yes folks, it’s just a matter of time — as further confirmed in April by the extension of the U.S. government’s debt ceiling and Standard & Poor’s warning of a credit downgrade on U.S. Treasury debt.

According to non-partisan agencies, the projected deficit for the U.S. federal budget will average about 5% of GDP over the next 10 years, adding another US$10 trillion to U.S. government debt. This will raise net government debt from 69% of GDP to 91.5% of GDP in 2021, “more than double a prudent level,” write Tony and Rob Boeckh.

What’s scarier is that these numbers are based on a couple of optimistic assumptions: Although recessions typically occur every 3 to 4 years, the 10-year period to 2021 assumes there will be none. Second, average annual growth in GDP over the period is assumed to be 3%; this compares to the 2.7% rate generated between 1983-2007 that was fueled by a credit expansion the U.S. can no longer replicate.

Even before the 2008 and 2009 financial crisis/recession dramatically ratcheted up government deficits and debt, there were serious concerns about the sustainability of government finances due to the “underlying trend of rapidly exploding future entitlement spending.” The present value of unfunded entitlement obligations, most of which is for Medicare and Medicaid, is over $60 trillion — a figure that dwarfs the level of current U.S. net public debt of about $10 trillion. The Boeckhs warn:

“Ultimately, it will become obvious to enough people that entitlements can’t be afforded as they are now legislated. They will be cut. This is all about promises that can’t be kept, falling living standards and whose ox gets gored.”

How will the U.S. sovereign debt crisis unfold? Creditors will lose confidence and dump U.S. bonds, stocks and the U.S. dollar, causing interest rates to spiral upward and the U.S. dollar to tumble. The U.S. government will then be forced to impose draconian spending cuts and tax increases, plunging the economy into a severe recession. Instead of the bad taste of an ounce of prevention, there will be the excruciating pain of a ton of cure.