The treasury’s AAA credit rating was properly taken for granted until a few months ago. Indeed, the whole structure of interest rates used Treasury debt as the risk free, base, interest rate with other rates calculated as premiums or spreads over the Treasury rate. The $US was long used as the prime international reserve currency. US Treasury debt was the safe have for foreign investors willing to accept a low rate of return in exchange for avoiding default risks in debts denominated in other currencies.
Now the massive borrowing by the Treasury in the last few months has put the traditional international role of the $US in question. We have worried about this happening for years. But it never happened. Every crisis led foreign investors and governments to bring money to the US for safekeeping. Other countries had to make painful spending cutbacks periodically after spending binges but the US has been spared because of its unique role in international finance and sufficient borrowing restraint.
In recent decades we have seen Russia, Thailand, Mexico, Brazil, Argentina, Turkey and countless smaller countries forced to take drastic spending cuts when international lenders demanded a large premium to lend to them. A few months ago, Iceland had to abruptly slash spending when lenders balked at additional loans. Given its small size, this event was ignored in the US. Then last week, the United Kingdom was forced by international creditors to cut spending sharply.
Foreign investors now have US Treasury debt in their crosshairs for the first time. We gave then plenty of reasons to do this. In the year ending next Labor Day, we quadrupled the federal deficit, wiped out previously generous state budget reserves, bankrupted several of our largest corporations and a large number of our largest financial firms and saw our largest state go bankrupt.
Investors are now asking out loud â€œcan the US repay its debts?â€ The answer would normally be â€œyesâ€ with some modestly painful spending cuts forced by demands for a small interest rate premium on new loans and debt rollovers. But this debt problem is different from ones in the past. For the first time investors question whether the Treasury intends to be responsible with its debts.
We have given them reasons to question our intentions. The new policy in Washington is debt forgiveness for the right kind of people combined with added spending on socially correct jobs. While this approach may generate the income to end the need for extra borrowing it does not generate self-sustaining jobs that permit the debts to be paid back. President Obama’s projection of a rapid fall in the federal deficit is dismissed as fantasy by investors.
Foreign investors are quickly abandoning Freddie Mac and Fannie bonds that they now realized can only be repaid with additional borrowing. This is the first step in the US lose of its unique currency position. Both the Euro and the Chinese Yuan are becoming more significant international currencies because the government behind each of these currencies is showing more spending restrain than we are.
It is not too late to reverse the loss of status of the $US and US Treasury debt. But there is no sign that actions are being taken to do this. Instead, the President and Congress are planning additional multi-trillion dollar spending programs for green energy and expanded healthcare. Neither of them will generate the self-sustaining jobs that permit the debt that financed them to be repaid. Recall that the initial surges in the last few years in solar and wind generators and the ethanol substitute for crude oil all collapsed when the government subsidies were exhausted.
Nonetheless, massive spending will lead to economic recovery later this year and continuing recovery at a modest pace next year before bills come due that cannot be repaid. The inevitable consequence is a pullback in federal spending, including construction credit, and/or much higher credit costs that force private construction customers to cancel projects.