The Debt Bomb!

Is the world financial situation about to "go nuclear"?

The calm of the New Mexico desert was shattered on July 16, 1945 when the United States tested the first atomic bomb, code-named "Trinity." This fission bomb released the equivalent of 18 kilotons of TNT (about 36 million pounds) and began the nuclear age. Seven years later, on November 1, 1952, technicians at the U.S. Pacific Proving Grounds detonated the first hydrogen bomb—"Ivy Mike." Its massive fusion reaction released a blast estimated as the equal of up to 12 megatons of TNT—up to 24 billion pounds—about 600 times greater than the first fusion bomb. Its fireball alone was 3.25 miles wide. Nuclear terror indeed!

Nearly 60 years later, the U.S. has constructed another terrifying "bomb" of sorts, which may in its own way be just as explosive as these earlier instruments of destruction. We can call it the "Debt Bomb"—and its fuse is lit; the clock is ticking.

Exploding Deficits

According to the Congressional Budget Office (CBO), the U.S. fiscal deficit in 2009—the difference between government revenues and expenditures—was $1.416 trillion, or 10.0 percent of Gross Domestic Product (GDP). In 2010, the deficit was $1.294 trillion—or 8.9 percent of GDP. These deficits, as a percentage of GDP, are the nation's highest since World War II.

Worse, the fiscal 2011 deficit is soaring even higher! As the CBO Monthly Budget Review reported: "The federal government incurred a budget deficit of $830 billion in the first six months of fiscal year 2011, CBO estimates—$113 billion more than the shortfall recorded in the same period last year" (April 7, 2011). Estimates suggest that the total federal budget deficit in 2011 will reach $1.6 trillion! Along with this sobering news, the International Monetary Fund projects that total U.S. debt will exceed the nation's annual output of goods and services sometime in 2012!

Herbert Stein, a noted economist who chaired the Council of Economic Advisors under U.S. Presidents Nixon and Ford, stated the obvious with what he called "Herbert Stein's Law." Put simply, he said, "If something cannot go on forever, it will stop." By that, he meant that extreme conditions that are unsustainable will cause their own demise. A good example of this would be the fiscal problems faced by the nation of Greece, which ran up huge deficits when there was easy access to money. Once creditors began to demand higher interest payments on loans, the nation was forced to attempt a severe austerity regimen in an attempt to avoid defaulting on its debt. This strained the Greek economy and led to riots and social unrest—even to deaths. To cope, the nation had to cede significant control over its fiscal policies to the European Union in exchange for a temporary bail-out.

The Bond Market Disciplinarian

In May 2011, despite austerity measures and EU controls, the "credit rating" of Greece's debt was downgraded to "B"—which is close to a "junk bond" rating—making Greek loans more undesirable than ever for cautious investors. This has further escalated Greece's costs for borrowing money—now exceeding 15 percent for two-year bonds—while sober creditors continue to dump Greek sovereign debt. "Beware of Greeks bearing bonds" has become an international joke.

Other EU nations have also had their ratings downgraded. Could something similar be on the horizon for the U.S. and Great Britain, long proud of their AAA ratings? The first signal that the bond markets are disciplining a profligate nation is a declining credit rating. And many careful investors will only hold debt with the highest credit rating. What will happen if the credit rating of the U.S. or Britain is downgraded? In April 2011, Standard & Poors gave the current U.S. "AAA" rating a "negative outlook"—a judgment that often precedes a downgrade. Should the U.S. lose its prized "AAA" rating, interest rates will rise suddenly as investors seek to diversify out of U.S. obligations, and the U.S Treasury will have difficulty placing additional debt. China and Japan will be particularly affected since they are holders of huge amounts of U.S. sovereign debt in the form of Treasury bonds.

Fitch Ratings, like Standard & Poor's and Moody's, is one of the major bond rating agencies. David Riley, head of sovereign debt ratings at Fitch, recently commented on the U.S. situation. His employer forecasts that "the U.S. AAA debt rating will likely survive the battle over this year's budget and debt ceiling, but the real test to the country's credit-worthiness lies ahead… Fitch projects the U.S. fiscal deficit, including state and local governments, to reach about 10 percent of gross domestic product this year, the largest of any AAA-rated sovereign. The government debt load will likely reach 100 percent of GDP by 2012, also the highest burden among any AAA-rated country" ("US rating to survive budget row, real test ahead—Fitch," Reuters, April 7, 2011).

More than a year ago, Moody's issued a similar warning. The New York Times "Economix" blog reported, "The gold-plated credit rating of the United States—an article of faith across America and, indeed, around the world—may be at risk in coming years as the nation copes with its growing debts… Moody's said the United States and other major Western nations, particularly Britain, have moved 'substantially' closer to losing their gilt-edged ratings" ("Moody's Says U.S. Debt Could Test Triple-A Rating," March 16, 2010).

In London, The Telegraph reported that Britain has also been warned. "Moody's, the ratings agency, said Britain's triple-A credit rating could be at risk if slower growth makes it harder for the government to rein in its budget deficit" ("Moody's warns Britain over triple-A credit rating," March 24, 2011).

Out on a Limb with the U.S.

China and Japan are nervous about the U.S. debt situation. In January 2011, China held $1,154.7 trillion in U.S. Treasuries—up from $889.0 billion in January 2010! Similarly, Japan held $885.9 billion in January 2011—up from $765.2 billion in January 2010. Generally speaking, these two countries use purchases of U.S. Treasury bonds to offset their big trade surplus with the United States.

But Japan has massive fiscal deficits of its own. As the New York Times reported, "Last May, Moody's cut Japan's AAA rating to AA2, as the market grew increasingly uneasy with Japan's debt burden" ("Moody's Warns on AAA Ratings," March 15, 2010).

It keeps getting worse. The BBC reported, "In early 2011, Moody's Investor Services changed its outlook for Japan's credit rating to "negative" from "stable" citing concerns about debt levels… In January, rival rating agency Standard & Poor's downgraded Japan's credit rating from AA to AA-, also citing debt concerns ("Japan's credit outlook is cut to negative by Moody's," BBC News, February 22, 2011). Around the same time, "Japan was overtaken by China as the world's second-largest economy. Japan has been trying to boost its economic growth and as a result government spending and borrowing has increased. Moody's said that the government needed to do more to cut borrowing levels. Japan currently has the highest government debt levels of any industrialised nation" (ibid.).

The U.S. seems unable to reverse its path down the same road.

TEA: "Taxed Enough Already"?

The issue of deficits has become a political football in Washington. The Obama administration knew that the massive stimulus spending signed into law at the beginning of President Obama's term would produce record deficits. They hoped to use the deficits to force large new tax hikes and promote income redistribution. Many commentators believe that the goal of the administration was to force a value added tax—a type of national sales tax—that would mimic the social democracies of Europe. This alternative, a "VAT," has been widely discussed in Washington. In effect, it was hoped that the record deficits would create a "debt bomb" that could only be defused by a new and far-reaching tax regime—or, at a minimum, by substantially higher effective tax rates.

But a new phenomenon appeared on the American political scene—a movement called The Tea Parties. The name refers to the "Boston Tea Party" in 1773 when colonists protested against a British tax on tea by dumping a cargo of British tea into Boston Harbor. Some Tea Party protesters carry signs using TEA as an acronym for "Taxed Enough Already." Few people in Washington anticipated this grass roots movement and its resulting influence.

Generally speaking, Tea Party members are adamantly against new taxes and growth in government. They now have considerable influence in Washington, and their votes elected—or defeated—a number of members of Congress in the last election cycle. Those politicians beholden to them—and others who fear being defeated in the next elections—will have a very difficult time voting for any new tax. The Republicans reject new taxes, and the Democrats oppose significant cuts in social spending. The conservative Republican Party controls the House of Representatives where new tax and spending bills can originate, but the liberal Democrats control the Senate and the presidency. The Senate must approve any cuts in spending, and the President can veto a law he does not like. So Congress is gridlocked. Multi-trillion dollar deficits are flying on autopilot and, in effect, fuel is getting low.

The Point of No Return

The Bank for International Settlements, BIS, is often thought of as "the central banker to central banks." They published a sobering assessment of the rapidly developing sovereign debt problem in the U.S. and other debt-ridden countries:

"The financial crisis that erupted in mid-2008 led to an explosion of public debt in many advanced economies… Our projections of public debt ratios lead us to conclude that the path pursued by fiscal authorities in a number of industrial countries is unsustainable. Drastic measures are necessary to check the rapid growth of current and future liabilities of governments and reduce their adverse consequences for long-term growth and monetary stability… [When] the interest rate is greater than the growth rate, the debt ratio will explode in the absence of a sufficiently large primary surplus… Our examination of the future of public debt leads us to several important conclusions. First, fiscal problems confronting industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis and recession for fiscal balances. As frightening as it is to consider public [U.S. Treasury] debt increasing to more than 100 percent of GDP [as will be true in the U.S. by 2012], an even greater danger arises from a rapidly aging population. The related unfunded liabilities are large and growing… [and] government revenues will be lower and expenditures higher, making consolidation even more difficult. But, unless action is taken to place fiscal policy on a sustainable footing, these costs could easily rise sharply and suddenly" (BIS Working Papers 300, The Future of Public Debt: Prospects and Implications, Stephen G. Cecchetti, M. S. Mohanty and Fabrizio Zampolli, March 2010).

The BIS economists warn that the U.S. could be approaching a "tipping point" in which interest on debt exceeds economic growth, forcing a spiral of more borrowing and deficits. This occurs around the point where government debt exceeds the gross domestic product—exactly where the U.S. is today. The BIS also warned that on the downside of the tipping point, interest rates can spike "sharply and suddenly," exacerbating the problem and accelerating the downward slide. This could be triggered by a downgrading of U.S. sovereign debt.

The Lehman Brothers Effect

Lehman Brothers was one of the largest of the Wall Street investment firms and had invested heavily in subprime mortgages. They had an investment-grade, "A" credit rating right up to their bankruptcy filing on September 15, 2008. When the ability of Lehman's subprime portfolio to repay its debt came into doubt, Lehman's credit rating was reduced by the rating agencies. As a result, their lenders quickly withdrew their lines of credit. Lehman immediately became insolvent, and they had to seek the protection of Chapter 11 bankruptcy. It happened very quickly.

But there is no bankruptcy court to protect nations. When they cannot pay, they default on their sovereign debt; however, their lenders usually demand high rates or stop lending altogether before that happens. Declining credit ratings and rising interest rates are the signs to watch for. Could something like this happen to the U.S.? Could the U.S.'s or Britain's triple-A rating be reduced and its lenders back away? The small nation of Greece was bailed out by the European Union, but who can bail out the U.S. or Great Britain?

Another Warning from Long Ago

The U.S. and Great Britain have been blessed greatly by God, and in past generations, the leaders and people generally have acknowledged that their blessings have come from God. God tells us that it is He who makes our creation of wealth possible, but he warns us about it as well. "Beware that you do not forget the Lord your God by not keeping His commandments, His judgments, and His statutes which I command you today, lest—when you have eaten and are full, and have built beautiful houses and dwell in them; and when your herds and your flocks multiply, and your silver and your gold are multiplied, and all that you have is multiplied; when your heart is lifted up, and you forget the Lord your God… then you say in your heart, 'My power and the might of my hand have gained me this wealth.' And you shall remember the Lord your God, for it is He who gives you power to get wealth" (Deuteronomy 8:11–14, 17–18).

A nation that is being blessed by God in creating wealth is often a lender to other nations. This was the situation with the U.S. and U.K. in the past. "Then all peoples of the earth shall see that you are called by the name of the Lord, and they shall be afraid of you. And the Lord will grant you plenty of goods, in the fruit of your body, in the increase of your livestock, and in the produce of your ground, in the land of which the Lord swore to your fathers to give you. The Lord will open to you His good treasure, the heavens, to give the rain to your land in its season, and to bless all the work of your hand. You shall lend to many nations, but you shall not borrow. And the Lord will make you the head and not the tail; you shall be above only, and not be beneath, if you heed the commandments of the Lord your God, which I command you today, and are careful to observe them" (Deuteronomy 28:10–13).

But what does God say will happen when He withdraws His blessing? Among other things, debts will increase. "The alien who is among you shall rise higher and higher above you, and you shall come down lower and lower. He shall lend to you, but you shall not lend to him; he shall be the head, and you shall be the tail" (Deuteronomy 28:43–44).

Some will need to learn the hard way that "the borrower is servant to the lender" (Proverbs 22:7). America has created a "debt bomb" that it struggles to disarm—and the fuse is burning shorter!