Wednesday, February 10, 2010

The Via Dollorosa

by "The Lex Column" (02/09/2010 Financial Times)

Timothy Geithner has surely been told that one should “never say never”. The US Treasury secretary’s assertion that the US will forever retain its triple A credit rating is still far from the shibboleth that statements about a strong dollar have become when uttered by former Treasury secretaries, but that day may not be far off.

Reacting to projections of a record $1,600bn budget deficit, Moody’s said last week that, unless further deficit reduction action was taken or the economy grew more quickly than expected, that rating would eventually be in jeopardy. Credit default swaps traders were last week willing to give 5 per cent odds not just of a downgrade but of a US default within five years.

Even given America’s rapidly deteriorating fiscal outlook – gross government debt to output has risen from 62 per cent in 2007 to 85 per cent in just two years and will probably reach one-to-one by 2012 – such a rapid collapse is far-fetched. But longer-run budget figures are more daunting. Without entitlement reform, the scope for Mr Geithner’s pledge of future fiscal restraint will be meaningless unless he acts soon and forcefully. By 2020, less than a third of the budget may be discretionary and it may be too late then to stop the red ink without breaking social contracts.

The only really strong argument for why the US may never default is one Mr Geithner could never make in public. Having the luxury of issuing debt in its own currency, it can always create more to satisfy claims. Of course, to use the printing presses for this purpose would be the economic equivalent of cutting off your nose to spite your face. Yet even dollar debasement is a receding option as the average maturity of US government debt has fallen to below 50 months and the portion of debt that is inflation-indexed is rising, partially at the request of anxious creditors such as China.

In order for Mr Geithner’s words to have meaning, painful cuts must be made soon or the market will eventually call his bluff.

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