The markets are telling us that the Greek debt crisis, which has supposedly been solved numerous times, is still with us and getting worse. Interest rates on Credit Default Swaps on Greek bonds hit a record 495 basis points on April 21st. While Greece is at the end stage of a sovereign debt problem, the U.S. is at the beginning. Some U.S. corporate bonds have recently had lower interest rates than equivalent treasuries indicating that the market believes those companies are in a better financial position than the U.S. government.
The problems that have arisen in Greece are those that occur when a government borrows too much money relative to its GDP. Eventually the interest payments on the debt become overwhelming and default becomes inevitable. Default can take place in two ways however. It can be a simple failure to make interest payments on bonds or it can result from a major inflation of a currency. With inflation borrowers get the nominal amount of money due them, but that money doesn't have the same purchasing power. Since Greece is part of a currency union and can't print its own money, it can only default by not paying off its bonds. The U.S. on the other hand, can print all the money it wants to so it can only default through inflation.
Up to now Greece has had no problem borrowing money. The problem is that the interest rate it has had to pay in the last several months is so high that it undoes the effect of budget cutting measures taken to get its fiscal house in order. The recent EU and IMF proposed 45 billion euro aid package makes funds available for Greece, but didn't do so in a manner that would lower Greece's interest payments. Unless Greece gets access to large amounts of credit at well below market rates, there is no possibility of it avoiding default. Even if it does, sovereign default in all likelihood will simply be delayed.
So what are the implications for the U.S.? The U.S. is not much more fiscally responsible than Greece is, but is does have the reserve currency of the world and a very big printing press. The U.S. can get away will a lot more than Greece does before an irreversible credit disaster begins. In the last few years, the national debt in the U.S. has been skyrocketing because of the Credit Crisis and the recession that followed. It was estimated in the proposed 2010 federal budget that that the U.S. will owe slightly more than $14 trillion by the end of the fiscal year. Debt service was listed as $164 billion.
Based on the budget figures, the U.S. is paying approximately a 1.2% interest rate on its national debt. Could interest rates get any lower than that? Not likely, especially considering that Federal Reserve has kept short term rates around zero. If interest rates return to a more normal, but still relatively low four or five percent, debt service would rise to around $600 billion, without any further increases in borrowing. U.S. federal debt is continually increasing by large amounts however. If 1970s interest rates return, debt service would eventually rise to around $2.4 trillion for the current debt, which is approximately the total estimated revenue for the federal government in 2010. Long before that happened, money printing would be a major source of revenue needed to run government operations on a day to day basis - and hyperinflation would become unavoidable.
The market has been sending hints lately that it is not happy with the U.S. fiscal situation. Interest rates on corporate bonds from Berkshire Hathaway (BRKB), Proctor and Gamble (PG), Johnson and Johnson (JNJ), Lowe's (L) and Abbot Laboratories (ABT) have been lower than equivalent U.S. treasuries at some point in the last few months. Corporate interest rates should never be lower than government rates, at least in theory, because corporations are supposed to be riskier than a government. The market is telling us that it sees things the other way around. Investors should consider this a long-term warning.
The euro (FXE) of course sold off on the latest developments in Greece, but did not make a new low. The market may therefore have already priced in the full impact, at least for the moment, of debt problems in the eurozone. There are more potential problems there in Portugal, Ireland, Spain and Italy however. Whether the market will continue to see those as more significant than the debt problems in the U.S. is still an unanswered question.
Disclosure: Not relevant.
Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21
This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.
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