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Overshadowed by the sovereign debt crisis in the Eurozone, theUSA is also heading for a worst-case scenario with its own pub-lic debt situation: partial non-performance of government obliga-tions. In other words, the United States may soon be in a positionwhere it is unable to pay its bills. The main reason for this is theinability of the Republicans and Democrats to reach an agreementon raising the debt ceiling. In reality, however, there is much moreat stake: the decision to take wide-ranging measures to tackle theurgently needed consolidation of the US budget.

History of the debt ceiling

The US debt ceiling is an institution which dates back to the 19thcentury. Prior to the First World War, the US Congress generallyonly allowed the Treasury to take out loans for specific purposes,for example for the construction of the Panama Canal. Within thisframework, the guidelines on the type of financial instrument to beused, the duration and the applicable interest rate were very strict.Congress only granted the Treasury wider ranging powers duringtimes of war, allowing it to issue bonds and Treasury bills to raisethe necessary financial resources.1 With the Second Liberty Bond

Act of 1917, Congress relaxed the strict conditions imposed onborrowing. With this change, the US Treasury was then allowed tomake its own decisions on the duration, coupon and type of secu-rities to be issued, working within the framework of a pre-defineddebt volume.

1 With the War Revenue Act passed in 1898 to finance the Spanish-American War betweenApril and August 1898, the US Congress authorised the Treasury to issue debt obligations witha maturity of less than one year in a volume of USD 100 mn and to issue bonds with longermaturity in a volume of USD 400 mn.

US debt disputeIs a default imminent?

29 July 2011

AnalystsJrg Angel, CIIAjoerg.angele@raiffeisenresearch.atValentin Hofsttter, CFAvalentin.hofstaetter@raiffeisenresearch.at

0

2,000

4,000

6,0008,000

10,000

12,000

14,000

16,000

Jan-3

9

Jan-4

4

Jan-4

9

Jan-5

4

Jan-5

9

Jan-6

4

Jan-6

9

Jan-7

4

Jan-7

9

Jan-8

4

Jan-8

9

Jan-9

4

Jan-9

9

Jan-0

4

Jan-0

9

Democratic President Republican President Debt ceil ing in USD bln.

Building up debt is nothing new

Source: The White House. Raiffeisen RESEARCH

Economic forecasts2009 2010 2011f 2012f

Real GDP (% yoy) -2.6 2.9 2.7 2.7

CPI (% yoy) -0.4 1.6 3.1 2.2

CPI core rate (% yoy) 1.7 1.0 1.3 2.0

Unemployment rate (%) 9.3 9.5 8.7 8.2

Employment growth*(% yoy)

-4.4 -0.7 1.0 1.1

Current accountbalance**

-2.7 -3.2 -3.0 -2.7

EUR/USD 1.39 1.33 1.46 1.30

* non-farm** % of GDPSource: Thomson Reuters, Raiffeisen RESEARCH

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2

According to the Congressional Budget Office, anindependent agency of the Congress, based on thebudget planned proposed by President Obama thebudget deficit of 9.5% of nominal gross domesticproduct for this year will only sink to 4.4% in 2016.Along with this, the ratio of debt would increase from93.2% of GDP in 2010 to 109.1%.4 With this, USdebt is approaching levels above which sustainabi-lity becomes questionable. Indeed, by 2021, the le-vel of debt is projected to rise to 116.0%.

One of the most problematic aspects of these projec-tions is that they are based on the assumption of ave-rage real economic growth of 3.4% yoy. Accordingto the estimation of the US Federal Reserve (centralbank), the potential growth rate of the US economyis around 2.7% yoy. For the period 1990-2010, the

average real increase in gross domestic product onlyamounted to roughly 2.5% yoy. Furthermore, onecan almost certainly assume that the US economywill slip into a recession again sometime before theyear 2020. Since 1950, the period of time betweenthe beginnings of two recessions has been just sixyears on average. The longest period without any re-cession at all was 1991-2001. Despite this, anotherperiod of recession is not included in the projectionon the public budget through to the year 2021 andthus this represents a significant risk factor, insofar asthe public deficit and debt paths may turn out to be

considerably worse than expected.

By way of example, following five recessions since1974,5 public debt as a percentage of nomnial GDPin the third year after the recession was higher by

4 If one filters out intra-governmental bond holdings (held by the public),the debt level increases from 62.1% to 79.9%.5 In relation to the double-dip recession in the early 1980s, only the firstphase of the recession in 1980 was taken into consideration and the se-cond recessionary phase in 1981/82 was not counted again.

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After the end of the First World War, separate cei-lings were once again instituted for borrowing fundsdepending on the specific type of security which wasissued. This meant, for example, that there were in-dividual limits on Treasury notes, Treasury bills, cer-tificates of indebtedness, etc. This practice was onlyabandoned in 1939, when a debt ceiling for all typesof government debt was introduced. In 1939, thisdebt ceiling was USD 45 bn, the equivalent of USD724 bn today.

The current dispute

Upon inception, the debt ceiling was never really in-tended to be a way of limiting government spendingor public debt. As noted above, its original purpose

was to make it easier for the government to take ondebt. Consequently, when the ceiling was reached,there was never any question as to whether the itshould be raised. This has happened on 73 occasi-ons since 1939, whereas there were only 4 instancesin which the debt ceiling was lowered.2 Regardlessof whether a Democrat or a Republican was sittingin the Oval Office, the debt ceiling and along withit, US public debt, was always adjusted to meet theneeds. Viewed in this light, the current dispute is anovel development. At its heart, the question is howthe US intends to gain control over its currently enor-

mously high budget deficit. In 2009 and 2010 alone3US public debt increased by USD 2,707 bn, whichis equivalent to slightly more than the nominal grossdomestic product of France. The plans to reduce thebudget deficit presented by President Barack Obamaso far are seen as being relatively unambitious.

2 This count only includes changes which resulted in an effective change inthe debt ceiling. If one also includes amendments which did not result in anumeric adjustment, there were more than 100 changes.3 Fiscal years.

-12.0

-10.0

-8.0

-6.0

-4.0-2.0

0.0

2.0

4.0

6.0

1980 1985 1990 1995 2000 2005 2010 2015 2020

30.0

40.0

50.0

60.0

70.080.0

90.0

100.0

110.0

120.0

Federal government deficit (% of nominal GDP)

Gross federal debt (% of nominal GDP, r.h.s.)

Forecast

No plans for consolidation

Source: Congressional Budget Office. Office of Management and Budget

1,0002,000

3,0004,0005,000

6,0007,0008,0009,000

10,00011,00012,000

13,00014,000

Q1

50

Q3

54

Q1

59

Q3

63

Q1

68

Q3

72

Q1

77

Q3

81

Q1

86

Q3

90

Q1

95

Q3

99

Q1

04

Q3

08

Recession due to BCDC GDP (real, in USD bn)

Restrictive monetary policy and/

or restrictive fiscal policy

1st oil price shock

2nd oil price shock andrestrictive monetary policy

2nd Gulf war/Savingand Loans crises

Burst of New Economy bubble

Subprimecrises

Economic cycle is very reliable

Source: The Business Cycle Dating Committee. Thomson Reuters. Raiffeisen

RESEARCH

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11.2 percentage points than it was in the year priorto the recession. Hence, it is highly likely that, ifthe current budget planning is followed, US publicdebt in 2020 will be higher by 20 to 30 percen-tage points compared to the current projections, andwill thus amount to 135% to 145% of US nominalgross domestic product, on the one hand because ofweaker-than-projected economic growth and on theother hand due to a renewed period of recession. Alevel of 135-145% of GDP would come close to thecurrent debt level of Greece.

As both the Republicans and the Democrats haverealised that this kind of debt level is no longer sus-tainable, both sides wish to implement a long-termplan to consolidate the budget. The problem is thatboth sides have completely different ideas about howthis should be done. While the Republicans are es-sentially arguing for spending cuts, the Democratswould rather increase revenues via tax increases.This dilemma has been reflected in all of the com-promise proposals that have been set forth so far.

For example, the latest proposal by the RepublicanSpeaker of the House, John Boehner, envisages spen-ding cuts on discretionary spending items (i.e. itemswhich are not stipulated by law) with a volume ofUSD 1,200 bn over the next 10 years. At the sametime, limitations on future spending are to be enac-ted, which are intended to minimise the increase inpublic spending. Additionally, the plan calls for thecreation of a committee which is to pinpoint anotherUSD 1,800 bn in potential savings on non-discretio-nary spending between 2012 and 2020, in particu-lar in the field of social expenditures. The proposal

does not contain any plans for tax increases. In re-turn for approval by the Democrat-controlled Senateand President Obama, the debt ceiling is to be in-

Spezial

creased in two steps by a total of USD 2,600 bn toapproximately USD 16,900 bn. The first step of USD1,000 bn will come after approval of the savingsmeasures in discretionary spending, with the secondstep occurring after agreement on further savingsamounting to USD 1,800 bn. Numerous Democratshave already signalled that they will reject this offer,as the savings are primarily centred on social ex-penditures, whereas higher income earners remaincompletely unaffected. President Obama has alreadyannounced his veto, as he is unhappy with the two-step approach to increasing the debt ceiling: he isworried that the same situation will occur next year,if the parties are unable to reach an agreement onthe savings of USD 1,800 bn.

In light of the Republicans fundamental opposition

to any form of tax increases, the Democratic Spea-ker of the Senate, Harry Reid, recently saw no alter-native but to make a compromise proposal himself,which has a volume of USD 2,700 bn and does notcontain an increases in taxes. In particular, this plancalls for cuts of USD 1,200 in discretionary militaryspending and other discretionary items over the next10 years. Furthermore, another USD 1,000 bn inspending is to be avoided by reducing the US pre-sence in Iraq and Afghanistan. Another USD 400bn is to come from the desired decline in interestpayments if the savings plans are implemented. In

return, the debt ceiling is to be increased in one stepby USD 2,400 bn to USD 16,700 bn. Even thoughMr. Reids proposal accommodates the Republicansinsofar as it does not contain any provisions for taxincreases, the initial reactions were negative. Wit-hout the broad support of Republicans in the Houseof Representatives, however, the plan has no chanceof being passed, as there is also some stiff resistanceto it amongst the Democrats themselves. In particular,many Democratic representatives find it highly unjustin social terms that the savings package does not callfor any participation of higher-income groups at all.

In the meantime, the Congressional Budget Office(CBO), an independent Congressional agency, hasanalysed both plans and reached the conclusionthat the anticipated volume of savings is significantlylower than stated by Boehner and Reid. Accordingto the CBO, the possible savings if all of Boehnersplans were implemented would only amount to USD850 bn and not USD 1,200 bn over the next 10years. No conclusions could be reached about thetargeted savings volume of USD 1,800 above andbeyond that, as no specific measures were stated forachieving these savings. By contrast, the CBO pro-

jected savings of USD 2,200 bn over 10 years withthe Reid plan, as opposed to Reids estimate of USD2,700 bn.

-5

0

5

10

15

20

25

30

35

0 1 2 3

1974 1980 1990 2001 2008 Average

Increase of gross federal debt compared to nominal GDP

in percentage points

Overly optimistic budget planning

0 = first full year of recession or year with the strongest impacts of a

recession

Source: Congressional Budget Office, Raiffeisen RESEARCH

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Moving towards a solution

Considering the almost fanatical position of certainRepublican representatives on tax increases and thedemands for draconian cuts in social spending, re-aching a compromise hardly seems feasible. Therude rejection of Reids proposal, simply becauseit did not include deep cuts in the healthcare pro-grammes Medicaid and Medicare as well as othersocial benefits, but does manage to avoid tax incre-ases and achieve roughly the same volume of sa-vings as the Boehner plan, raises the suspicion thatthose involved are actually not interested in reachinga compromise and would rather attempt to reap asmuch political profit as possible from their obstructio-nist policy. In this regard, the Republican membersof the so-called Tea Party movement are playing a

particularly negative role, as they called upon all Re-publican representatives to refuse any compromisesolution, including that of their fellow party-memberJohn Boehner. At the same time, the proposals which have beenmade so far could easily be used to find a viablecompromise: tangible cuts in military spending asproposed by Senator Reid; cuts in the field of health-care the USA spends by far the most money of allOECD countries on its healthcare system6 as wellas further cuts in discretionary spending and spen-ding caps, as demanded by Boehner; quick imple-

mentation of the savings measures starting in 2011already, but by 2012 at the latest as envisaged bythe Republicans; increasing the debt ceiling in onestep to around USD 17,000 bn as desired by Presi-dent Obama. With a compromise like this, it wouldmost certainly be possible to avoid the looming par-tial default by the USA; the negative economic con-sequences would be minimal and the governmentbudget deficit could at least be stabilised in the nextfew years.

This notwithstanding, real consolidation of the USbudget is still miles away. In order for such consoli-dation to proceed, tax increases will be unavoidableover the medium term. The calls by some Republicanrepresentatives to immediately reduce spending somuch that the budget is balanced and then to main-tain this balanced budget in the coming years arecompletely unrealistic. The fiscal shock that this wouldtrigger would be certain to plunge the US economyinto another recession. And as the effect of automaticstabilisers would essentially be negated in de factoterms, there would be a risk of a vicious downwardspiral with devastating consequences. Germany was

6 According to the OECD, the USA spent around 17.4% of its nominalgross domestic product on its healthcare system, more than any other OECDcountry. Although a large part of the spending is privately financed, theUSA also ranks among the highest in terms of public spending on health-care as well.

one of the countries that had this experience duringthe global economic crisis in the 1930s, when theGerman state reacted to the steep decline in reve-nues with massive spending cuts, which actually exa-cerbated the crisis itself.

Whilst tax increasesare generally to be used withcaution and should always be the last instrument de-ployed, in the case of the USA a modest increase inthe tax burden would clearly outweigh the possibleramifications of sharp cuts in spending. Accordingto calculations by the EU Commission, measuredin terms of 2009 gross domestic product, the taxburden in the USA was just 24.2% and was thuslower than that of any other industrialised country.Tax burdens are higher even in so-called tax havenssuch as Ireland (28.2%), Switzerland (29.5%) and

Slovakia (28.8%). Viewed in a historical light, a taxratio of less than 25% is also extremely low by Ame-rican standards.

0.0

10.0

20.0

30.0

40.0

50.0

60.0

US

Japan

Ire

lan

d

Slova

kia

Sw

itzerlan

d

Greece

Spa

inUK

Luxem

bourg

Ne

therlan

ds

Germany

Norway

France

Austria

Ita

ly

Finlan

d

Be

lgium

Swe

den

Denmark

Tax burden in % of nominal GDP

USA with low tax burdens

Source: EU Commission

There are two very simple toolswhich can be used totangibly increase the governments revenues, withoutexcessively dampening economic activity: one of

these would be the introduction of a nationwide va-lue added tax, which has never existed in the USA,in contrast to all of the members of the EU. With thenominal volume of private consumption at more thanUSD 10,000 bn, levying a value added tax of justone percent would immediately generate additionalrevenues of around USD 100 bn. Over a 10-yearperiod, this would result in additional revenues ofalmost USD 1,300 bn, working on the assumptionof an estimated increase of 3.75% yoy in nominalconsumption expenditures (the average rate for theperiod 2000-2010). This would be equivalent to

one-third of the savings volume of USD 4,000 bnwhich is desired by President Obama and is viewedby the rating agencies as necessary to achieve a sus-tainable debt path. Above and beyond this, there

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is leeway for increases in personal income tax. Forexample, the top tax rate is currently at 35% and isthus very low compared to the historical average.Following the Great Depression, the top tax rate wasincreased to 63% in 1932. To finance the massiverise in public debt during the Second World War,it was even raised to over 90% at times. Only fromthe mid-1960s was the top tax rate reduced belowthis high level, but it still was over 70% until the early1980s. While income tax rates this high are not desi-rable, one glance at the tax rates of the past confirmsthat there is ample leeway to increase rates.

0

15

30

45

60

75

90

105

120

135

150

1913 1925 1937 1949 1961 1973 1985 1997 2009

0

10

20

30

40

50

60

70

80

90

100

Gross federal debt (% of nom. GDP)

Top bracket income tax

Lowest bracket income tax

Top tax rate low in historical comparison

Source: Internal Revenue Service, Congressional Budget Office

shutdown, meaning that numerous government servi-ces will be suspended. Amongst other things, such ashutdown would include the closure of governmentoffices and agencies, national parks and schools. Ifthis situation only lasted a short time, the economicimpacts would most likely be manageable.

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

02-

Aug

09-

Aug

16-

Aug

23-

Aug

30-

Aug

Interest payments Medicare/MedicaidSocial security benefits OtherDeposits

Interest payments covered (theoretically)

Forecast based on daily revenues and spending in August 2010

Source: Treasury, Raiffeisen RESEARCH

A longer-lasting shutdown, however, would have se-rious consequences for the economy. For example, ifno agreement on raising the debt ceiling is reached

by August 31, the outstanding payments wouldamount to around USD 145 bn. This would repre-sent a massive fiscal shock and have the potential inits own right to trigger a recession in the economy.At the same time, the negative impacts of the shut-down on other economic processes are at least asserious: licenses would not be renewed, applicationswould not be processed, no social security cardsand passports would be issued and permits wouldnot be granted. In 1995/96, the last time there wasa government shutdown, in just three weeks some25,000 visa applications went unprocessed, whichresulted in millions in losses for the airlines. Thus, fai-lure to raise the debt ceiling in a timely manner is likeplaying with fire and in the worst case, it could causethe US economy to slip into recession again.

Even if a compromise is reached by August 2, webelieve that it is unlikely that the related consolida-tion measures which are planned will be sufficientlylarge, in light of the current destructive atmosphere.It is more likely that an emergency solution will befound. The rating agencies have announced that theywill lower the USAs current AAA rating in that caseas well as in the case of raising the debt ceiling too

late. In mid-July, both Moodys and S&P assigned anegative outlook to the AAA rating and warned ofa possible downgrade to AA within the next threemonths, unless a credible plan is presented on how

What will happen if worst comesto worst

If the parties to the conflict are unable to reach anagreement on raising the debt ceiling by early Au-gust, starting from August 3 the US Treasury will onlybe able to spend as much as it receives from currentrevenues. The budget is thus automatically balanced.Nevertheless, a default in the traditional sense of theword, i.e. failure to service interest payments on out-standing government bonds, is highly unlikely. Thecurrent revenues of the Treasury are easily sufficientto pay the interest due and to cover various socialbenefits. But there is no automatic prioritisation ofpayments. This means that it is up to the Treasury todecide which obligations it wishes to settle.

Redemption of maturing bonds is not affected by thespending limits. Old debts can be rolled over at anytime, as they do not result in an increase in the level

of debt. Accordingly, as long as the USA can findenough investors (and one can assume that it will),default on payment is impossible. In any case, it isvery likely that there will be a so-called government

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the USA intends to avert further growth in the debtin the years ahead. According to S&P, such a con-solidation package would have to have a volume ofat least USD 4,000 bn over the next ten years, inorder for the AAA rating to still be justified. In lightof the current political environment in the USA andlooking at the results of negotiations so far, a resulton this order of magnitude appears highly unlikely.Consequently, US politics will probably fail to con-vince the rating agencies, even after an agreementis reached on raising the debt limit. Hence, a down-grade to AA is likely to come from at least one ofthe three major rating agencies in the weeks/monthsahead. Many market participants now take the sameview: a Reuters survey this week showed that 30 of53 economists polled were expecting a downgradeof the USAs credit rating.

What consequences would loss ofthe AAA rating have?

Naturally, failure to raise the debt ceiling in timeand in particular the loss of the AAA rating by theworlds largest economy would come as a painfulblow to the credibility and reputation of the USA.In theory, a lower risk rating should result in higherrisk premiums and thus higher financing costs for the

US government. In the worst case, this would meanthat US debt servicing was much more expensive;moreover, the higher interest burden could signifi-cantly dampen US economic activity. Accordingly,it is very probable that there would be some short-term turbulence on the financial markets. While theimpact on US government bonds is relatively neutral(their prices should actually fall, but this could becompensated by the concomitant rise in risk aver-sion and the ensuing declines on the equity markets,etc.), German government bonds should profit overthe short term as an alternative investment, with theUS dollar thus depreciating versus most other curren-

cies. There will not, however, be a massive sell-off ofUS government bonds. Even with an AA rating, USgovernments would still be the most risk-free securi-ties in the USA. If the US sovereign rating is loweredto AA, most of the other AAA-rated issuers in the USA(e.g. the state-affiliated mortgage banks Fannie Maeand Freddie Mac, and other issuers with close ties tothe government) would also be downgraded to AAat best.Accordingly, investors alternative options toreallocate capital into better USD securities withadequate liquidity and market depth are seriouslylimited, and this would strongly reduce the impact on

bond yields. Of course, there are certain portfolioswhich are only allowed to invest in AAA-rated securi-ties. But as long as all three of the major rating agen-cies do not lower the US credit rating and at least

one of the agencies leaves the AAA rating in place,it will be possible for most of this capital to remain in-vested in US government bonds. On the other hand,if all three agencies lower the rating, then this capitalwould have to seek alternative investment opportuni-ties and turbulence on the financial markets would beunavoidable. The experiences with the downgradeof Japans credit rating from AAA to AA, however,suggest that this turbulence would also be limited. Inthat case, there was neither any unnatural turmoil onthe market nor have yields on Japanese governmentbonds risen since then. In our opinion, the argumentthat in contrast to Japan the USA is a net importerof capital is not strong enough: because many non-resident buyers of US government bonds also havelimited alternatives to US government bonds, such asUS banks or insurers. First and foremost, this group

of investors includes foreign central banks, some ofwhich purchase massive amounts of US bonds andUS dollars, to keep their own currencies weak. Thesebuyers thus have no other option than to continueinvesting in US government bonds. Consequently,unless these countries, including China, dramaticallychange their exchange rate policy, their investmentin US government bonds will hardly be affected by adowngrade to AA.

We confirm our EUR/USD exchange rate forecastof 1.50 for September, as we expect further esca-

lation of the debt dispute over the short term and adowngrade of the US credit rating despite an even-tual agreement on raising the debt limit. Althougha brief downward correction in EUR/USD can beanticipated following an agreement on raising thedebt ceiling, interest rate developments will continueto diverge in favour of the Eurozone and this willsupport the euro.

We leave unchanged our Sell recommendation onUS government bonds; it is not so much the currentdebt and rating debate that is a factor here, butrather our expectation of an improvement in the US

labour market in the second half of 2011.

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This report was completed on 29 July 2011

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Special