How will the US deal with this? They basically have two options:
1. Cut spending (don’t bet on it)
2. Raise taxes (more likely but this is usually self-defeating as higher taxes tend to slow economic activity resulting in lower tax revenues)
Of course they can also start running the printing presses to inflate away the debt but that won’t help with debt ratings. Either way, foreign holders of US debt may begin dumping their holdings at some point and the US will be forced to buy up the debt (running the printing press) creating runaway inflation and ultimately hyperinflation. Many top Austrian economists feel that this is the most likely outcome if the US doesn’t make drastic cuts in spending. Several feel that the US is past the point of no return (listen to John Williams interview)
From Abrose Evans-Pritchard:
US must cut spending to save AAA rating, warns Fitch
Fitch Ratings has issued the starkest warning to date that the US will lose its AAA credit rating unless acts to bring the budget deficit under control, citing a spiral in debt service costs and dependence on foreign lenders.
By Ambrose Evans-Pritchard
Published: 5:30AM GMT 12 Jan 2010
Brian Coulton, the agency’s head of sovereign ratings, said the US is shielded for now by its pivotal role in global finance and the dollar’s status as the key reserve currency, but the picture is deteriorating fast enough to ring alarm bells.
“Difficult decisions will have to be made regarding spending and tax to underpin market confidence in the long-run sustainability of public finances. In the absence of measures to reduce the budget deficit over the next three to five years, government indebtedness will approach levels by the latter half of the decade that will bring pressure to bear on the US’s ‘AAA’ status”, he said.
Fitch expects the combined state and federal debt to reach 94pc of GDP next year, up from 57pc at the end of 2007. Federal interest costs will reach 13pc of revenues, meaning that an eighth of all taxes will go to service debt. Most fiscal experts view this level as dangerously close to the point of no return for debt dynamics.
The rating alert is a reminder that fiscal stimulus and bank rescues across the world have merely shifted private debt on to public shoulders. The bail-outs looked deceptively ‘costless’ at the time, but the damage to sovereign states may take years to repair. The US Treasury says interest payments as a share of GDP will rise to 3.6pc by 2016, the highest since data began in 1940 – when it was 0.8pc.
Mr Coulton said the US is vulnerable to “potential interest rate shocks” due to its reliance on short-term debt and foreign investors. The average maturity of US government debt has fallen to four years, compared to seven for Europe’s AAA club, and 10 for Britain. “The share of three-month bills has risen very sharply as a result of recapitalising banks,” he said.
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