The US averted a potential debt default by increasing the debt ceiling before a deadline on 18 October, 2013. US government runs a debt of $16.75 trillion that is around 76% of the size of the US economy. The days leading up to the debt ceiling deadline was lined with dire predictions of what would happen if the US were to default on its debt. It does not take much analysis to figure out that a country running a debt of $16.75 trillion and defaulting on principal and interest payments on the debt would tantamount to collapse of the entire world economy. The US Dollar would collapse, foreign countries that hold 48% of US government debt would have to write down the value of holdings and world trade that is largely denominated in USD would come to a standstill.
The raising of the debt ceiling does not in any way take away the fact that the US is running a large debt. As one trader on CNN put it "US ran out of money $17 trillion ago".
US has already spent the money and nothing can be done about that. Can the US bring down the debt? Maybe but that would require years of budget surpluses and given rising costs of healthcare and other public services, it would be difficult for the debt to be brought down to meaningful levels even over a fifteen-year period.
The real question is how does this debt affects everyday lives of people in the US and around the world? Should businesses stop investing on worries of debt default by the US? Should companies in India stop doing outsourcing work for US companies? Should governments stop investing in US debt? The answer is an obvious no and it is an obvious no because the ugly head of government debt may not raise its head in the near or even the far future. Yes, there is always the risk of the US not being able to pay its creditors but can one really position for that risk?
Similarly countries such as Japan and UK run debt levels of $10.5 trillion and $1.1 trillion respectively, which is around 210% of GDP and 75% of GDP. India too runs a debt of $95 billion, around 66% of GDP. Would all these countries default on their debt? When would they default? Should one avoid these countries all together?
Everyday lives have to continue despite governments running high debt as unless there is a real, near term risk of default due to lack of money to pay creditors, the risk may only be on paper. The paper risk may exist for a long period of time, maybe for generations. Hence, selling all assets and buying gold or some other so called safe haven asset may never work in this generation or even the next.
Markets play their part efficiently in punishing erring countries. The sharp rise in sovereign bond yields of the PIIGS (Portugal. Ireland, Italy, Greece and Spain) countries is a grim reminder of risks of holding bonds of indebted nations. India too has faced the markets wrath when bond yields rose 400bps from lows on the back of the fiscal stimulus provided by the government post the credit crisis in 2008-09. Hence it is best to take the markets lead in worrying about government debt levels.
It is also important to remember that markets become overly optimistic and overly pessimistic. At times of over optimism or over pessimism, it makes sense to judge whether markets are being efficient in factoring risk levels of government debt. If one senses that markets are being inefficient, it is best to go against markets.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.
Updated Date: Dec 21, 2014 00:47 AM