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Analysis/Comment Last Updated: Jan 28, 2011 - 6:11 AM

Dr. Peter Morici: US debt should be downgraded to below Japan's: Japan sound, US insolvent
By Professor Peter Morici
Jan 28, 2011 - 5:49 AM

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President Barack Obama delivers his State of the Union address in the House Chamber at the US Capitol in Washington DC, Jan. 25, 2011.

Dr. Peter Morici: S&P has downgraded Japan’s long-term debt from AA to AA-, indicating the US AAA rating should be taken down several notches to less than AA-.

National economies must generate foreign currency for their governments to pay foreign creditors, and national governments must be able to tax, sell bonds or print money, without causing inflation, to cover operating expenses and pay interest.

Japan’s ability to pay is simply much stronger than the United States.

Japan has a strong current account surplus - - thanks to a powerful manufacturing export machine - - and the Bank of Japan sits on $1trn in foreign currency reserves. It has more than enough cash flow and adequate reserves to service the claims of foreign creditors. The United States can hardly make such a claim.

Domestically, Japan does suffer from deflation, slow growth and maintains a large budget deficit to prop up domestic demand, because Japanese citizens save so much. With prices falling, even in the face of global commodity inflation, the Japanese government has adequate latitude to sell bonds to its savers, and the BoJ has more than enough flexibility to purchase those bonds as needed - - monetarize debt - - without instigating domestic inflation or creating other adverse macroeconomic consequences.

The United States is a wholly different situation. The US has a gapping current account deficit - - on oil and with China - - and policies pursued by the Bush and Obama Administrations are worsening those conditions. Owing to the large current account deficit, the United States must run a huge budget deficit, close to 10% of GDP, just to sustain growth at 3.5% and keep unemployment from flying out of control.

The large US current account deficit indicates the US economy as a whole is not generating adequate revenues to pay foreign creditors interest due on US debt, and Washington must service the interest on externally held debt by printing more bonds and selling those abroad, but foreign private demand for those bonds is satiated. Consequently, the United States is much too dependent on the government of China to print yuan to buy dollars, and in turn, to use those dollars to buy Treasuries to finance the US private economy’s current account deficit and the federal budget deficit.

Beijing plays along because the resulting weak yuan and trade surplus with the United States helps deal with Chinese unemployment, but printing so many yuan requires Beijing to sterilize those extra yuan by persuading Chinese investors to purchase too many yuan-denominated government bonds - - bonds the private sector does not want. The result is domestic inflation and global commodity inflation, as the Chinese private sector chases oil, commodities and food with too much liquidity.

Sterilization has not been wholly successful, and inflation domestically and globally is resulting from printing presses in overdrive at the Peoples Bank of China and the Federal Reserve. This is evidenced most vividly by rising energy and food prices globally in most countries

The government in China is like a big man sitting on the lid of a boiling pot. It is trying to regulate domestic fuel, commodity and food prices, but sooner or later all the pressure inside the pot will thrust the man off and the boiling water will scald him and all those standing close to him - - including Uncle Sam.

Energy, commodity and food inflation will soon push up US inflation and constrain Washington’s ability to sustain even modest growth. Treasury borrowing rates will rise the second half of 2011, pushing up the federal deficit, and inflation will limit the Federal Reserve’s ability to monetize government debt through quantitative easing.

The dollar may be the reserve currency, but the global economy cannot absorb enough US bonds and dollars with a US federal deficit exceeding $1.5trn or 2.5% of global GDP. No one wants that much cash, and China can print and sterilize only so many yuan to buy US debt without setting off a Weimar Republic inflation in the Middle Kingdom.

Even though the US dollar is the reserve currency, Washington faces limits in how many bonds and dollars it can print without wrecking havoc. It is now over the limit.

The US government must soon dramatically cut its deficit, and correct the problems that require such a large federal deficit - - huge trade deficits on oil and with China, and chronically low household savings - - or face financial Armageddon.

Japan is sound, but the United States is teetering on insolvency.

SEE also Finfacts article: Return to normal growth in Ireland may take up to 10 years says IMF chief; Japan and US warned on debt challenges

The worry for Japan and the U.S. is not their risk of default, says Andrew Freris, senior investment strategist, Asia at BNP Paribas Wealth Management. He is more concerned that their interest rates will spike rapidly, and explains why, to CNBC's Martin Soong, Karen Tso and Sri Jegarajah:

"I think you're seeing it across the Republicans and Democrats, a realization that our tax system is broken, it was designed when America used to have all the key businesses," John Chambers, CEO of Cisco Systems told CNBC in Davos:

Peter Morici,

Professor, Robert H. Smith School of Business, University of Maryland,

College Park, MD 20742-1815,

703 549 4338 Phone

703 618 4338 Cell Phone




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