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Deficits may soon run the U.S. smack into several debt walls

Scott S. Powell is a visiting fellow at Stanford University's Hoover Institution, a partner at RemingtonRand, and a former debt portfolio manager

Scott S. Powell

is a visiting fellow at Stanford University's Hoover Institution, a partner at RemingtonRand, and a former debt portfolio manager

Nobody wants to say it, but a major reason corporations are not creating many jobs and expanding in the United States is the increasing systemic risk being created by Washington.

The United States is supposedly in economic recovery, yet President Obama projects a record $1.6 trillion deficit for 2011 - with years more trillion-dollar annual deficits and escalating debt ahead. Government debt is growing by $120 billion a month, three times faster than the $40 billion monthly increase in GDP. What is going on?

The real issue is not the U.S. government's debt ceiling to accommodate ongoing deficit spending, but rather the wall that we are about to hit: foreign governments balking at financing U.S. debt except at significantly higher yields to offset the inflationary impact of the dollar's declining value.

Recently, officials from China, Brazil, and other countries blamed high food and raw-materials prices on Washington - charging it with exporting inflation by degrading its currency through quantitative easing. No surprise here, as most commodities are traded in dollars. The Wall Street Journal notes that some economists blame dollar weakness induced by Fed policy for contributing as much as 50 percent of the price inflation in commodities such as corn, sugar, wheat, coffee, cotton, rubber, the metals, and oil.

This year Charles Plosser, the president of Philadelphia's Federal Reserve Bank, has a vote on Ben Bernanke's Federal Open Market Committee. In a recent interview, Plosser revealed he opposes his boss' policy of quantitative easing, saying that "the costs outweighed the benefits" and that price stability has "got to be job one" at the Fed. There is, however, another issue for the Fed to worry about.

Another looming debt wall is the one from declining credit quality. An unsettling report, "Evolution of Moody's Perspective on the U.S. Aaa Rating," received little attention when released Jan. 27 in the midst of upheaval in the Middle East. But, coming on the heels of a similar warning from Standard & Poor's, it has serious implications.

Moody's states that "recent trends in and the outlook for government financial metrics in particular indicate that the level of risk, while still small, is rising and likely to continue to rise in the next several years." It continues, "The time frame . . . appears to be shortening, and the probability of assigning a negative outlook in the coming two years is rising."

Moody's infers that accelerating government spending since the financial crisis of 2008-09 is the reason for shortening the time horizon for the negative credit watch revision. That debt is growing more than four times faster than revenue in the United States should be alarming by itself.

But the Moody's report goes further, comparing the United States to other triple-A rated countries. It turns out that the United States is the outlier, with three times more growth in debt to revenue than the triple-A median, and more than twice that of Germany, France, the United Kingdom, and Canada, all of which have undertaken austerity measures. In addition, the combined federal and state debt in the United States is approaching the tipping point of 100 percent of GDP - considerably worse than any of the Triple-A-rated European countries.

The U.S. government has enjoyed unlimited access to financing because of its role in having the reserve currency and being the safe haven in global financial markets. Thus, the U.S. Treasury bond has been the risk-free benchmark. But if the credit-rating outlook on U.S. sovereign debt turns negative, the dollar will risk losing its status as the world's reserve currency because its associated government debt could no longer be considered risk free. Demand for dollars would decline precipitously and cause further devaluation.

The important take-away here is the imperative of reducing systemic risk by tying the debt ceiling to deficit reduction. Longer term, the debt ceiling should be capped at a percentage of GDP.

Without telegraphing the will to radically cut spending, the United States will hit a Greek wall of deficit finance and liquidity problems. If that becomes headline news it is already too late. History reminds us that such crises happen faster than most anticipate and almost always before the ratings agencies take action.