Which of the "Rich Four" Countries Will Default First?

Volume in the credit default swap market for rich countries has soared and so have credit spreads, according to a recent Financial Times story, while volume in emerging markets CDS has stagnated. In other words, traders are betting against the governments with high budget deficits, like Britain and the United States, as well as against those with high debt levels, like Japan and Italy.

So is there really a substantial chance of a big rich-country default, and what would it look like if it happened?

It's not obvious which of the "Rich Four" countries would go first.

Japan, for instance, has the highest debt. But Japanese consumers are such great savers that they essentially owe almost all of the debt to themselves.

The country needs fiscal discipline and higher interest rates (to reward Japanese savers properly), but there's a decent chance Japan will get both, in which case default is unlikely.

Italy has high debt - at about 120% of gross domestic product (GDP) - and not much discipline of any kind. On the other hand, Italy has the best budget position of the four rich countries, with a 2009 deficit forecast at only 5.3% of GDP, according to the Economist.

Italian Prime Minister Silvio Berlusconi is something of a rogue. But unlike his counterparts in Japan, the United States and Great Britain, Berlusconi avoided the tendency for wasteful "stimulus" public spending when the recession was at its worst. Consequently, for as long as he's in power, Italy is unlikely to default.

Unfortunately, Berlusconi is 73, and his opponents on the "center-left" are far less responsible. That means they are prone to all kinds of economically damaging policies. So Italy isn't out of the woods.

Britain is in probably the worst shape of the Rich Four. It has the highest budget deficit - at an astounding 14.5% of GDP in 2009 - and very little chance of improvement.

Opposition leader David Cameron has pledged to bring that deficit down, but he's no Margaret Thatcher, to put it bluntly. And it would probably take another Thatcher - or perhaps even an Attila the Hun - to chop away at Britain's overgrown public sector, infested as it is with extra costs from the European Union.

Britain also has the problem that its primary industry - financial services - is currently the global economy's Public Enemy Number One, and therefore seems unlikely to provide the tax revenue or support for London house prices that nation has come to expect. Yes, there are lots of other things Brits can do, but their wage costs will have to come down a long way before they can make money doing them. Meanwhile, default is quite likely, though it's probably eight years to 10 years in the future, since debt is still well below the levels currently borne by Japan or Italy.

Then there's the United States. The U.S. deficit for calendar year 2009 is projected to be 11.9% of GDP. But it looks likely that the U.S. deficit will be even slightly larger in 2010. In addition, the healthcare bill wending its way through Congress is likely to add nearly $200 billion a year to the deficit - starting in 2014 - when its full provisions kick in.

(The official cost is less, because Congress has timed it to include 10 years of income, but only six of expenses.)

On the other hand, U.S. debt should still be only around 100% of GDP even in 2020, which is generally bearable. Thus, if there's to be a U.S. default, it will be after that date - and probably not until the late 2020s, when the baby boomers are retired but still getting sick, receiving social security and generally chewing up resources.

After careful review, it appears that we're reasonably safe from a near-term default. On the other hand, however, the odds of an eventual default by one of these four indebted countries is pretty high.

That isn't good news, even if the defaulting country is not the United States. Bond markets have large exposures to all four countries, and each of them has a large number of multinationals. That means risk premiums worldwide will rise for practically everybody. That, in turn, will make debt financing very difficult to obtain and will probably induce the stock markets to crash again.

In short, investors and consumers worldwide are most likely looking at yet another recession, though this new one that we're warning about isn't likely to come our way for some time.

If the United States were to default, the outlook would be a grim one for those of us who live here. If the country defaults on its debt, it won't be able to pay Social Security or Medicare - at a time when the programs are already in deficit mode, paying out more in benefits than they re taking in.

Hence, either payments to the baby boomers will stop with a sharp jolt, or - alternately (since baby boomers vote) - the U.S. Federal Reserve will be forced to print money in order to make Social Security and Medicare payments. That will result in very nasty inflation. And the country won't dodge a recession either, since U.S. companies will find it difficult to raise money, the same problem U.S. firms had this year.

Better hope for fiscal discipline to break out worldwide. But I wouldn't bet the ranch on it.

[Editor's Note: Martin Hutchinson has terrific foresight. He warned investors about the dangers of credit-default swaps - half a year before those deadly derivatives ignited the worldwide financial firestorm. Hutchinson even predicted where and when the U.S. stock market would bottom (a feat that won him substantial public recognition).

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