24/7 Wall St.

Part of the financial game that the US and China have played for more than a decade is that America imports tremendous amounts of Chinese goods and China buys US debt. That keeps the Treasury operating as it prints money to keep up with the federal deficit.

The game has become more important, especially for the US. as China’s exports have gone to hell.

The Congressional Budget Office now estimates that the fiscal 2009 deficit will be $1.2 trillion. Adding the new government stimulus package on the back of that and the total gets closer to $2 billion.Since a deep recession is likely to undermine tax revenue and increase the need for social services, the figure could get larger in 2010.

The Treasury is going to have to run daily debt auctions to keep up.

According to The New York Times. "China has bought more than $1 trillion of American debt, but as the global downturn has intensified, Beijing is starting to keep more of its money at home" The paper says that the action will be painful for US, but it is actually much worse that that.

The easy part of the calculation is that falling demand for Treasuries will drive up the interest rates the government will have to pay to attract buyers. But, what if there are few buyers at all, even if yields rise?

The US government faces the very real prospect that an extremely deep recession will drive most buyers of debt out of the market completely. Some of those are sovereign banks and funds, and some are huge institutions looking for safe places to put cash. As the value of institutional holdings drop due to redemptions and a falling market, the entire pool of capital for Treasuries begins to dry up.

Is the amount of interest the Treasury can pay on its paper limited? In theory, yes. At some point the yield being offered begins to severely undermine the value of the principle that the auctions bring in. The chance that the Treasury may have to defer some interest payments on Treasuries becomes very real,

The elephant in the room is whether the US would even default on a portion of its debt. The idea is nearly unimaginable. But, if the economy moves close to a depression, the government will have to make the awful decision of what is in its best interests. Default may drive investors out of Treasuries at astonishing rates. The failure to default may almost completely undercut the ability of the US to fund its own budget obligations.

What was once viewed as impossible has simply become improbable.

Douglas A. McIntyre