The journey to insolvency can be quick, or it can be slow, but most analysts agree that the first signpost along the way will be the withdrawal of the U.S.’s coveted Aaa bond rating. And when that happens, woe be unto him that owns government bonds.

By Kevin A. Hassett National Review via American Enterprise Institute

Sometimes the best argument in favor of buying one type of asset is a damning analysis of another. There are lots of places to invest one’s money, and U.S. government bonds are beginning to look terrible.

With the U.S. government deficit hovering around a trillion and a half dollars, our nation’s creditworthiness is coming under increased scrutiny. The Congressional Budget Office issues budget outlooks that get grimmer and grimmer, and even those bleak projections are the result of implausibly rosy assumptions.

The journey to insolvency can be quick, or it can be slow, but most analysts agree that the first signpost along the way will be the withdrawal of the U.S.’s coveted Aaa bond rating. And when that happens, woe be unto him that owns government bonds.

Throughout modern history, the U.S. has had a relatively low cost of funds because Moody’s and the other ratings agencies have given it the highest rating possible. If Uncle Sam loses that rating, then borrowing costs will increase. These higher costs will make the U.S. fiscal situation more untenable, inviting subsequent downgrades and an ultimate death spiral that can be stopped only by massive policy intervention.

Thomas Friedman accurately characterized the impact of ratings in 1996, when he said, “There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.”

When bombers show up on radar, it’s time to head for the shelters. What should bond investors look at? No one can know for sure, but there is a fairly regular and predictable relationship between a nation’s total level of indebtedness and its bond rating. As debt goes up, ratings go down.

The question then becomes, how high must U.S. debt climb in order to make a downgrade inevitable? The accompanying chart provides the sobering answer. It plots two different measures of national debt for large industrialized countries in the year that these countries lost their Aaa status. For comparison, it provides the same number for the U.S. in 2010, and for the U.S. at the end of the current ten-year budget window.

Canada, for example, was downgraded in 1994. At the time, its net debt, that is, debt held by the public, was 68 percent of GDP. Its gross debt, which includes debt that the government owes itself in trust funds and the like, was just shy of 100 percent of GDP.

The U.S. in 2010 looked very similar to Canada of 1994, suggesting that a downgrade is possible. By 2020, the U.S. will have a net debt as a share of GDP that is above even the high levels experienced by Japan just prior to its downgrade.

Every other country in this chart that has reached levels as high as the CBO projects has seen a downgrade, and the U.S. will too.

Kevin A. Hassett is a senior fellow and director of economic policy studies at AEI.

Photo Credit: iStockphoto/JOE CICAK

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