Would a Default by the US Government Help America?

Question for the Day

“Would a default on Treasuries accomplish what the Balanced Budget Amendment was supposed to achieve, by forcing the government to spend no more than it takes in?  With more collateral damage, of course. . . .” — Glenn Reynolds (The Instapundit, Law Professor at U of Tennessee), source.

Contents

  1. The short answer
  2. Default comes in many forms
  3. Focus on the favorites:  inflation and devaluation
  4. Two examples of successful default
  5. Conclusion
  6. Other articles about this topic
  7. Reactions to Reynold’s question
  8. For more information on the FM website, and an Afterword

(1)  The short answer

A default on a loan occurs when the borrower does not make required payments or in some other way does not comply with the terms of a loan.  The hysterical answers to Reynolds are wrong, since default is a commonplace of history (sometimes successful, sometimes not).  It’s a perfectly legitimate question, the type a skilled lawyer asks his client.  We will need to make difficult choices to get America back on track, and clear evaluation of all options is essential.  Here is the short answer, in pieces.

  1. Yes, the budget would be balanced since there would be no more borrowing until the US re-established its credit.  But default does not fix the underlying problems causing the borrowing, which is why so many people and nations become serial defaulters.  Philip II the Spain defaulted several times, despite Spain’s riches stolen from the western hemisphere.  Today we have Greece and Costa Rica.
  2. Nations seldom default solely due to large debts. since debts can usually be managed.  To rephrase Milton Friedman, default (and its handmaiden, hyperinflation) are everywhere and always a fiscal phenomenon.  Nations default when they are running massive deficits and can no longer borrow.
  3. The costs of default cannot be reliably forecast, but would probably range from massive to catastrophic.  Government bonds are the foundation assets for domestic financial institutions.  Such as banks, insurance companies, and pension plans.  A default solves one problem and creates a thousand more.  Which is why nations default only as a last resort. 
  4. Why default when the government can just print money (aka monetize the deficit)?  Inflation probably has fewer side-effects than default, and we have much experience with inflation.
  5. Default on treasuries would eliminate our debt, now $7.9 trillion (from past spending).  The government’s liabilities (debt plus promises to spend) are far larger, in excess of $70 trillion.  See here for details.
  6. Emerging nations have different economic dynamics than developed ones.  Situations differ even among developed nations.  The calculus of default differs greatly in Greece and the USA.  This considers only America.
  7. This is a brief sketch of a complex subject.  See the links at the end for more information.

While this answer’s Reynold’s precisely worded question, it does not answer broader question posed in the title.  I briefly discuss this in the conclusion, but a full analysis requires several thousand more words.  So it must await another day.

(2)  Default comes in many forms

Governments default on their debt so frequently that have developed a thousand ways to do so, beyond just refusing to pay.  Just like in the song…

A Thousand Ways to Say Goodbye, by Jubal Lee Young

Where did the passion go I lie and wonder Whispering rain, spinning blades, listening to the sound of thunder Lightning struck here once, will it ever strike twice? This raging fire has turned into sculpted ice It’s all over but the crying now…

Au revoir, hasta la vista Sayonara, baby There’s a thousand ways to say goodbye Adios, arrivederci Do svidanja , baby There’s a thousand ways to say goodbye Goodbye

Where did we go wrong? I’m so tired of trying I remember a time when we were so high we were flying It’s just a matter of time as to how long we’ll hold on to what is gone There ain’t no need to fight, I don’t have to be right and baby you got the right to be wrong It’s all over but the crying now…

Yeah we might have stopped then and we’d still be friends But we held on til the bitter end Now a thousand “I’m sorries” will never be enough I guess that’s why they call it love

They’re called soft defaults.  Such as the following:

  1. Temporarily suspend or change the terms of payments (e.g., US and UK de facto suspended payments in gold during WWI)
  2. Renegotiating the terms (often combined with threats to take stronger action), extending the maturity at lower interest rates
  3. Changing the mode of repayment:  from gold to currency, or a foreign (hard) currency to ones own currency. 
  4. Inflation and devaluation (Siamese twins of default) — Pay back the full amount in nominal terms, but less in real terms.
  5. Shifting the debt onto special entities, who can later default with lesser consequences

Most nations have used one or more of these techniques. Most nations used option #3 during the 1930’s — after which their economies stabilized (see Bernanke’s speech about this).  The US did so on 3 June 1933 with the wonderfully titled congressional resolution “To assure uniform value to the coins and currencies of the United States” (text here).  America did so again in 1971, when President Nixon ended convertibility of the US dollar into gold by governments (see Wikipedia).  Inflation and devaluation are commonplace tools of economic management throughout history.

(3)  Focus on the favorites:  inflation and devaluation

With the perfection of fiat currencies in the 19th century (after the early trials with the American continental and the French assignat), inflation and devaluation became the favored methods of default.  They offer the illusion of a smooth, controlled, and even painless reduction in government’s debt. 

There are many studies discussing this, but this is perhaps the most interesting:   ”Is Inflation Effective for Liquidating Short-Term Nominal Debt?“, Guillermo A. Calvo, IMF, 3 January 1989 (Hat tip to Zero Hedge).  From a major quasi-governmental institution, it comes close to recommending a soft-default by inflation (and devaluation) for hard-pressed governments.  Classified secret when written, to avoid alarming government creditors.  Abstract:

The possibility of reducing the real value of domestic non-indexed government debt through inflation is studied. A central result is that this kind of debt liquidation is possible even though prices are sticky and government bonds are short term. A policy implication is that short bond maturities are no safeguard against surprise devaluations intended to lower the burden of the debt. If devaluation incentives are present, it is further argued that nominal non-indexed bonds could give rise to situations where devaluations are a consequence of self-fulfilling expectations cycles.

Other experts say that however attractive in theory, in practice inflation does not reduce government debt.  See this clear explanation:  “The debt-inflation myth debunked“, blog of the Financial Times, 4 August 2009.

The problem with the idea of governments inflating their way out of a debt burden is that it does not work. Absent episodes of hyper-inflation, it is a strategy that has never worked. Government debt: GDP burdens tend to be positively correlated with inflation. Market mythology has created the idea that inflation will help reduce government debt ratios. The facts do not support the myth. OECD government debt rises as inflation rises. Meaningful reductions in government debt will require a low inflation future.

In brief, unexpected inflation provides the magic sauce for profligate governments.  But the government’s creditors see the situation equally clearly and take protective action. 

  • Shorten maturities (which are less affected by inflation)
  • Shift investment preferences from government bonds to inflation-protected bonds (e.g., TIPS) and hard assets.
  • Move money into harder currencies, even physically out of the country.

Consider America’s situation in 2 years (to pick an arbitrary number, when we’re well into the recovery).  Everybody (including elderly widows in Smallville) will own just only hard assets, inflation protected securities, or short-term debt.  The average maturity of the Federal debt will be 2 weeks. Under these circumstances the government must avoid inflation at any cost, as the resulting increase in its interest cost would be lethal.  Japan is in a similar situation today.

Note that these actions by themselves push up interest rates, worsening the government’s financial position. 

(4)  Two examples of successful default

The Soviet Union, following the revolution.  German’s Third Reich.  The latter is most relevant.  For details see  ”Currency vs. Banking in the German Debt Crisis of 1931“, Albrecht Ritschl and Samad Sarferaz, 8 August 2006.  Note that both were totalitarian states, which allowed the government to control inflation through wage and price controls.  And suppress protests.  Both were economic success stories, if horrific from a broader perspective.

(5)  Conclusion

There are no easy or certain solutions.  We have to work our problems carefully,  in the correct sequence, aware of trade-offs.   I believe a default — in any form — is not necessary at this time.  Nor will it be if we act quickly and wisely.  The costs of default would be large and avoidable if feasible.

The chief problem we face today is a weak economy, and the risk of a double-dip recession (historically quite common).  In the third year of this recession the reserves at all levels are drained — households, businesses, and governments.  We are weak, as was the world in a physical sense after WWI – vulnerable to the 1918  influenza.   Another downturn might be worse than the first.   Should the economy weaken from here, failure to promptly enact another stimulus program might have cataclysmic — even historic — consequences.

(6)  Other articles on this topic

Articles with vital lessons for us:

Other valuable articles on this subject:

  1. Even superpowers default:  “The Sustainable Debts of Philip II: A Reconstruction of Spain’s Fiscal Position“, 1560-1598″, Mauricio Drelichman and Hans-Joachim Voth, 6 November 2007
  2. One of the best studies about governments getting in over their heads and the inevitable consequences that follow:  “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises“, Carmen M. Reinhart and Kenneth S. Rogoff, April 2008
  3. Will America default?“, blog of The Economist, 12 February 2009
  4. Why Default on U.S. Treasuries is Likely“, Jeffrey Rogers Hummel (Assoc Prof Economics at San Jose State U), Library of Economics and Liberty, 3 August 2009

(7)  Reactions to Reynold’s question (to be updated with new developments)

Mostly hysterical.  Esp given that governments (including ours) have defaulted so often, in so many ways.

Reynold’s reply to Bartlett is either over-the-top exaggeration or batshit crazy (typical of extremists, he says this with no attempt to explain or support it — as if the USA being like Zimbabwe is self-evident):

“Bruce, I’m not trying to turn the United States into Zimbabwe. That would be the guy in the White House, whom you seem surprisingly anxious to defend.”

That is an odd thing to say, since Obama’s economic and foreign policies largely continue those of Bush Jr.  And about Zimbabwe’s inflation, the 2nd largest in record (from “On the Measurement of Zimbabwe’s Hyperinflation“, Steve H. Hanke and Alex K. F. Kwok, Cato Journal, Sping/Summer 2009):

 20090601-cato-journal1.jpg?w=619&h=229

Anyone making that comparison needs to read this:  Where to go to learn about economics, and help you understand what’s happening to America and the world.


Originally published at Fabius Maximus and reproduced here with the author’s permission.