Could the U.S. Government Default? It Defaults Everyday!

LvMIC:

A few days ago, The Economist asks the big question on whether or not the U.S. government will eventually default on its debt.  In highlighting a series of papers out of the Mercatus Center at George Mason University, the popular magazine lists some opinions from economists who agree that the long term spending prospect for the U.S. is bleak but can be controlled.

Peter Wallison takes the (fairly widespread) view that a government with debt denominated in its own currency and with access to the printing press will not default on its debt. But he can still envisage a crisis in which repeated failure by politicians to tackle the debt burden means that investors eventually conclude that the debt will be inflated away. This will lead to a weaker dollar, higher prices for commodities and other real assets and a wage-price spiral.

This is the most plausible outcome of a system built upon theft and cronyism, aka the state.  Politicians act as drunks addicted to the slosh of pork barrel spending.  Though the political class scores electoral points by decrying pork spending, the truth is, to paraphrase Lew Rockwell, the entirety of the government’s budget is pork barrel spending.  Down to the very last penny.  Wallison’s view is similar to the Modern Monetary Theory school which holds that sovereign nations with their own printing press can never go bankrupt.  Sure a loaf of bread may cost $300 but as long as troops remain scattered across the globe and the Social Security checks keep being mailed, then the illusion of solvency can be maintained.  But going bankrupt or defaulting are not one in the same as I will get to soon.

Garett Jones thinks that neither outright default nor inflation is likely, in paper because the markets would see such an outcome coming and push interest rates up to prohibitive levels. Furthermore, Americans will be able to see the messy state of Europe and will resolve to avoid the same outcome. Thus a massive deficit-cutting deal will be achieved although Mr Jones thinks this is more likely under the Democrats than the Republicans, because of the latter’s anti-tax philosophy.

Lenders can ditch dollars all they want, the Fed will be there to resupply so it’s kind of hard to see interest rates ever reaching a point to force Congress into action less done purposefully like Volcker’s term as Chairman.  Jones acts like Congressmen ever do the right thing which is the equivalent of believing in Santa Claus.  Tax increases are unfortunately likely but I have a bridge to sell him if he thinks the increased revenue will be used to pay down the national debt.

In contrast, Arnold Kling argues that neither Democrats nor Republicans will be willing to compromise because of the effect on their electoral prospects. However, a negotiated default would bring in the IMF to broker a deal, which would inevitably involve both tax rises and spending cuts.

I have a lot of respect for Arnold Kling but seeing as how the United States provides a large amount of funding for the IMF and the dollar is still the reserve currency of the world, it would be very peculiar to see the U.S. being bailed out by the international community.  If the U.S. were to undergo a fiscal crisis, the potential issues posed to the global economy may override any effort by the IMF to shore up America’s finances.  One good outcome of IMF blackmailing (which is what it amounts to) could be the possibility of Congress cutting all funding from the institution; thus posing a serious blow to the banker class which uses it as mechanism to leverage bailouts in its favor.

Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a)federal tax revenue will never consistently rise much above 20% of GDP, b)politicians have little incentive to come up with the requisite expenditure cuts in time and c)monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that

The long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.

Why does he take this view? Once allows for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.

Hummel nails it.  Default is ultimately in the best interest of the U.S. as it punishes creditors stupid enough to lend to the government in the first place.  An outright default would make borrowing costs much higher in the future absent further Fed intervention which would in turn place a limit on future deficit spending.  It would also serve as a much needed wake up call to those who still believe the entitlement programs will be there to pay for the good life come retirement.  As Hummel mentions:

Reliance upon these government promises constitutes a particularly egregious form of fiscal illusion….The best way to alleviate future suffering is to repeatedly and emphatically warn the American people that these programs will go under. The more accurately people anticipate this inevitable outcome, the better prepared they will be.

When current Presidential candidates speak on “saving Social Security” or “preserving Medicare,” they are doing a disservice to anyone who listens to them.  The future unfunded liabilities of the U.S. government amount to over $100 trillion.  There is no possible way to pay for them in full.

So there are your choices. Default on the debt in real terms via inflation, default in nominal terms or break the promises made to future benefit recipients. Not an appealing menu but an indication of the likely political battles over the next 10-20 years.

The truth is the U.S. government defaults everyday the Federal Reserve prints a new sheet of crisp dollar bills.  When creditors are being paid back a principle nominally but worth less in real terms, that constitutes default.  Social Security checks can stay the same amount nominally but will purchase less and less.  Eventually the medical industry will likely be nationalized completely as to ensure medical care is given while quality inevitably declines.  So yes, the U.S. will default ultimately by continuing to monetize its debt.  The grand promises of utopia made by politicians will never be fulfilled.  The sooner the overall public and private creditors realize this, the better.