Could the American government default?

By Buttonwood

WHILE Greece continues to inch its way towards a deal with its EU partners, the creditors of a much-larger debtor, the US government, appear to be untroubled. Ten-year Treasury bonds still yield just 2%. But the issue of how the US addresses its long-term fiscal problems is, as yet, unresolved. A series of papers from the Mercatus Centre at George Mason University in Washington DC, called “Tipping Point Scenarios and Crash Dynamics” attempts to address the issue. The academics seem to agree that the long-term position is unsustainable – that not all of the promises made by the government will be met. But in terms of the actual outcome, you pays your money and takes your choice.

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. Foreign creditors may only be willing to lend to the US in renminbi, rather than dollars. Such a crisis will finally push Washington into putting its finances in order.

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.

Bondholders, concerned about principal, not principle, will see the GOP as the key political barrier to repayment.

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.

The external guidelines would give both (parties) political cover to vote for compromises that would otherwise anger their bases.

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.

If Ricardian equivalence holds even approximately, then the decline in the value of Treasuries should be mostly offset by an eventual rise in the total value of both privately issued assets, such as shares of stock and corporate bonds, and expected future wage income.

I am not so sure about this. If the US government defaults, most US borrowers will surely face higher borrowing costs especially as the banks are relying on an explicit and implicit guarantee from the government on their liabilities. Mr Hummel refers to the relatively short-lived effects of widespread defaults in the 1840s (after a canal-building boom). While I am all in favour of learning from history, the financial system was rather less sophisticated (and less leveraged) at that point.

But Mr Hummel doesn't stop there. The 1840s defaults were followed by greater fiscal discipline at the state level. Default would also be a good thing, he argues since government would be forced to renege on its social security and Medicare promises.

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.

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.