Thursday, August 27, 2009
treasury default in the cards?
It is not literally impossible that the Federal Reserve could unleash the Zimbabwe option and repudiate the national debt indirectly through hyperinflation, rather than have the Treasury repudiate it directly. But my guess is that, faced with the alternatives of seeing both the dollar and the debt become worthless or defaulting on the debt while saving the dollar, the U.S. government will choose the latter. Treasury securities are second-order claims to central-bank-issued dollars. Although both may be ultimately backed by the power of taxation, that in no way prevents government from discriminating between the priority of the claims. After the American Revolution, the United States repudiated its paper money and yet successfully honored its debt (in gold). It is true that fiat money, as opposed to a gold standard, makes it harder to separate the fate of a government's money from that of its debt. But Russia in 1998 is just one recent example of a government choosing partial debt repudiation over a complete collapse of its fiat currency.
... [U]nconvinced that the Treasury will default? The Zimbabwe option illustrates that other potential outcomes, however unlikely, are equally unprecedented and dramatic. We cannot utterly rule out, for instance, the possibility that the U.S. Congress might repudiate a major portion of promised benefits rather than its debt. If it simply abolished Medicare outright, the unfunded liability of Social Security would become tractable. Indeed, one of the current arguments for the adoption of nationalized health care is that it can reduce Medicare costs. But this argument is based on looking at other welfare States such as Great Britain, where government-provided health care was rationed from the outset rather than subsidized with Medicare. Rationing can indeed drive down health-care costs, but after more than forty years of subsidized health care in the United States, how likely is it that the public will put up with severe rationing or that the politicians will attempt to impose it? And don't kid yourself; the rationing will have to be quite severe to stave off a future fiscal crisis.
it's thought impossible, but it pays to remember rogoff and reinhart as they observed that better than 50% of world governments typically end up in some manner of default during depressions such as this -- a far more common occurrence than hyperinflation. national defaults also generally are not the death sentence one might infer. particularly in the case of the united states, which is a very large component of global economic activity regardless of its fiscal condition, the idea that the country is going to become an international economic pariah is silly. indeed, willfully engaging in hyperinflation would likely be the more chaotic step by far.
so the option is there, if it is needed. much depends on the extent to which the government is compelled to explicitly backstop the financial system and provide fiscal stimulus -- and particularly to what extent social insurance commitments are retracted.
some measure of devaluation of the dollar at some point seems likely to close the american current account deficit, and any default would likely be accompanied by heady dollar trauma. but i continue to think deleveraging will result in deflation and probable relative strength in the dollar in the intermediate term. i think competitive devaluation is far more likely than a unilateral dollar crash, and privately created money emergent of fractional reserve banking is being destroyed on a scale the fed will find difficult to counteract.
UPDATE: two sides of the debate on federal deficits and debt presented by paul krugman, jim hamilton and krugman again. i tend to agree with krugman.
[I]n 1950, federal debt in the hands of the public was 80 percent of GDP, which is in the ballpark of what we’re looking at for 2019. By 1960 it was down to 46 percent — and I haven’t heard that anyone considered America a debt-crippled nation when JFK took office.
So how was that possible? Was it through drastic cuts in defense spending? On the contrary: we’re talking about the height of the Cold War (with a hot war in Korea along the way), and federal spending actually rose as a share of GDP. So yes, it wasn’t entitlement programs, but it wasn’t exactly discretionary either.
How, then, did America pay down its debt? Actually, it didn’t: federal debt rose from $219 billion in 1950 to $237 billion in 1960. But the economy grew, so the ratio of debt to GDP fell, and everything worked out fiscally.
the trick of course is that it wasn't until 1954 that private, as opposed to public, debt reached a minima. the growth seen from the end of the 1953 recession forward to the 1970s -- a period rightfully associated with the peak of american global economic power -- was made possible by the complete resolution of the private debt bubble which popped in 1929 and more than two subsequent decades of household and corporate balance sheet repair. what economic strength was seen in the intervening time was largely a product of government deficit spending -- again, the refinancing through government-derived income of private debts onto the public balance sheet, particularly between 1941-45. and of course there was the assistance in that resolution of an apocalyptic cycle of defaults and bankruptcies.
if we're to return to the kind of growth track that allowed our society to outgrow its debts following the second world war, we first have to use public policy today to effect private sector balance sheet repair. we have done that only modestly thusfar. krugman is of course correct that government deficits have moderated the default cycle in a way that they didn't in the early 1930s. but a monster debt pile remains to be resolved in the private sector, and government -- particularly through the operations of the federal reserve -- has taken steps to delay or even attempt to prevent this resolution at the possible expense of creating even larger debt resolution problems down the road for an economy that has reached zero hour and experienced a classic bout of what minsky called financial instability, leaving it in a very poor position to grow.
this is a long way of saying that america needs to proceed smartly toward a massive expansion of public spending and debt as a means of refinancing the private sector, transferring obligations to the taxpayer through income so as to provide real relief. of course much debt must simply be liquidated -- not all of the private sector obligations will fit under the treasury umbrella with private debts around 300% of GDP outstanding -- and that means a measure of absolute balance sheet contraction. such contraction can hopefully proceed in lockstep with the closing of the current account deficit and weaning the banking sector off wholesale funding. all this, and an efficiency-minded reconfiguration of social insurance as well.
there's a lot on the american plate, no matter how you look at it. but krugman is i think essentially correct -- this is less a problem of mathematical certitude than political will.