A few years back, I proposed an alternative budget for the UK. IIRC, it involved cutting taxes by a quarter, spending by a third. Even assuming no increase in economic growth (that would boost sales tax revenue), this would have created a massive budget surplus that could have cut the UK national debt by over 10%.
I opposed default then for what I still think were good reasons: first, many private individuals and institutions bought bonds in good faith; but second, because the UK nearly had to surrender to Nazi Germany in 1940, and had refused to confront Hitler when war was still not necessary partly because of the consequences of a partial default on war bonds from the First World War. In essence, appeasement was the necessary policy of 1930s British governments because they could not expect to borrow so had to pay in gold and whatever the British public could be persuade/forced to raise (yes I know pacifism was big too, but the financial imperative meant that it was the only option).
Whether we take an interventionist view or not, the re-militarization of the Rhineland in 1936 was the moment when, without firing a shot, Hitler could have been stopped.
What does this have to with events in Europe and the USA today? In short, I think the financial situation is so dire, and the political solutions on offer so inadequate, that default is now the only credible outcome. I therefore conclude that it needs to happen very soon, rather than after wasting more resources on more “bail-outs.”
We will just have to take our chances that no one decides to, invade the Falklands, or grab Gibraltar, or build nuclear weapons and give them to terrorists, or blow up US embassies. I explain why below. The US debate on “raising the debt ceiling” misses an essential point. The credit ratings of many governments are on the brink of being downgraded unless there is an improvement in the debt/asset ratio or there is clear evidence of economic recovery without inflation. Neither of these outcomes is clearly at hand.
To increase the debt ceiling by any amount merely worsens the over-borrowing of the past two decades. If anything, the debt ceiling should be cut not raised. There are exactly four ways of doing this: default, print “money,” cut spending or raise taxes.
As Barack Obama put it so eloquently during his US presidential election campaign: “raising taxes in a recession is stupid.” Putting up rates will probably not raise revenue because the people and businesses that are driven to bankruptcy will more than offset any marginal increase in revenue.
Cuts is spending are almost impossible: contractual obligations have been made, any cuts to public sector pension payments will be challenged and, judges being so-to-retire-public-sector-persons, they might not interpret the law the way spending cutters would like. The sad truth is that the commitments cannot be met, but only a default will prove the legal way for governments to stop spending.
Printing “money,” is actually the current strategy, and it looks OK, until inflation kicks in. When it takes a wheelbarrow of banknotes to buy a loaf of bread and cash registers have to count pounds by the hundred million, such a policy could lead to political instability and revolution.
I’ve outlined two problems with defaulting: bondholders are punished and in a real emergency, the government would not be able to raise money. There is a third problem, which is an opportunity: once a default has been called, the interest rates for government bonds have to go up, a lot.
This normally bad thing means that entire government programs will simply have to stop because the money to pay for it cannot be raised. It means that private borrowing becomes harder too, at least for those whose credit ratings are not good. But it also means people quickly have incentives to sort out their own over-borrowing and to start saving: those savings accounts offering 10% suddenly look quite attractive.
It is by cutting excessive debt and re-building deposits that the financial system can re-build itself.
I’m therefore praying for the most childish behaviour from the American politicians and for someone to say “No” in Europe to propping up the Greek welfare state.
Oh! but we must borrow more in order to pay the interest, etc on the obligations we have created before.
In a more serious vein, there is a question that is generally being avoided (certainly at the U S political levels):
Who will be the lenders of the additional credit sources required?.
Ancilliary:
What will be the sources of capital for those lenders; and from what other uses will that capital be diverted?
A few comments on this thoughtful post:
1) Default on our debt will not happen unless the Obama administration makes a conscious decision to do so, which would be an impeachable act. There is plenty of revenue to meet all debt service obligations, and any maturing debt can be “rolled over” without exceeding the current ceiling, as it would simply be replacing existing debt. When Obama and Geithner threaten default they’re lying, plain and simple. (Yes, I know: quelle surprise.)
2) Certain government pension obligations are indeed contractual, but the big ones (Social Security, Medicare and Medicaid) are not. The Supreme Court long ago specifically ruled that SS payments are not a right or a contract, but rather can be changed (raised, lowered, even eliminated outright) by simple act of Congress. (The same applies to all other welfare schemes.) Whether Congress would ever do so is an entirely separate question, but the fact remains that these payouts could be reduced should Congress have the will. (This is why I object to calling them “entitlements”; they are nothing of the kind, but mere expectancies.)
3) Even the truly contractual pension obligations might not be quite as sacrosanct as you think. Yes, the courts would probably rule otherwise, but a Congress with the courage to reduce Social Security and other welfare payments would also have the courage to invoke sovereign immunity and repudiate the contracts. That’s beyond the reach of the courts.
4) A downgrade is inevitable, as you say, whether or not the debt ceiling is raised. Rumors are that S&P has already privately told the Administration that only spending cuts in the range of $4 trillion would prevent it. None of the proposals being bandied about come anywhere near to that level of cuts. It won’t happen, but a downgrade will. And it won’t be the end of the world, just a modest increase in our debt service cost.
5) As you say, the current “strategy” (if one can dignify it with that term) is to inflate our way through this mess. That is a short-term solution at best, and it can’t continue for too much longer: price inflation is already beginning to take its toll, notwithstanding the government’s best efforts to pretend it away by playing games with the CPI index. But nascent inflation is already “baked in” to the currency; “excess” bank reserves (discussed by Midwesterner in his article last summer) are today 60% higher than they were then (see this). Sooner or later they’re going to start “leaking” out into the general economy and trigger massive inflation.
6) If the US were to truly default on the payment of its bonds, the results would be very bad not only for us but for the rest of the world as well. Greece can default; the US cannot. For good or ill, the dollar is still the world’s reserve currency, and there is nothing apparent which could take its place. But rather than default, the more likely scenario would be a simple inability to incur additional debt, as the Chinese (and others) cut back on their purchases. That will happen sooner or later (debt ceiling notwithstanding), and it would force massive spending cuts and some pretty serious economic dislocations. And not just here: remember, when the US gets a cold the rest of the world gets pneumonia. (If we get pneumonia I shudder to think what will happen elsewhere.) In the long run getting our spending back to some normal, sustainable level will be a good thing, but the transition will be extremely unpleasant.
I’d start looking at hard assets.
Useful summary, Laird – thanks.
I fully agree with Laird, the US cannot default. The US government has got the ratings agencies to talk publicly about a downgrade simply to put pressure on Republicans to raise the debt ceiling. The US will increase taxes, reduce entitlements and put the National Guard on the streets to maintain order but it will not default.
I would take issue with Laird’s statement that there is nothing to take the dollar’s place as a reserve currency. The dollar obtains an enormous advantage from its reserve status and so to compare the reserve dollar and the non-reserve euro is misleading. Were the euro to become the reserve currency, capital would flow out of the US and into the EU, solving all the piggie problems at a stroke and leaving the US is a very precarious position indeed.
The US will not allow this to happen as it would be virtual suicide, but it would not be that much of a problem to the rest of the world if it did. In any case its hard to see how the reserve currency can change while the petrodollar system remains in place, and that is enforced by half the world’s military, which happens to be American.
My understanding of all this from all you really smart guys is that default immediately solves two problems. No more debt and no more borrowing. The budget is forcibly balanced if we can’t borrow. As for repurcussions in the US or elsewhere, I’m no economist or sage, but I find it hard to believe they’d be worse than what we’re facing on this course.
I agree, Roue, that the Euro would be the obvious choice as the world’s reserve currency should the dollar fail. The problem, however, is that the Euro is in even worse shape than the dollar, what with propping up the economies and the PIIGS nations and all. So I still feel that there’s no real alternative to the dollar available. But I agree with you otherwise.
Demand for tangible assets, gold and property, would tend to rise in a default situation. I’m checking the use by dates on canned food: anything past 2015 is good. 😉
I see that Moody’s remains pessimistic even if a debt ceiling increase should be enacted. If not an outright downgrade we’re due for a “negative outlook” in the near term.
Antoine, this one’s for you.
People now living (including many people involved in this site) will live to see the end of this farce – for it will end soon.
The end will, most likely, be terrible – but at least it will be the end.
That is some comfort.