What It Would Mean to Default on the Debt
The other day I commented on a blogger's suggestion that it might be better to default on the debt than raise taxes. In the course of doing some research on debt default I came across the following article in which a friend of mine, Chris Whalen, actually made a serious argument for defaulting on the debt. It's too good not to share. BB
With Debt Burgeoning, Could the U.S. Default?
Kathleen Day
Washington Post
June 14, 1992. pg. H.01
Picture Uncle Sam telling you what a number of foreign governments have told their creditors and bankers: "I'm not going to pay you."
Unthinkable?
Not to R. Christopher Whalen, 34, a Washington-based financial consultant who worked for three years as an analyst in the foreign department of the Federal Reserve Bank of New York.
Whalen, whose heroes include economists Milton Friedman and the late F.A. Hayek, doesn't like the prospect of the United States defaulting on its debts. But he says defaulting is preferable to a long, painful slide that will only postpone the day when the United States returns to economic and financial health. By doing it now, he contends, the nation could swallow all the bitter medicine in one big gulp, and get on with rebuilding.
"Let's just admit the reality that the {national} debt will never be repaid, or will be repaid in inflated dollars, and start over," he said. "It would be beneficial to the economy because you would cripple the government's ability to borrow. I think that would be wonderful because then the government would have to go to the people every time they wanted to spend money."
He added: "If it's good enough for Brazil and Mexico, why not us? After all, doesn't the world owe America one debt forgiveness?"
How could a default work?
According to Whalen, the government could announce that it would no longer pay interest to holders of U.S. Treasury bills, notes and bonds. Then the Federal Reserve Bank system could agree to buy back these securities for their face value, in cash. To do this, the government would have to print as much as $2.7 trillion, the portion of the total national debt now held by foreigners, investors and anyone other than the government or its agencies.
Such a measure would be extremely painful. The printing of reams of money would, in the short term, cause unprecedented inflation. Millions of Americans, especially such groups as college students and the retired, would have to forgo the money they count on from government fixed-income securities. Insurance companies, which are big holders of long-term bonds, would find their assets drastically devalued.
Nevertheless, Whalen believes that given the inability of Congress and the Bush administration to deal with the continuing deficits, it would be the quickest way to put the U.S. economic house back in order.
The national debt would be gone, and the government wouldn't have to borrow several hundred billion dollars a year to pay the interest on it. The government would have to balance the budget - taxes would have to equal spending - because nobody would be willing to lend it money for the time being.
Longer term, the clean slate could help business and promote rapid growth by creating a climate of low inflation and low interest rates. As confidence in the U.S. government returned - it might be buttressed by its bold action, once the initial shock of what it had done had passed - some federal borrowing might be possible. But it would be for productive investments, such as education, infrastructure, science and space exploration, not for repaying interest.
In short, the risk of economic turmoil would be outweighed by action that "would wake up the nation and tell taxpayers what the story is," Whalen said. "The only way politicians have gotten away with this is that the consequences of over-borrowing have come out in dribs and drabs."
One result of the steadily rising annual interest payments on the federal debt is a core rate of inflation of about 3 percent a year, Whalen contends. When the government goes in debt to fund current spending, it makes the economy run faster than it would if it couldn't borrow. Excess dollars chasing goods and services causes inflation.
In a default, the country takes the entire inflationary impact of its excesses in one blow, instead of spreading it out over many years. Over 15 to 20 years, Whalen believes, the current inflation rate will have the same ruinous effect on the U.S. credit rating as a one-time default now would have.
"If the government doesn't move soon for an orderly reduction of debt, we're headed for a repudiation of interest," he said. "It'll be Third World economics time. It would destroy a lot of wealth. It would put us in the ranks of Brazil."
Such talk of default is dismissed as dangerous and irresponsible by most Washington fiscal experts and economic policy makers. But on Tuesday, House Speaker Thomas Foley (D-Wash.) uttered the "D" word - not to endorse the idea but to describe the possible consequences of a balanced-budget amendment.
"It could create problems with forfeit," he said on the Public Broadcasting Corp.'s McNeil-Lehrer News Hour. "I should say a problem in the sense of not meeting our obligations, and we {could} have a default on U.S. government obligations in a year when Congress and the president could not come to agreement and not meet the obligations that the full faith and credit of the United States is pledged to."
James Dale Davidson, chairman of the National Taxpayers Union, wrote in the Wall Street Journal recently, "If we continue to ignore this degraded balance sheet and let the deficit skyrocket, the day will come when the escalating cash demands of government will inevitably overwhelm credit markets, resulting in a downgrading of all government securities."
Davidson said that the Social and Economic Congress of Japan has warned Japanese investors that the U.S. Congress may default on the national debt.
A less drastic step than declaring an outright default, according to Whalen, would be for the government to impose a higher federal tax on the interest earned on Treasury securities, recouping some of the interest costs without officially announcing a default.
In fiscal 1991, the U.S. government paid out $196 billion in interest on the $2.7 trillion in debt held by the public. This annual budgetary expense will grow to $280 billion by 1997 under present scenarios. (Not included in this liability are outstanding U.S. government guarantees on pension funds, student loans and home mortgages.)
The annual interest payments on the debt account for nearly half of this year's estimated budget deficit, and are the third-largest item in the federal budget after defense spending and Social Security.
Some of Uncle Sam's debt is at extremely high interest rates - up to 15.8 percent. When interest rates were at record levels in the early 1980s, the U.S. government-issued bonds had to offer such premiums in order to finance the deficit. Unlike many borrowers, the U.S. government cannot refinance most of its long-term loans at today's lower interest rates, because that would upset the financial markets.
The creditworthiness of the U.S. government, which enables the Treasury to pay the lowest market interest rate available to its creditors, has been a given for decades. Treasury securities, long considered the closest thing to a risk-free investment, serve as the benchmark for stock, bonds and currencies. To undermine faith in the U.S. Treasury would risk global financial instability. Therefore, most observers agree that a repudiation of the debt is unlikely in the foreseeable future.
The day the government defaults on even a penny promised a bondholder, said Edward Yardeni, chief economist for C.J. Lawrence in New York, "that's the day you'd be talking about the U.S. being in the same camp as Brazil. Before we'd let that happen we'd raise the tax on gasoline by $2 a gallon."
Yardeni said the bond market carries more clout than other special interest groups, and wouldn't let it happen. For if the government defaulted on interest, bond prices would collapse and interest rates would skyrocket and that would induce a depression. Nonetheless, he said, "There's a compounding effect of interest, so something has to happen."
"I don't think a default is likely," agreed James Grant, editor of Grant's Interest Rate Observer and one of Wall Street's most pessimistic analysts of the stock market and economy. But some of Grant's views echo Whalen's. "Is the state of the public financing reaching some serious point of no return? Yes," he said.
Where Grant parts company with Whalen is in his belief that "government will conjure up some way to pay... ." He suggests jestingly that the government in theory could repay its debts with assets other than dollars - failed savings and loans or cans of tuna fish included.
Default and debt restructuring has been a favorite tool for the likes of Donald Trump, Latin American countries and others who borrowed too much money in the 1980s. The decision of Bridgeport, Conn., to file for bankruptcy last year showed that local governments are not beyond drastic measures to cut expenses.
Whalen takes exception to the idea that defaulting on interest payments would throw the markets into intolerable chaos, dismissing that as a "quaint notion of the 1950s" that has been overwhelmed by the depth of the country's current economic woes.
The U.S. government's vaunted creditworthiness has had its negative side, he suggests, enabling the country to borrow excessively from investors who didn't ask tough questions about the underlying health of the country's finances.
"Debt is bad. It's always been bad," Whalen said. "And public debt is especially bad because it carries the pernicious illusion that the state can carry it forever."
Addendum
I subsequently came across an article in The Freeman and another article by Murray Rothbard that also seriously advocated repudiating the debt.
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Bruce (or anyone), In a
Bruce (or anyone),
In a previous post, you stated that one consequence of default by the federal government would be that "interest rates would skyrocket to unprecedented levels, which would cause a collapse of private borrowing". On that thread I asked (not rhetorically) the following question, which I'll ask again here:
Why why would interest rates in the private sector necessarily “skyrocket”?
The federal government will, I assume, have destroyed its credit rating and I assume would thus either be literally unable to borrow or would have to pay high interest rates, but the credit ratings of borrowers in the private sector would not have been damaged (correct?). Assuming we have defaulted rather than monetized the debt (the latter of which would causing great and I assume also somewhat unpredictable levels of inflation), why would real or even nominal interest rates in the private sector necessarily “skyrocket”? Why would federal default necessarily dramatically drive up either repayment risk of private debtors or inflation risk or currency (exchange rate) risk, or am I missing a factor that would greatly affect private sector interest rates, perhaps indirectly, such as the losses creditors will have experienced on the Treasury debt they had held or the reduction in total available debt capital if taxes are increased (rather than the budget balance entirely by spending cuts), or the elimination of the risk-free benchmark, or something else?
Forget it...
"Nevertheless, Whalen believes that given the inability of Congress and the Bush administration to deal with the continuing deficits, it would be the quickest way to put the U.S. economic house back in order."
Didn't you forget to mention the responsibility of the current administration?
"The national debt would be gone, and the government wouldn't have to borrow several hundred billion dollars a year to pay the interest on it. The government would have to balance the budget - taxes would have to equal spending - because nobody would be willing to lend it money for the time being."
Think about what you're saying... Defaulting would leave the country vulnerable in every way...
No way; this would be a death blow to the country.
A Default on the Debt = Revolution
Bruce,
Your friend Mr. Whalen fails to recognize what would happen if we defaulted on the debt. Before we would come up for air from the impact of a default, I am willing to bet dollars to doughnuts that the government would be overthrown.
Too many people depend on government programs from entitlements to student and small business loans to government contracts. This does not even consider defense spending, FDA regulation of our food and drugs, and the loss of everyone's life savings if a default occurred. In other words, every single American would be impacted. The anger you see today in the public area would be a walk in the park compared to what you would see after a debt default. I am sure in such a scenario you could find a majority willing to start a coup (even in America).
The real world vs. the fantasy world
The U.S. Defaulting on it's debt is one of those thought experiments that doesn't take into account the actual reality of the world. It's like the doctor telling you to lose 30 pounds, so instead of diet and excersize you cut off a leg.
In the real world, where I live and work with clients of my financial planning practice, millions of people need the interest payments either from the treasury bonds they own, the mutual funds they have that own them, and / or the pension plans that invest in those bonds. Millions more have life, long-term care, and disability insurance plans whose reserves are substantially invested in Treasuries as well. While 20 years from now the country "might" be better off, there is actual real world pain for millions who have worked hard, invested, and lived life they way we are suppose to encourage it to be lived who will be left with no income, no insurance coverage, and vastly devalued investments. How are they suppose to buy food, medicine, shelter?
This is the economic equivelent of nutso environmentalists who scream for the population to go back to a couple million people so we can preserve the planet - nice thought but 6 billion people have to die. This theory is the same, nice thought but 50 million hard working, law abiding citizens have to live their golden years in abject poverty. What a great idea!
Nice find!
"A Portrait of the Analyst as a Young Radical"?
It seems that Chris Whalen and James Grant were the Tea Party ticket in 1992. I was living in Tokyo at the time and must have overlooked that.
I must say that I've only been following finance much since Fall '08, but during that time Whalen has consistently seemed to be one of the voices most grounded in reality. He occasionally veers off on some partisan Republican blather, but nobody's perfect.
Bruce should have gone ahead and posted some numbers as of the end of Clinton's second term, compared to when these apocalyptic comments were being made near the end of Bush the Elder's term (GDP, debt as percent of GDP, fiscal surplus, unemployment rate).
Anyway, rather than default or repudiation or hyperinflation, the issue I've been wondering about is whether the US might someday be forced to borrow in another currency or a basket such as SDRs in order to pay for oil.
Serious Problem
The reason I bring up the issue of default is not because I don't think the United States will ever lack the wherewithal to pay its debts, but because Congress might force a default by failing to raise the debt limit in a timely manner. I do believe that there are many Republicans in Congress that really would rather default on the debt than raise taxes. I can see them delaying a timely debt limit increase to the point where a technical default occurs. And when this happens they will be egged on by right wing talk radio clowns and irresponsible bloggers etc. That is why the idea needs to be nipped in the bud now before Glenn Beck and the tea party crowd start demanding a default to prevent a tax increase.
Why sovereign default would raise private sector rates
TO "Bruce (or anyone)"
1) private sector interest rates are keyed off Treasury rates. e.g. 30y mortgages off 10y Treasuries, or ARMs off LIBOR which is off Fed Funds.
2) a sovereign default would likely lead to a wave of private sector defaults. As other commentators have pointed out, the private sector holds a 'lot' of Treasuries. Defaulting would harm private sector balance sheets, reduce creditworthiness and therefore raise borrowing costs.
There is pain in every solution
MK brings up the many people depending on the returns they get from Treasuries. For those past their earning years, fortunate enough to own Treasuries with high returns vs inflation, default would cause a lot of pain. For those entering into their high earning years, however, the current solution looks terrible; very low to non-existent returns on safe investments, the prospects of increasingly high taxes, inflation, non-existent private defined benefit plans, and the expectation that public defined benefit plans will be drastically reduced by the time we reach an ever increasing retirement age.
Default would be an extremely painful solution, and I agree that most people suggesting it have not fully thought through the ramifications. I suspect, however, that most people have not fully thought through the ramifications of any path forward, or more people would be as pessimistic as I am. Mr. Bartlett writes as if the biggest obstacle to a sustainable fiscal solution is Republican opposition to tax cuts. I agree that that is a big problem, and that no solution is possible without increased revenue; but I continue to believe that a bigger obstacle by far is bi-partisan opposition to reduced government spending and reducing or eliminating public programs and entitlements.
What is your proposal
Mr. Bartlett,
No, I don't want to default on the debt, not even through a technical default - like refusing to raise the debt limit. Neither do I want a strait-jacket balanced-budget constitutional amendment that doesn't allow for flexibility in emergencies.
But neither am I satisfied that congress, Democrat or Republican, left to its own devices and even with "pay-go" rules (and given its perpetual incentives to put off pain) can be trusted to keep spending, taxes, the size and scope of government, and the debt under responsible control. I don't trust the government to be restrained and wise, and so I want something stricter than what we have. In your opinion, is this simple a hopeless naive fantasy, and should I just give up?
I know you favor a VAT as an additional revenue stream, but I guess it would only be that, and I doubt it would act as a long-term "fix" to the above concerns.
So what should a person like me to do to apply my infinitesimal amount of pressure to the parties? What is your practical advice in terms of policy and politics? It's easy to attack extreme suggestions or polls that demonstrate low levels of public knowledge (which they always do, no matter which party is targeted), and then overgeneralize and mock a whole segment of the population, including many reasonable, informed, educated, and intelligent people.
The trend and tone of this blog is, unfortunately, veering towards snarky ridicule of the above point-of-view, as if the people who hold it cannot comprehend the consequences of the enactment of their preferences, and that they are "ignorant, immature, and intellectually illegitimate" instead of worthy of respect. I wish instead that it were more positive and "channeling". "You have good intentions, but your proposed actions aren't likely to be effective, and instead you should ..."
The tea-party crowd seems incoherent and jumbled because it is a mass of very different people with diverse views but with a few common interests (those mentioned above) and who generally feel they have no competent, credible party, with it's own well-articulated intellectual foundation, with which to align.
In a functional and adaptable political system, their interests would find an outlet and representation instead of mere jeering and disdain. In a sustainable and responsible society, these views might even achieve a status something like a "consensus viewpoint". Hard to imagine in our world, I know...