All Commentary
Friday, July 1, 2011

Default in the Future

Thinking the unthinkable.

The on-and-off discussions in Washington over how – not whether – to raise the debt ceiling and reduce future budget deficits have long passed the point of farce. Watching the politicians’ antics, one wonders why anybody ever thought they (or their predecessors) could be trusted with power.

One thing they all want us to believe is that a default on government debt is unthinkable. Hence the game of chicken now being played. With an August deadline looming, each side seems to believe that the others will either give in or compromise in a major way rather than see the government unable to pay its creditors.

In the end they might patch something together in time and pass a new debt limit with token spending cuts and even some “revenue enhancement.” It will be presented to the public as a grand statesman-like compromise, and the sober voices that emanate from the New York and Washington Post will praise the “grownups” who finally prevailed and averted catastrophe.

Big Con

It will be one big con on the public. At best the “statesmen” will have kicked the can up the road, leaving it for others to grapple with in the not-too-distant future. But those others will likely be no better able to solve the problem than their predecessors.

Does that mean default is in the U.S. government’s future? Economist Jeffrey Rogers Hummel, San Jose State University, thinks so. He writes in “Why Default on U.S. Treasuries Is Likely”:

Almost everyone is aware that federal government spending in the United States is scheduled to skyrocket, primarily because of Social Security, Medicare, and Medicaid. Recent “stimulus” packages have accelerated the process. Only the naively optimistic actually believe that politicians will fully resolve this looming fiscal crisis with some judicious combination of tax hikes and program cuts. Many predict that, instead, the government will inflate its way out of this future bind, using Federal Reserve monetary expansion to fill the shortfall between outlays and receipts. But I believe, in contrast, that it is far more likely that the United States will be driven to an outright default on Treasury securities, openly reneging on the interest due on its formal debt and probably repudiating part of the principal. [Emphasis added.]

Whether this would be good or bad is beside the point. (Let’s not forget that taxation – fiscal force — is how governments usually pay their debts.) Hummel makes a persuasive case that the powers that be will decide that default is the best of the available alternatives.

Other Alternatives

The other potential alternatives are inflation, taxation, and spending reductions. None, Hummel writes, will save the day. As he wrote in The Freeman, inflation, because of fractional-reserve banking and other factors, has long stopped providing substantial cash benefits – seigniorage — to the State.

Outside of America’s two hyperinflations (during the Revolution and under the Confederacy during the Civil War), seigniorage in this country peaked during the Civil War under the Union, when it covered about 15 percent of the war’s cost. By World War II seigniorage was financing only a little over 6 percent of government outlays, which amounted to about 3 percent of gross domestic product (GDP). During the Great Inflation of the 1970s seigniorage was below 2 percent of federal expenditures, or less than half a percent of GDP.

Monetizing the debt through inflation theoretically would reduce its real value, but what about in practice? Hummel notes that in the 1970s, the federal government did make some money that way, but the inflation was unexpected.  However,

investors are much savvier these days. Globalization, with the corresponding relaxation of exchange controls in all major countries, allows them easily to flee to foreign currencies, with the result that changes in central-bank policy are almost immediately priced by exchange rates and interest rates. Add to this the ability to purchase from many governments securities that are indexed to inflation, and it becomes highly unlikely that investors will be caught off guard by anything less than sudden, catastrophic hyperinflation (defined as more than 50 percent per month) — and maybe even not then.

So much for inflation as a way out of the debt crisis. This doesn’t mean there will be no inflation whatever. There might be lots of it but, Hummel says, it won’t obviate default.

Structural Limit

What about taxes? No good. Aside from the libertarian objections to raising taxes, there is the fact, as Hummel points out, that “federal revenue … has bumped up against 20 percent of GDP for well over half a century”:

That is quite an astonishing statistic when you think about all the changes in the tax code over the intervening years. Tax rates go up, tax rates go down, and the total bite out of the economy remains relatively constant. This suggests that 20 percent is some kind of structural-political limit for federal taxes in the United States….  [F]ederal tax revenue at the height of World War II never quite reached 24 percent of GDP. That represents the all-time high in U.S. history, should even the 20-percent-of-GDP post-war barrier prove breachable.

Well, can’t the politicians cut their way out of the debt? Not likely: “[P]ublic-choice dynamics tell us that politicians have almost no incentive to rein in Social Security, Medicare, and Medicaid.” Polls show that even self-described tea partiers oppose cuts in those programs. “[A]fter 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?” Hummel asks.

Another big budget item is “national security” (not to be confused with defense), which all told comes to about a trillion dollars a year, according to Robert Higgs’s calculations. The potential for cuts is great there, but what are the chances? Powerful interests make fortunes off that budget and the endless wars it funds — and that spending is easily protected by stigmatizing cutters as “weak on national security.” It’s an old story.

So spending is going nowhere but up. But with the structural limit on revenues already noted, that only means a growing debt. When interest rates rise, as sooner or later they will, the government will face higher interest payments – and even more debt.

“Still unconvinced that the Treasury will default?” Hummel asks.

  • Sheldon Richman is the former editor of The Freeman and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America's Families and thousands of articles.