David R. Henderson  

Hummel Predicts U.S. Government Default

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San Jose State University economist Jeff Hummel, in Econlib's feature article, predicts that the U.S. government will default on its debt. The other option he considers is that the federal government will monetize its debt. The problem with this second option, he points out, is that in a highly developed financial system such as ours, the federal government's gain from printing money, what economists call seigniorage, is quite small. Therefore, monetizing the debt simply wouldn't fill the bill, so to speak.

His closing lines:

Mises also argued that the mixed economy was unstable and that the dynamics of intervention would inevitably drive it towards socialism or laissez faire. But in this case, he was mistaken; a century of experience has taught us that the client-oriented, power-broker State is the gravity well toward which public choice drives both command and market economies. What will ultimately kill the welfare State is that its centerpiece, government-provided social insurance, is simultaneously above reproach and beyond salvation. Fully-funded systems could have survived, but politicians had little incentive to enact them, and much less incentive to impose the huge costs of converting from pay-as-you-go. Whether this inevitable collapse of social democracies will ultimately be a good or bad thing depends on what replaces them.

Well worth reading.

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CATEGORIES: Fiscal Policy

COMMENTS (17 to date)
winterspeak writes:

Any entity that can issue currency need never default. This includes the US Govt with its US$ obligations. Moreover, "monetizing" debt is a meaningless concept. Different parts of the Government swap some numbers within their own internal spreadsheet, it really makes no difference in a zero interest rate environment.

We are not on a gold standard anymore.

E. Barandiaran writes:

Hummel's starting point ("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.") is fully justified by the increasing corruption of your country's political system and therefore one can ignore the possibility of any judicious tax and/or expenditure policy.
In Argentina, the same point was made in the early 1950s, but 60 years later corruption is a much more serious problem and the fiscal "balance" is maintained by a high tax on agricultural exports and terrible government services (most of government revenue is redistributed to pay pensions, political constituencies and interest groups).

Matt C writes:

The problem with this second option, he points out, is that in a highly developed financial system such as ours, the federal government's gain from printing money, what economists call seigniorage, is quite small.

At least, with the techniques used at present. Can the government not come up with other clever approaches for increasing the money supply that add more directly to its bottom line?

From the article:

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.

When you frame it that way, it sounds like an obvious choice. But how about this framing: faced with the alternative of declaring default and being shamed and scorned and hated, or printing more money (just for a little while longer) and hoping that by some miracle they can evade or mitigate the long term consequences, my guess is that U.S. politicians will always choose the don't-blame-me option.

Richard A. writes:

According to Hummel, it was the 10/3/08 bailout legislation (that setup TARP) that allowed the FED to begin paying interests on reserves. Paying interests on reserves is what caused the banks to hold on to reserves--not some alleged liqidity trap, and this is what drove down the M1 money multiplier. This allowed the FED to use the monetary base as a slush fund without causing M1 to grow too rapidly.

Who voted for this legislation--
Emergency Economic Stabilization Act of 2008

Gu Si Fang writes:

I think the Fed's seigniorage is the wrong metric to balance both options. Most of the benefits for government finance from an expansion of the Fed's balance sheet are indirect - i.e. not seigniorage. For instance, a multiple expansion of bank credit will increase asset prices, inflate a new bubble, increase tax revenue etc. To answer the question "who benefits from inflation?" is not like answering "who gets seigniorage?" in the same way that "who pays taxes?" is not the same as "who bears the tax burden?" I think of it in terms of Cantillon effect.

Historically, I think there have been cases when a prince chose default rather than inflation because his currency was mainly used abroad and provided a currency for international commerce. But what if the US convince other central banks to inflate along? Then the dollar will retain its eminent position without having to default on US debt. I suppose this little game can work as long as expectations are kept low. Then there will be double digit inflation. The political advantage of this scenario is that it pushes the painful decisions into the - maybe not so distant - future.

Floccina writes:

They have the power to raise taxes and they will use if need be.

winterspeak writes:

FLOCCINA: That's the thing -- they don't *need* to raise taxes. Taxes are about reducing inflation, not funding Government spending.

In a gold standard, a Government needed to tax in order to spend. In our fiat regime, it's the opposite.

Jeremy, Alabama writes:

Arnold linked to this article recently. It is compelling. Hummel appears to slam shut all the exits:

You can raise taxes but you can't raise revenues. You can put treasuries up for sale but you can't make people buy them. You can print money but if you pay interest on reserves it increases your effective debt.

The US will already require an eventual tax burden of between 35% and 75%, depending on GDP growth vs debt. This is 2 to 4 times greater tax than the US has ever tolerated. But the government is still growing, not shrinking, unfunded obligations!

For several reasons, not least an atrociously invasive (and wrong) IRS demand a few years ago, I am diversifying out of dollars. I am a very low-net-worth investor. High net worth investors already have 12 trillion overseas. These flows start small and avalanche suddenly, and the flows are already not small.

Floccina writes:


winterspeak presumably at some point inflation will rise. Inflation will make it easier to raise taxes relative to real dollar spending.

BTW on a side note even if money is free to the government (they can borrow without every paying it back or create money at will), if in spending that money they make otherwise productive people unproductive (for me the quality of the people doing very simple jobs for the post office come to mind) there is a cost in lost productivity.

Bottom line to me though is productivity is growing so fast through new technology that growth in Government waste cannot keep up enough to absorb all excess and so standard of living will continue to rise.

PeterW writes:

Am I missing something, or can't the Fed just *stop* paying interest on reserves and then print money to its heart's content?

David R. Henderson writes:

PeterW asks:
Am I missing something, or can't the Fed just *stop* paying interest on reserves and then print money to its heart's content?

I don't know whether you're missing something because I don't know what you're assuming or concluding. You're absolutely right that the Fed can do that, but Jeff Hummel's point is that they can't raise much revenue from doing so.


Richard A. writes:

If you look at the simple money multiplier (MM)

MM=(demand deposits)/reserves

In normal times, reserves held are a tiny fraction of deposits. As a result, MM is much greater than 1. The FED, by paying interest on reserves beginning in October, caused the banks to hold their deposits as reserves causing MM to crash to a little less than 1. Why did they do this? So they could expand the monetary base M0 without an undue expansion in the money supply M1.

M1 = MM x M0

Driving down MM from about 1.6 to a little less than 1 had the effect of offsetting the expansion in M0.

winterspeak writes:

FLOCCINA: Every time the Government spends, it creates money. Every time it taxes, it uncreates money. The difference between creation and uncreation is called the "deficit" and it is what funds all net private sector savings.

If inflation gets too high, the Govt can simply raise taxes to stop it. Not exactly an issue right now given we have zero interest rates, deflation, and a 10% unemployment rate.

I agree that the Government hurts productivity, but it does so in lots of ways, and this, frankly, is the least of it. It is a monopoly supplier of currency, it needs to produce the right amount.

PETERW: Fed can start or stop paying interest on reserves whenever it likes. It does print money whenever it likes. Two are not connected.

RICHARD A: They money multiplier model is based on this gold standard idea that banks lend out a fraction of their reserves. In reality, this is completely wrong. Banks make loans that will be paid back, creating deposits BY making the loans. They then borrow (or lend) on the interbank market, to meet their reserve requirements. If the sector as a whole is short, it goes to the discount window. Lending is not reserve constrained in any way.

The Feds starting paying interest on reserves because the interbank market stopped working normally, and they needed another mechanism to set short term rates. The overnight interbank market only works to set short term rates because it does not have credit risk, once credit risk was introduced, it stopped working normally.

Hummel, with respect, has no idea how banking works, thinks we are still on a gold standard, and draws a series of erroneous conclusions from those incorrect assumption.

Ken in Canada writes:

Floccina wrote: "Bottom line to me though is productivity is growing so fast through new technology that growth in Government waste cannot keep up enough to absorb all excess and so standard of living will continue to rise. "

Isn't this just plain wrong?

"Productivity", as used in this context, is putting people OUT of work. Indeed, it means the productivity of capital, not the productivity of people.

How does putting people out of work or demoting them to low-pay, low-esteem service industry jobs cause the standard of living to rise?

Except, of course, the standard of living of those increasingly few who control the bulk of the wealth. Can they truly spend enough to keep the consumption-based economy going, never mind growing?

I know some of them try, but for every Paris Hilton trying hard to inject lot$ there is at least one Warren Buffet $ucking even more out.

What am I missing??


winterspeak writes:

KEN: What you are missing is that the economy as a whole is demand constrained. The US Govt must provide the private sector with more net savings.

Productivity is not putting people out of work, lack of demand is. There is a lack of demand because the private sector does not have enough nominal wealth to meet it's savings desire, and the public sector 1) is refusing to provide that nominal wealth while, 2) not stepping in to purchase all that excess (real) capacity itself.

Total waste.

A payroll tax holiday would solve this in about 6 months.

Jeffrey Rogers Hummel writes:

Winterspeak's first comment way above starts out: "Any entity that can issue currency need never default (emphasis mine)." Technically this is correct, and my article admits as much, just as it admits that is possible that the U.S. government might raise taxes high enough or cut benefits low enough to avoid a fiscal crisis. But I was exploring what would be the likely outcome given political incentives and economic constraints. Even absent a gold standard (which I was hardly assuming still existed), sovereign default is far from uncommon. Standard and Poor's reports 84 sovereign defaults from 1975 to 2002, all under fiat regimes. The following is from their list of States (along with the dates) that defaulted either on their domestic, on their foreign debt, or on both. I've excluded cases like Mexico (1982-1990), where the default was not on government securities but on foreign-denominated bank debt, which shortens the list considerably. Yet some governments, like Argentina's have had more than one default.

Angola (1976), Argentina (1982, 1989-1990, 2002-04), Bolivia (1989-97), Brazil (1986-87, 1990), Congo (1979), Costa Rica (1984-85), Croatia (1993-96), Dominica (2003-04), Dominican Republic (1975-2001), Ecuador (1999-2000), El Salvador (1981-96), Gabon (1999-2004), Ghana (1979, 1982), Guatemala (1989), Ivory Coast (2000-04), Kuwait (1990-91), Madagascar (2002), Moldova (1998, 2002), Mongolia (1997-2000), Myanmar (1984, 1987), Nigeria (1996-88, 1992, 2002), Pakistan (1999), Panama (1987-94), Paraguay (2003-04), Russia (1998-99), Rwanda (1995), Sierra Leone (1997-98), Solomon Islands (1996-2004), Sri Lanka (1996), Sudan (1991), Ukraine (1998-2000), Venezuela (1995-97, 1998), Vietnam (1975), Yugoslavia (1992), Zimbabwe (1975-80).

Admittedly, many of these defaults involved government debt denominated in foreign currencies, which in total value exceeded defaults on government securities denominated in domestic currencies. But still, more than half the defaults listed involved the latter. It all puts me in mind of quotation from a 1991 Gordon Tullock article: "There is a myth that floated around the banking community not many years ago that governments do not go bankrupt. I cannot imagine who dreamed that one up."

winterspeak writes:

Jeffrey: With respect, each and every one of your examples has a currency which is fiat, but was convertible or with a fixed fx rate in some way or the other (your foreign fx denominated obligations are included).

The US$ is non-convertible, and floating. The US Govt is absolutely unconstrained in any operational way to spend. It is not deficit constrained in spending. The US$ does not have obligations in other currencies, its obligations are only in US$ which it can create, in any quantity, at any moment, for any reason, with no constraints.

Not only are we no longer on a gold standard, but we are no longer on anything that looks like a "secret" gold standard either.

I will bet you any quantity of money you choose that the US will not default in the next 20 years.

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