David R. Henderson  

Must Default Be Avoided at All Costs?

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Default must be avoided at all costs and should not be an option on the table.
This is from Jason J. Fichtner and Veronique de Rugy, "The Debt Ceiling: Assets Available to Prevent Default," January 25, 2013.

What's their reasoning? Here is the full extent of it:

Raising the debt ceiling without a commitment to improve our long-term debt problem has adverse consequences as well. Recently, the rating agency Fitch warned the US government that while it wants the debt ceiling to be raised, it also wants the government to come up with a credible medium-term deficit-reduction plan. Without it, the agency could downgrade the US credit rating by the end of this year. Other rating agencies have also warned the United States of the negative consequence of not dealing with the country's long-term debt.

The rest of the article is about how to avoid default, not whether it's a good or bad idea.

I'm unconvinced. The U.S. government has dug itself a deep hole. Commitments that it has made to various people must be broken. There is no plausible way, for example, that the U.S. government will be able, 20 years from now, to pay for all the Medicare, Medicaid, and Social Security benefits that it has committed to pay. One such commitment to consider breaking is the commitment to pay the debt.

Bruce Bartlett, in The Benefit and the Burden, his book about taxes, writes that default "would constitute a grossly immoral theft of trillions of dollars from those who loaned money to the federal government in good faith." In my review of his book, I commented, "Really? It's worse to default on creditors who took a risk than to forcibly take money from taxpayers who have no choice?"

Now you could argue that the commitment to pay the debt deserves a priority because of part 4 of the 14th Amendment to the U.S. Constitution, which says:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.

I take the U.S. Constitution seriously. But note that Fichtner and de Rugy don't make an argument based on the Constitution. Their argument is based on the economics--and, as I noted, I don't think it's that persuasive. To lay out why default might be a good idea takes too much space here. If you want to see a sustained case for default, see Jeffrey R. Hummel, "Some Possible Consequences of a U.S. Government Default," Econ Journal Watch, January 12, 2012.

Fichtner and de Rugy write that it is "irresponsible to signal to the international community that a default on the debt obligations owed by the US government is possible while Washington works through whether it will raise the debt limit before or after it formulates a plan to reduce government spending."

But I think it's irresponsible to tell people that there is unlikely be a default. I'm planning my financial future on the idea that there's a substantial probability that the U.S. government will go right up to the big financial cliff and then default and limit Medicare, Medicaid, and Social Security. The earlier we prepare, the better.

HT to Warren Gibson.

Postscript: Here's Jeff Hummel in a podcast on the same issue.


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CATEGORIES: Fiscal Policy



COMMENTS (26 to date)
JohnE writes:

"Really? It's worse to default on creditors who took a risk than to forcibly take money from taxpayers who have no choice?"

So do you think there will be few consequences for taxpayers if the federal government defaults?

Ted Levy writes:

There will be numerous consequences to many individual taxpayers, some positive and some negative. The largest overall consequence to taxpayers is they will become potentially wealthier, as a future tax burden will be removed. Removing the future tax burden the debt implies means people's human capital becomes more valuable.

John Wilkins writes:

Why would there be a default when the United States has a fiat currency that it has the sole power to create? We can spend up to the limit of our economic capacity and we are fare short of that now. If you don't like the debt -- which, of course, is the private sector assets --let's change the law and top selling bonds. Since 2008, there is no longer an operational ned to sell,bonds because the fed pays interest on excess reserves. Bond selling was a reserve drain and an interest rate maintenance operation, allowing the Fed to hit its positive overnight target. But with IOER, that is no longer required. The Treasury can spend, and thee Fed will add to excess reserves, which is no counted as debt.

Harris @ OZ Surrey writes:

Thanks for the link to Jeff Hummel's podcats, I'd urge everyone to listen to that as well if they can - he makes some very interesting points.

As for the article itself I agree with you David, I remain utterly unconvinced. You've articulated my thoughts far better than I ever could.

Ted Levy writes:

"Why would there be a default when the United States has a fiat currency that it has the sole power to create?"

Because destroying the value of your currency to pay off your debt is much more destructive to your economy than defaulting on your debt. Hyperinflation is worse than default. It's that simple.

Matthew writes:

I'd think the biggest consequence to individual taxpayers would be the complete meltdown of the financial system leading to years-long depression and massive unemployment.

Short of just dropping a nuke on some random city for no reason, fully defaulting (not just a haircut) on the national debt would be the most irresponsible, dangerous, and downright stupid thing the US government could do. Since it's so stupid everyone assumes that it won't actually happen, or if it does happen it will be minimal. Don't mistake "this isn't dangerous since it's so obviously stupid nobody would actually do it" for "this isn't actually dangerous".

(Note that believing in the sheer danger of a US default is an anti-deficit position: although the US will most likely be fine with debt/GDP loads higher than currently existing, it's not worth the risk given the cost of failure).

Maurizio writes:

Matthew, what do you mean by a "meltdown of the financial system"? That the government will not be able to sell bonds to borrow money? Or that private enterprises too will not be able to borrow money?

David R. Henderson writes:

@JohnE,
So do you think there will be few consequences for taxpayers if the federal government defaults?
No, I didn't say that. The main consequence for taxpayers, as Ted Levy notes above and as Jeff Hummel notes in the article I referenced above, is lower taxes than otherwise.
@John Wilkins,
I really do recommend reading Hummel. He does handle the inflation argument, pointing that the gain to the government from inflation is very low.

Bostonian writes:

Under a government default a taxpayer with a $1 million tax liability and who owns $1 million in government debt would still owe the government $1 million even though it broke its repayment promise to him. I don't think wiping out taxpayers' assets but not their liabilities is fair or politically viable. Tax compliance would fall.


David R. Henderson writes:

@Bostonian,
I was answering JohnE's question about taxpayers, not bondholders. Obviously, bondholders qua bondholders would be worse off.

Ted Levy writes:

"Tax compliance would fall."

Bug or feature?

John B. writes:

Please don't lump real defaults with actions that just change statue law.

If the Federal government does not pay interest on outstanding bonds, that's a default. If it does not pay off maturing bonds, that's a default.

But if the Federal government changes the payouts for Social Security or pensions, that's not a default. It's a policy change, it's potentially a political disaster -- but it's not a default.

My understanding (though I am not a laywer nor any kind of expert) is that (just as with bankruptcy) there is a priority order for Federal payments:

  • Bond interest and repayment are Constitutional obligations and come first;
  • Contract payments come next (this may include salaries);
  • Statutory obligations are last, and may be changed unilaterally by the Federal government (Medicare, Social Security, etc.).

I seem to recall that there was already a Supreme Court case on whether an individual's Social Security income was that individual's contractual right. I believe it was decided that it was not.

Bottom-line: there is no real danger of a real default even if the debt limit is not raised. There is a danger that some spending programs will change.

Bob Murphy writes:

Obviously I'm no constitutional scholar, but I read that as just explaining what was US government debt and what wasn't--since there would have been some understandable confusion when half the territory tried to break away and issued bonds in the process.

For an analogy, if someone has a U.S. Treasury Bond with the corner ripped off, and he takes it to a clerk for clarification, when the clerk says, "Yes, that is a legitimate US Treasury Bond backed up by the full faith and credit of the US government," it doesn't mean anything more than for a different US Treasury. The morality or immorality of default is the same as it would be for any other government, whether they had language like the 14th Amendment regarding their own bonds.

Daublin writes:

This discussion hinges on what "default" means.

If you mean literally don't pay back explicit loans, then I have a hard time thinking that's a good choice.

However, I don't think it would be so bad to reneg on mandates from Congress due to lack of funding. For example, suppose Congress passes a mandate to build a military base, but does not raise the debt ceiling. In such a case, the executive branch has other options than issuing bad debt. It could, instead, decline to build the military base.

In essence, the scenario would lead to a form of line-item veto.

John B. is exactly right. You can't conflate Treasury bonds with promises to SS and Medicare beneficiaries. They're two different things.

And the 14th Amendment argument is baloney, that's all about letting it be known that the Southern states, upon being allowed back into the Union, couldn't get away with a power play to either not repay the debt incurred by the North to win the Civil War, nor pay off the Confederate bond holders.

Since I've beaten Jim Glass here, I'll also point out that that 14th Amendment language didn't stop either US Grant (Greenbacks) or FDR (Gold Clause cases) from 'defaulting' on promises to bondholders.

Doug writes:

Defaulting by even one cent destroys the financial system, completely locks up all capital in fear, and grinds the economy to a halt. Raising the social security retirement age and putting per-person annual spending caps on medicare slightly lowers the quality of life for a small subset of people.

If you have to choose renege on some of your commitments default on general debt is much higher priority than any of the so-called mandatory spending.

Ted Levy writes:

Amazing the number of comments about the debt that clearly haven't read the short, pertinent Hummel piece Henderson linked to. Granted, it's not obligatory, but why raise concerns and questions the OP link clearly covers?

Doug's comment above ignores that many state and national defaults have occurred in the past, without the results he describes.

mark writes:

For the commenter who asked:

Why would there be a default when the United States has a fiat currency that it has the sole power to create?

The reason is that the currency is controlled by an independent central bank, which has two missions, neither of which is to avoid default. If the Fed chooses not to monetize the fisc's spending, and there is a debt ceiling, then you can have a default

The 14th Amdt solution is, I agree, a red herring. "Validity" does not mean "payment". It just means that, when the debt was created, it was created lawfully. Every time a debtor goes into bankruptcy, it defaults on valid debts. A creditor can get a judgment from a court to say, debtor, pay the creditor. That's as valid as a debt gets. Yet, if the debtor does not have the money, the debt does not get paid. Validity is a condition to enforceability but not identical to payment.

Manfred writes:

In my review of his book, I commented, "Really? It's worse to default on creditors who took a risk than to forcibly take money from taxpayers who have no choice?"

David Henderson: this is not strictly correct and true. Taxpayers do have a choice - actually, more than one. One choice is to *vote* for politicians that do not increase taxes. Another choice is to leave the taxing jurisdiction (such jurisdiction being a country), and set up tent somewhere else, in a jurisdiction that does not raise taxes (much like a Tiebout model). Another choice is simply not to pay, and face the music.
So, I gave you three choices that taxpayers have.

Thomas Molitor writes:

Speaking of deficits, at the time Peter Schiff was writing his book, Crash Proof, the U.S. current account balance was minus $200 billion. He showed a chart of the balance going from zero deficit to minus $200 billion between 1990-2005. He was railing that America is a nation of consumers, not producers. Since 2006 the current account balance has gone from minus $200 billion to minus $107 billion (the last reporting period, Q3 2012). What are some of the contributing factors to the balance deficit being cut nearly in half since Schiff was ringing the warning bell in 2006?

Thomas Boyle writes:

Manfred,

a) you're more likely to get rich by buying a lottery ticket than you are to change government policy by voting.
b) US citizens cannot "leave the jurisdiction". They must pay an exit tax, to buy their freedom. In effect, they are serfs.
c) is essentially what people mean by "no choice", since it means being subjected to violence. No-one threatened the bondholders with violence to get them to lend money to the government, but taxpayers are threatened with violence to pay for purchases they did not choose to make.

Tom West writes:

Wouldn't a complete US default result in the political destruction of current regimes in China and Japan, the two biggest debt holders?

If so, I would expect there would be a small, but non-trivial chance of catastrophic political consequence, up to and including action by the imminent losers to make the US "pay" for its choice.

Tom E. Snyder writes:

Those of you who oppose or don't believe a default (non-repayment of debt) is good, answer me this: when do you plan to pay off the $16 trillion and rising debt? If never, why continue to propagate the lie that you will? If you won't that's a technical default. Don't be left holding the Old Maid when it all comes down.

RogC writes:

Outside of devaluation of the currency, I don't believe any nation has ever paid it's debt once that debt reaches a substantial percentage of GDP. I doubt the USA will be the one to break the trend.

Mark Bahner writes:
John B. is exactly right. You can't conflate Treasury bonds with promises to SS and Medicare beneficiaries. They're two different things.

One also can't conflate real Treasury bonds (traded publicly) with "Special Issue" Treasury bonds (issued by one part of the government to another, ala the Social Security "Trust Fund").

Note that although I wrote that one "can't" conflate the two, Paul Krugman routinely does so. Disgraceful!

Mark Bahner writes:
Those of you who oppose or don't believe a default (non-repayment of debt) is good, answer me this: when do you plan to pay off the $16 trillion and rising debt? If never, why continue to propagate the lie that you will?

It's not absolutely necessary to pay down the debt, as long as the debt does not keep increasing...and especially increasing faster than the economy grows.

For example, if we have $16 trillion in debt for a $16 trillion economy, that's much more problematic than $16 trillion in debt for a $60 trillion or $160 trillion economy.

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