American Debt Default?

A few days ago the Congressional Budget Office released a long-term outlook on government debt. Their dire prediction: by 2050 the share of the federal debt that is held by the public will have risen to 195 percent of GDP.

This is a frightful outlook, but it is only the beginning of the story. First of all, it does not include the debt held by other government institutions – an omission that should give us all pause – and therefore does not tell us the full impact that the debt has on the economy. When creditors look at buying U.S. Treasuries, they assess the debt default risk based on the entire body of debt; to them, it does not matter if the debt is owned by the Social Security Trust Fund or by the general public. Therefore, to not include the entire debt in the CBO calculation is to cushion the story in front of Congress and the American people.

Secondly, the CBO outlook does not take into account the effect on debt costs from a deterioration of U.S. credit worthiness. On the contrary, when CBO Director Phillip Swagel commented on the report at a Senate hearing, he noted that the U.S. economy is the strongest in the world, that our currency is a world reserve currency and that this means we are not in any imminent danger of a debt crisis. This is a mistake, albeit from Swagel’s viewpoint an understandable one: if he would start talking about the United States losing its credit worthiness he would most likely repel a lot of the audience he now had.

There is a third component that was left out from the CBO report, namely a discussion of the policy alternatives that Congress now has. However, it is not that hard to put together a list of what options our legislators have: there are three bad ones and one good. The three bad ones are:

  1. Austerity. This means, plainly, spending cuts and tax increases in order to balance the budget. Contrary to libertarian conventional wisdom, it is not a good option. It means spending cuts without corresponding tax cuts, thus raising the price of government either in absolute terms – spending cuts are accompanied by tax hikes – or in relative terms. This last part is the one that libertarians tend to not grasp: even if taxes are not raised, a spending cut increases the price of government. If you pay $100 in property taxes for your children’s schools and the schools cut their budget from $100 to $90, you get a poorer-quality education for the same money. While it may seem desirable in itself, this change in the price-product relationship means that we get less for the same money, while we could have used the $10 for private-sector spending instead. By choosing austerity, Congress will depress the U.S. economy on a broad scale, with the same detrimental effects as I documented in Europe during the Great Recession and the austerity response there.
  2. Monetization. This is perhaps an even more dangerous path, where Congress relies on the Federal Reserve to purchase large chunks of its new debt by simply printing more money. There is a downward slope of increasingly bad effects from this policy strategy, a slope that the Europeans got on ten years ago but shifted away from when they took to austerity instead. Venezuela, on the other hand, continued printing money at breathtaking rates, eventually causing hyperinflation. As I explained in a recent EconTalk episode of my podcast, we are inching closer to that precipitous point. We are not on the doorstep of hyperinflation – not at all – but the fuse that makes hyperinflation explode is lit, and it is shorter than most people think.
  3. Debt default. Yes, this is now an option that is being floated around in Washington, DC. It is talked about quietly, but when it is mentioned it comes with an inconspicuous moniker known as “debt restructuring”. This means, simply, that the U.S. Treasury unilaterally decides to only pay back cents on every dollar creditors owe them. This is the Greek solution, one that would have epic repercussions on our economy and our ability to function as a country for decades to come.

The third option has been unthinkable in the U.S. debate – until now. The Greeks had the same experience; for those who do not believe that the Greek experience is relevant to the United States, I recommend my paper for the Center for Freedom and Prosperity on the Greek crisis (Part 1 and Part 2). To make matters worse, the debt crisis does not even have to become a real debt crisis to have serious ramifications: the mere suspicion that the federal government would consider “restructuring” its debt could spark a surge in interest rates. At that point the cost of debt rises accordingly, in turn aggravating the debt situation by accelerating current government costs.

When default concerns raise interest rates, Congress has only two options: to take rapid action to curb the worries among lenders, or accelerate monetization. If the latter measure is already being used – as is currently the case – it is already exacerbating default concerns. Therefore, once default concerns raise interest rates, panic-driven spending cuts will dictate the fiscal agenda for Congress.

A coming episode of EconTalk at the Liberty Bullhorn will discuss panic-driven spending cuts in contrast to the kind of structural spending reform that constitutes the only productive path away from our looming debt crisis.