"Why Default on U.S. Treasuries is Likely"

Matt Welch | August 6, 2009

That's the sobering title of a new paper by San Jose State Associate Economics Professor Jeffrey Rogers Hummel, published at the Library of Economics and Liberty. The summary of Hummel's thinking about the unthinkable:

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.

Whole thing here. Hummel wrote about "The Fed's Binge" for Reason in January, and is contributing to an inflation forum in the forthcoming October issue.

Comments

Rich|8.6.09 @ 8:53AM|#

It's Bush's default!

|8.6.09 @ 8:58AM|#

Good.

Tomcat1066|8.6.09 @ 9:00AM|#

OK, so...what would the results of something like this be? I mean, obviously we'll end up paying higher interest in the future if we can get loans at all, but I mean other than that?

|8.6.09 @ 9:01AM|#

We can use the Odious Debt arguement to justify it.

http://en.wikipedia.org/wiki/Odious_debt

|8.6.09 @ 9:03AM|#

Again, I'm reminded of the poor fiscal choices of the Weimar Republic before its massive case of inflation and general economic collapse. You can either get your act together--cut spending, balance the budget--or you can walk off the cliff. The damage runaway inflation and/or a Treasury default would do to the U.S. and to the global economy would be nothing sort of disastrous.

All anyone really wants is a little move towards fiscal responsibility. No one expects us to get the whole house in order or to eliminate all deficit spending.

Tim|8.6.09 @ 9:04AM|#

OK, so...what would the results of something like this be? I mean, obviously we'll end up paying higher interest in the future if we can get loans at all, but I mean other than that?

Double, triple or maybe higher interest rates, and massive, Zimbabwe, Wiemar Germany style inflation.

|8.6.09 @ 9:04AM|#

I thought Odious Debt was just the name of a Tool cover band

|8.6.09 @ 9:05AM|#

Subprime paper, dogs and cats sleeping together. . . .

|8.6.09 @ 9:06AM|#

obviously we'll end up paying higher interest in the future if we can get loans at all, but I mean other than that?

You might actually be able to come out ahead by saving money. That would be a nice reversal of a very long trend.

-jcr

|8.6.09 @ 9:08AM|#

I though "Odious Debt" was a Who song:

Odious debt--It's a put-on.
It's an odious debt.
It's an odious debt--It's a put-on.

Tricky Prickears |8.6.09 @ 9:15AM|#

Never underestimate the government's ability to generate income by raising taxes. Of course no politician in their right mind would raise taxes or cut spending during a recession. So, I imagine, timing will be everything. Will the government get it right? Suuuuuuuuuuuuuuuure.

Tim|8.6.09 @ 9:16AM|#

You might actually be able to come out ahead by saving money.

Wouldn't saving money work best in a deflationary environment, and buying hard assets on debt be best in inflation?

Rich|8.6.09 @ 9:21AM|#

Doc, nice thought; but think "personal debts of the regime that incurred them" would ever fly?

|8.6.09 @ 9:22AM|#

doom
DoooM
DOOOOM

Space Fiend|8.6.09 @ 9:46AM|#

As the article briefly notes, we're in bad shape, but the thing is, every other first world state is in as bad of shape or worse. Furthermore, a default on US debt of any sort would collapse the world economy completely.

I anticipate this eventually reaching a crisis point that involves all European and European political lineage bearing states getting together with an international solution, that will definitely lead to an erosion of national sovereignty and more government economic control.

T|8.6.09 @ 9:53AM|#

I anticipate this eventually reaching a crisis point that involves all European and European political lineage bearing states getting together with an international solution, that will definitely lead to an erosion of national sovereignty and more government economic control.

Wow. You're just full of good thoughts this morning. Are you gonna kick a puppy for an encore?

Mind you, I don't necessarily think you're wrong.

|8.6.09 @ 9:56AM|#

OK, so...what would the results of something like this be?

(1) Any future debt issuances would be hella expensive.

(2) The US Dollar would stop being a reserve currency forevermore, destabilizing our import/export trade and raising prices domestically for imported goods.

(3) Multiple nations around the world would feel enormous pain, including the British, the Japanese, and the Chinese.

(4) At a minimum, a massive global recession, and perhaps a bona fide global depression.

(5) I can't quite figure out the monetary impacts, but it might be a bout of severe deflation, followed by hyperinflation.

|8.6.09 @ 9:57AM|#

Oh, I forgot

(6) Gold at $5,000 an ounce. Easy.

|8.6.09 @ 9:59AM|#

I have often wondered if we as a nation can legally default on our debt. My reasoning is based on this section of the 14th amendment. Perhaps I'm just taking it out of context:

4. 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.

5. The Congress shall have power to enforce, by appropriate legislation, the provisions of this article.

|8.6.09 @ 10:08AM|#

Can't we just give California to the Chinese to settle the debt?

|8.6.09 @ 10:16AM|#

Quick solutions:

1) Make FICA fully progressive by removing income limit cap then put it in Al Gore's lockbox.

2) Means-based Medicare and SS reimbursement.

Yes, it sucks to be upper middle class or wealthy. Remains better than the alternative.

Oh yeah, 3) The election of a majority of politicians who will redefine gov't obligations to their rightful roles and reduce spending. HAHAHAHAHAHAHAHAHAHAHAHA.

|8.6.09 @ 10:20AM|#

I heard an interesting piece on National Public Radio yesterday extolling the virtues of... *Canada's* bailout. Yes they liked the fact that we're spending only 2.5% of GDP but we're spending it all in one year, making it actually viable as a stimulus.

The U.S. package, on the other hand, spends 5% of GDP but spreads it out over three years, making it pretty much useless for stimulus purposes. NPR went on to declare the U.S. stimulus as "looking more and more like a failure." And they pointed out that the stimulus is little more than gravy for Democrat special interest groups.

Hooray! Now if only we could get ourselves up here in Canadia to stop referring to ham as "back bacon"...

|8.6.09 @ 10:20AM|#

RC is right about the effects of a US debt default. That is why it won't happen. What will happen instead is there will finally be real entitlment cuts. You could do the two things listed by T-Bone and then made medicaide into a catastrophic health insurance voucher program and avoid bankruptcy. The pain assoicated with those changes would be a lot less than defaulting on the debt.

|8.6.09 @ 10:21AM|#

NPR is admitting that the stimulus was a failure? That doesn't bode well for the Dems.

Xeones|8.6.09 @ 10:26AM|#

Now if only we could get ourselves up here in Canadia to stop referring to ham as "back bacon"...

But that's one of the most charming features of America's Hat!

kilroy|8.6.09 @ 10:30AM|#

You can bet that any real threat of a default will be the genesis of a Global Currency, most likely with a Global Reserve.

|8.6.09 @ 10:49AM|#

I think some form of fiscal responsibility will be forced on the government, simply because to walk right off the cliff--taking the rest of us and the world with them--would mean that whatever party did the walking would cease to exist. Yeah, it's that big of a deal. Self-preservation usually is what saves us from these situations. I mean, self-preservation for politicians, not the country.

Incidentally, a lot of people talk like China is calling the shots or is immune from all of this. China's economy will likely be destroyed if the U.S. defaults, due to all of the repercussions that a default would bring. Again, I don't think this will happen, but any country that depends on U.S. and European consumer consumption is in jeopardy.

|8.6.09 @ 10:56AM|#

The US defaulted on its debt back on August 15, 1971.
Its creditors are only now beginning to allow themselves to believe it, though.

|8.6.09 @ 10:58AM|#

Is that when we dumped Bretton Woods?

|8.6.09 @ 11:03AM|#

Yes. It's when Tricky Dick announced the US would no longer pay gold to (foreign) bearers of dollar bills, i.e. would no longer pay money to people who held our IOUs. "Gold is money, and nothing else." --JP Morgan

|8.6.09 @ 11:18AM|#

You can bet that any real threat of a default will be the genesis of a Global Currency, most likely with a Global Reserve.

Already in the works, as the Chinese begin tunneling their way out of the soi disant "dollar trap."

Eric Hanneken|8.6.09 @ 11:18AM|#

RC is right about the effects of a US debt default. That is why it won't happen

I think this is the nub of your disagreement with Jeff Hummel. The U.S. government (and other governments around the world) are going to have to choose between contracting the welfare state, and contracting the welfare state after a financial apocalypse. Jeff thinks the former is unlikely, because he believes the crisis will happen suddenly, taking rulers by surprise. Up until then, they'll keep building entitlement programs, because it will be politically expedient. If the crisis develops slowly, you may be right.

|8.6.09 @ 11:20AM|#

Has no one yet linked to the Onion?

|8.6.09 @ 11:37AM|#

(6) Gold at $5,000 an ounce. Easy.

At which point the govt makes it illegal to own gold and confiscates yours.

|8.6.09 @ 11:38AM|#

The U.S. will not technically default on its obligations. It is true that in 1971 we did default, but we weren't on fiat currency then. We will simply devalue the $.

1:1 with the Renminbi in 20 years.

|8.6.09 @ 11:49AM|#

How will the dollar be devalued, when it is already nonconvertible into anything of value? I have an idea, but what do you mean by this?

|8.6.09 @ 12:58PM|#

How will the dollar be devalued, when it is already nonconvertible into anything of value?

The usual stunt with banana kleptocracy currencies is to simply announce that yesterday's $10 is now $1, and require everyone to exchange their currency at the new ratio. Not sure how that works in a digital world.

T|8.6.09 @ 1:12PM|#

Not sure how that works in a digital world.

Even easier, as the bank just does it for you.

JB|8.6.09 @ 2:19PM|#

Guns & ammo are becoming a better investment every day of this Joker's presidency.

|8.6.09 @ 3:05PM|#

That's not really devaluing the dollar, but just replacing it with a "new dollar". Devaluation must occur so that the existing currency buys less stuff, allowing debts to be more easily paid off. Replacing the old dollar with a new more valuable dollar, will not help, since the existing debts are denominated in old dollars.

When the dollar was defined in terms of a weight of a commodity, you could take dollars to the Treasury and exchange them for that commodity.

Before 1971, the government could devalue the dollar by officially changing the ratio of dollars to gold, from say 20 dollars per ounce to 35, in 1933. When Nixon officially reduced the value to zero ounces of gold, that devaluation reached its endpoint. You cannot reduce the value below zero.

So what do you get now, when you take your dollars to the Treasury? Instead of getting a commodity like gold, you get the promise to pay you more dollars later. This is debt based money, and its value is determined by the interest rate, that is, by how many dollars you will receive later.

We are now at the point where the Federal Reserve, which is the sole source of money in our society, has reduced its interest rate to zero. That is, for its special class of borrowers, the cost of obtaining money from the Fed is zero: They can get money from the Fed now, and pay back the same amount later. They get free use of the money. For these borrowers (which are the big banks), the money is free.

So what gives the dollar is apparent value? Only the fact that it can be exchanged for stuff. You can still exchange dollars for gold (or other commodities) on world commodity markets. In this sense we are still on the gold standard. The government and the Fed set the value of the dollar by manipulating the prices of key commodities (gold, silver, oil etc.) on world exchanges to keep prices "stable".

All the government has to do, to devalue the dollar, is change the target managed price ranges for key commodities like gold and oil. This can be done suddenly for maximum effect, with key players forewarned so they are protected from the adverse side effects. Conveniently, the sudden change in prices for everyone else, can be blamed on "speculators" or "OPEC" or any other external factors. But, since the Fed and the government define and control the supply and distribution of money, a general rise in prices will be due solely to their actions.

Which is what I think is going to happen.

Invisible Finger|8.6.09 @ 3:31PM|#

You aren't cynical enough.

First we'll have 10 years of protectionism.

Then we'll remove our protectionism in exchange for not paying back what we owe.

Invisible Finger|8.6.09 @ 3:33PM|#

They can get money from the Fed now, and pay back the same amount later.

No.

They can get money from the Fed now, deposit it at the Fed, the Fed pays interest on those deposits, and THEN they pay back the original amount later. In effect a below-zero interest rate.

|8.6.09 @ 3:44PM|#

This can be done suddenly for maximum effect, with key players forewarned so they are protected from the adverse side effects.

How exactly can a bank, whose entire base of assets consists of mortgage, credit card, and other debts (whose value would be ruined by such a devaluation event), "protect" itself with this foreknowledge? Aren't people going to ask some questions if they just go into the commodities markets and start buying gold and oil futures?

|8.6.09 @ 3:48PM|#

Or they could also loan it to others, at a higher rate of interest, if they could find someone they wanted to loan it to. There is no cost to them of obtaining the cash. It is free to them.

That's what banks do, borrow at one rate, and lend out at a higher rate, which means as you point out, a net below zero rate.

And by the way, the banks can loan out more money than they have on deposit, by the reserve ratio of 10:1. So the dollars they get, whether from you depositing your paycheck or the Fed loaning them the money, when lent out, earns them much more than merely the difference in the deposit/lending interest rates.

|8.6.09 @ 4:15PM|#

How exactly can a bank, whose entire base of assets consists of mortgage, credit card, and other debts (whose value would be ruined by such a devaluation event), "protect" itself with this foreknowledge?

By getting backstopped by the Fed and the Treasury with sufficient amounts of bailout funds. Neal Barofsky, the Inspector General for the TARP program, recently commented that the cost of that program, originally pegged at $700 billion or thereabouts, could reach $23,700 billion (but that was the high estimate).

Aren't people going to ask some questions if they just go into the commodities markets and start buying gold and oil futures?

They have been, and are, asking questions. See the voluminous literature at GATA.org. Or, watch the YouTube video of Congressman Alan Grayson grilling Ben Bernanke on where exactly $500 billion in funds the Fed created and gave to foreign central banks in 2008 went.

Here is an interesting piece on the Fed boosting stock prices by giving (sorry, "loaning money at basically zero interest rate") to its large member banks, who then go out and buy lots of stock:
Fed Laundering Money Through Big Banks. Looks like green shoots, doesn't it?

And then there's this well written article on the history of the current crisis, talking about how interventions by the Fed and the Treasury twice averted total financial collapse over the last year and a half. The gist of the article is that, by suddenly creating and distributing multiple trillions in cash to failing institutions around the world, the Fed and Treasury averted bankruptcy of the entire world economy. The downside, also mentioned in the article, is that this flood of new money will cause massive inflation down the road, when it starts to be lent out or used to buy stuff.

Tim Cavanaugh|8.6.09 @ 4:44PM|#

Was the United States considered a good credit risk in the late 18th and early 19th Century? The McCullough John Adams book left me with the impression that it was hard to get anybody except the king of France to lend until after the Revolution was over. I know the War of 1812 was plagued by budget problems and I believe left a substantial debt.

That bit from the 14th Amendment holds the government to its debts while forcing lenders to the Confederacy to lose their investments. That seems to me the right move for an unconditional victor to make: Reassure your own creditors while punishing third parties who sided with your enemy. (To the extent you can tell them apart: In many cases your creditors and your enemy's are the same people.)

So at what point did the U.S. become the world's favorite borrower? How long does it take a country to establish a credit record?

|8.6.09 @ 6:12PM|#

The downside, also mentioned in the article, is that this flood of new money will cause massive inflation down the road, when it starts to be lent out or used to buy stuff.

And this, of course, is why the Fed and the U.S. government *cannot* simply restart inflation: because people are moving to a new conservative frame of mind and simply will not come forward to borrow the funds which are offered.

Was the United States considered a good credit risk in the late 18th and early 19th Century? The McCullough John Adams book left me with the impression that it was hard to get anybody except the king of France to lend until after the Revolution was over. I know the War of 1812 was plagued by budget problems and I believe left a substantial debt.

Actually, when the coin of the realm was gold and could not be manufactured out of thin air, the federal government had to go to the nation's banks begging, hat in hand, for loans when it was short on cash needed to meet its obligations. This happened repeatedly in the nineteenth and early twentieth century's. James Grant's Money of the Mind is an excellently written and detailed account of this glorious pre-Bretton Woods period.

|8.6.09 @ 6:13PM|#

Ugh, I have been really screwing up with my apostrophe's lately. Time to go review Bob the Angry Flower's guide.

|8.6.09 @ 6:36PM|#

And this, of course, is why the Fed and the U.S. government *cannot* simply restart inflation: because people are moving to a new conservative frame of mind and simply will not come forward to borrow the funds which are offered.

That's what I used to think, too. Except, the trillions of dollars needed to make all these institutions around the world solvent again, must be created and put out there, to keep the world system from crashing. And these dollars cannot be called back, for that would make them insolvent again. So there they sit, waiting to be deployed. Maybe not by lending to unwilling borrowers, true. But banks and other institutions need not make use of them by lending them out: They can also use them by buying stuff, from commodities to shares to anything else they think is worth having.

And when they use these dollars to buy stuff, they will not be making themselves insolvent again, because the assets they purchase will be worth something, and be carried on their balance sheets as capital, but not in the form of cash balances.

As these purchases are made, the dollars will leave their current holders, and enter the general economy. This is when prices will start to rise.

The Fed and the other central banks have already created trillions in new money, to keep the system from crashing. This is what central banks are designed to do: halt bank insolvency by creating and deploying cash. This is (monetary) inflation. And, since there are still many more bankruptcies ahead of us, many more trillions will be created before this phase of the crisis is over, and systemic bankruptcy is put behind us.

But the new money will be spent or lent by its new owners, and when this happens, that is when we will see price inflation.

The new money will flood into the economy when we hit bottom, as defined by a slowing of the bankruptcy rate.

First comes the crash, which prompts the monetary inflation. The new money sits in place until near the bottom of the crash. Then, it comes flooding out, causing price inflation.

qwerty|8.6.09 @ 8:22PM|#

Jeffrey Rogers Hummel, I will bet you $10,000 that the Federal government will not default on its debt in the next 10 years. I'll even give you 2:1 odds. I'm serious. Give me a call.

perilisk|8.6.09 @ 10:55PM|#

We can't default on our debt until we get better implantable neural control devices. We owe Neal Stephenson that much.

OU812|8.6.09 @ 11:45PM|#

qwerty | August 6, 2009, 8:22pm | #
Jeffrey Rogers Hummel, I will bet you $10,000 that the Federal government will not default on its debt in the next 10 years. I'll even give you 2:1 odds. I'm serious. Give me a call.

That depends on what you mean by "default." Paying a debt using worthless dollars is a de facto default, but a slick lawyer can make the case that this isn't legally considered a default.

qwerty|8.7.09 @ 12:55PM|#

That depends on what you mean by "default." Paying a debt using worthless dollars is a de facto default, but a slick lawyer can make the case that this isn't legally considered a default.

True. I think there is some chance that the government might "monetize" the debt: jack up inflation so that the real value of the debt is less. However, Hummel is claiming that the government will simply stop paying its debts, and I don't see that happening.

|8.10.09 @ 1:36AM|#

The US defaulted on its debt back on August 15, 1971.

That's when the USA defaulted on its debt to foreigners. The government defaulted on its debt to US citizens when it reneged on redeeming gold certificates for US citizens.

-jcr