Blog Post: Can a country default on its debts? Can the US?

[MnMark]

John, I take your main point in this post to be: the U.S. cannot and will not inflate to pay off its debts; instead it will be forced to default on them.

After ridiculing people who think differently, you get down to explaining why you think this is so:

"The dollar is the world's reserve currency, and many, many trillions of dollars are held by people, businesses and governments around the world. This effectively means that it's politically impossible to inflate the currency to reduce the debt. "

You argue that the U.S. couldn't inflate the dollar supply because all those people holding dollars would be angered. What about all the people holding the Treasuries that would be defaulted on? You don't think there'd be some focused anger there? Political power is influenced by small committed groups or individuals with the resources to lobby and affect the politicians. The holders of Treasury debt are some of the most powerful institutions and individuals in the world. Do you think the political power of the masses, most of whom do not understand inflation anyway, is going to be enough to offset the political power of these Treasury-holding powerbrokers? I don't.

You argue that if we were going to inflate away the debt, why haven't we done it already? Well of course there are negative repercussions to inflating away the debt and there would be no point in doing it lightly or before being forced to because no one would buy anymore debt. So far the market has happily soaked up all the new Treasury debt being offered - so much so that rates are at historic lows. There's no need so far to engage in "quantitative easing", i.e., printing money, because so far there are takers for the new Treasury debt.

But when the amount of borrowing that needs to be done starts to exceed what the market wants to soak up, rates will start to rise - and then the Fed will start buying the excess Treasuries with printed money. I cannot foresee a situation where the Fed would sit by as new Treasuries were offered, and not bought up, and do nothing so that the debt has to be defaulted upon. And that is what would have to happen - the government would have to need to borrow more money than the market would want to buy, and the Fed would have to refuse to step in. Interest rates would skyrocket to the moon, business activity would crater as all available funds went to feed the high-interest-paying government borrowing, the total debt would start to grow exponentially to the point where the interest payments would be greater than what is taken in in tax revenues in a year, and the economy would collapse.

That will not happen. And besides the political power of the bond-holders, the reason it won't happen is because the U.S. is in the enviable position of owing debt to the rest of the world denominated in U.S. dollars, the supply of which it controls. It's different for a country that owes money denominated in someone else's currency - then default really is the only option unless someone with a lot of that currency (the U.S., the IMF) comes along to bail them out. Printing is not an option if the debt is in some other currency. But in our case we can print our way out of debt.

And printing is a much more politically pallatable option than default. Printing can be done gradually, relatively quietly. No single great printing event need alert people to trouble. A default however, is earth-shaking. It immediately throws the confidence in the country out the window.

According to your reasoning, no country would ever inflate in this situation. Because every country has holders of its currency who would be hurt by the inflation, so according to your reasoning, it should be politically impossible for any country to ever inflate. Yet they do, all the time.

A year or two ago we exchanged some emails where I predicted that because there is no real sense of fiscal restraint or respect for real capitalism and the free market's price signals left in our government, the government's response to the approaching fiscal crisis would be to bail out and nationalize companies and industries left and right. You ridiculed that idea, saying the government would never nationalize. Well that's just what's happened on a trillion dollar scale. And they're not done yet.

Already, in the last couple of Fed announcements, they've said they will consider buying long-term Treasuries - i.e. "quantitative easing", i.e. printing - if necessary to keep rates low. That is what will happen. When the government has to borrow the trillions of dollars they need this year, the Fed will step in to print in order to keep the rates down. They will do it in the hope that later on they can withdraw that printed money again before it causes inflation. But the exponential growth of the debt of the government will prevent it from ever being paid back and thus allowing the Fed to withdraw the printed money again. The printed money will be spent by the government on the massive pork programs Obama and the Democrats are planning, dispersed around the economy, and result in growing inflation especially as the supplies of goods for sale decreases as businesses go bankrupt.

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On an unrelated note, may I offer a suggestion for the organization of your forum: create a new category for discussion of your blog posts, with one forum topic for each blog post you make so that we have somewhere specific to post our comments about your blog post. Otherwise it has to go into some other existing category and gets lost.

Best Regards,
Mark

[MnMark]

But let me offer one more thought: a default would be the RIGHT thing to do. It would preserve the purchasing power of the dollars in the accounts of the savers and retirees. A bankrupt entity, whether government or business SHOULD have to default. But that's not what will happen. The easy way out is to quantitative easing, and the easy way is virtually always the way that is chosen by government.

[wtf]

But let me offer one more thought: a default would be the RIGHT thing to do.

That almost guarantees that the government will NOT do it.

"The dollar is the world's reserve currency, and many, many trillions of dollars are held by people, businesses and governments around the world. This effectively means that it's politically impossible to inflate the currency to reduce the debt. "

Politically impossible to inflate blatantly, but politically easy to inflate subtly or to feign hopelessness in controlling inflation.

[Higgenbotham]

According to your reasoning, no country would ever inflate in this situation. Because every country has holders of its currency who would be hurt by the inflation, so according to your reasoning, it should be politically impossible for any country to ever inflate. Yet they do, all the time.

I spent some time trying to figure out how to answer this in a way that hasn't already been done here. To do that, I'll have to start with this. Before on this forum, I've stated that no country in the situation of having the world reserve currency has ever been able to inflate their way out of a burst credit bubble despite heroic efforts to do so.

I understand this is not exactly what you are saying here. Basically I will first make the case that, historically, "no country ever could achieve the end result of inflation in this situation" even if they tried, which some did. I really don't know about the political impossibility of past historical situations. It does seem to me that the situation today could prove to be politically impossible, but even if it isn't, historical outcomes are not ultimately on the side of inflation in these instances.

Therefore, the premise is that countries that have been in the same situation as the US is now have historically tried to inflate their way out of a burst credit bubble, but have never been successful.

The 3 best examples that I can think of where a country had both the world reserve currency and a credit bubble are:

1. Britain 1720 (South Sea Bubble)
2. Britain 1825
3. Britain 1873

and possibly:

4. Britain 1772

5. Then of course we all know about 1929.

These are the only 5 I know of that fit this situation.

Number 1 fits our situation the most closely from an overall historical standpoint in my opinion. But in a lot of ways it's different too. One similarity, as John has pointed out many times on the website, is the fact that there was a generational unravelling period where the bubble was blown up even bigger and none of the other situations are similar in that respect, except for 1929. The others fall more into the K-Wave cycle. If I remember right, Britain and France had just been involved in The War of the Spanish Succession which ended around 1707 and both had piled up a lot of debt. This would be similar to the situation where the US and the USSR had been in the Cold War and both had piled up a lot of debt. Both Britain and France blew a bubble to try to work off the debt. I can't for sure remember the exact scheme but it seems like the British packaged the debt up and sold it as some kind of annuity in the South Sea Company, offering shares to the general public. Eventually the Mississippi Scheme blew apart first in France in 1719 and the result was hyperinflation. A year later, the South Sea Bubble collapsed and Britain, which had the world reserve currency, collapsed into deflation with the British stock market losing over 90% of its value in 2 years. In the current situation, the Soviet Union first blew apart and the result was hyperinflation. The US has been able to hold on for quite awhile with some of the new techniques Wall Street and Greenspan used to keep the bubble going but it appears it has finally blown apart.

Greenspan was quoted (if the source is authentic, which it seems to be) years ago saying that he knew K-Winter was coming and he was going to try to defeat it. The Central Bankers are getting better at holding off deflation after having had several go-rounds with it. Whether they will be able to defeat deflation here or not is a judgment everyone is going to have to make for themselves, but there isn't any historical precedent for making a judgment other than these 5 cases that I am aware of. The historical examples all say they ultimately can't inflate their way out.

Number 2 is interesting from the standpoint of some quotes I dug up from a source on the Internet regarding the great lengths that the British Central Bank had taken post 1825 to resurrect the bubble after it burst. They claimed to have tried everything they could come up with, but were unable to stop deflation.

Number 3 was a similar situation. A lot has been written about the post 1873 deflation and it was known as the worst deflation before 1929. I don't recall reading anywhere that inflation was attempted in this case, but it may have been. Again, Britain had the world reserve currency and the most notable thing I remember about the bursting of this bubble was that real estate prices fell every single year(!) for over 2 decades. The only price index I have for this period is for the US. Between 1873 and 1900, prices in the US fell 31% during this period.

Number 4 I haven't read enough about to comment.

Granted, the Central Bankers and governments today are much stronger than they were in the past and have some historical examples to work with. But in my view, their ability to hold off deflation only results in a bigger more unmanageable bubble that they are ultimately unable to resurrect.

Some of the other subjects to be addressed could be:

1. What do the US Treasury Bond holders really want? My guess is that they do not want the Fed to do quantitative easing. Russia hasn't said what they want besides to get the world off of the dollar standard, and I don't see how quantitative easing helps them get that, but a default probably would. More important than that is what China wants and I don't know the answer to that either. Russia has Topol-M SS-27 missiles pointed at Washington that are on hair trigger alert. The Chinese have nukes pointed at us too and have said they will use them. That may trump what the masses here want, which is quantitative easing, unlimited government programs, and so on. I mean, I really don't like making a statement like that, but power is what it comes down to. This situation hasn't existed before in history and seems to put a damper on Central Bank ambitions.

2. The Richard Koo argument that John has been putting forth for quite awhile here says that there will be enough domestic savings to finance the government debt because there is a 1 to 1 correspondence between domestic savings and what the government will need to borrow. I don't think Koo is right on everything, but it has to be considered that he might be substantially correct.

3. If the US needed to borrow money and could not get all the long term debt auctioned that they want to, then they can go down to the short end of the curve and auction it off there instead before going to quantitative easing. Granted, that is not really a solution and probably would not change anything in the long run.

4. Debt default will occur on corporate, municipal, commercial, consumer (credit card, auto, student loan), and prime real estate before it hits the US bond market. Post bubble episodes by definition always result in a widening of credit spreads as the market rushes to the relative safety of government debt. Government debt isn't safer than it was (before these other entities that are going bankrupt or have lost their source of income edge into default), just relatively safer, so that's where the money flows until the process is done. It hasn't been any different this time.

5. Finally, and this is an important subject that almost everyone seems to neglect when discussing this type of thing, is a large and sudden event outside the realm of economics. Pandemics, earthquakes, volcanoes, terrorist attacks, large industrial accidents, power grid lockups (due to solar flares or who knows what), and similar things that tend to occur generally during crisis periods or seem likely in this one tend to lead toward deflation and default because governments are unable to anticipate and instantaneously respond to them. At the beginning of each year, I try to take a fresh look at all of these events and add the probabilities of exceeding different dollar levels of loss according to expert opinions. It's a lot higher than one would think at first glance and seems to be increasing. This situation hasn't existed before in history from the standpoint of losses on the order of a trillion or more that have the potential to occur within a short time. Buffett (being basically an insurance man) pointed out a few years ago that the detonation of a nuclear device in a large American city is an almost certain occurrence within the next 50 years and his insurance policies specifically state that they don't cover it. Is such an event inflationary or would it tend toward default? My guess is almost definitely the latter.

Anyway, that's a start but it's not really complete. It outlines some of my thinking on the subject.

[StilesBC]

Higgs,

I regards to number 4. I think that is one reason why any of this is not likely to happen for a good amount of time (toward the end of the crisis - or even as a catalyst for the next awakening). As a percentage of debt/GDP (even though the latter is falling), the US is still far below where Japan is. And Japan is still seen as a low chance of default. As people gradually abandon risk and reduce debt, the personal savings rate will rise. It will probably rise far beyond the historical mean of about 6%. I wouldn't be surprised to see it above 10% for a time. This rise will facilitate the Treasury to issue far more debt without rising. In order for interest rates to rise, people's time preferences need to shift closer to the present. This is not something I think is plausible anytime in the near future.

The inflationists can't seem to grasp this. They think that an increase in debt MUST be commensurate with an decrease in the value of the dollar and an increase in the interest rate. But they are completely leaving out the tectonic (generational) shift in time preferences people have only started to undergo.

[Higgenbotham]

In regards to number 4. I think that is one reason why any of this is not likely to happen for a good amount of time (toward the end of the crisis - or even as a catalyst for the next awakening). As a percentage of debt/GDP (even though the latter is falling), the US is still far below where Japan is. And Japan is still seen as a low chance of default. As people gradually abandon risk and reduce debt, the personal savings rate will rise. It will probably rise far beyond the historical mean of about 6%. I wouldn't be surprised to see it above 10% for a time. This rise will facilitate the Treasury to issue far more debt without rising. In order for interest rates to rise, people's time preferences need to shift closer to the present. This is not something I think is plausible anytime in the near future.

I had posted this a few days ago in the other thread:

All that is necessary to end the stimulus effect is for the long end of the treasury curve (30 year bond for example) to rise as default risk increases due to increased borrowing. It is a time dependent phenomenon that will show up on the long end first and choke off the recovery....The long end of the yield curve acts like a boa constrictor and will exert its discipline. It constricts the private sector and results in job losses, slower real estate markets, things like that.

It seems like there is a feedback loop between private debt, savings and government borrowing. Some private debt gets liquidated, credit spreads widen and the savings rate goes up. There is a rush into government bonds (interest rates on government bonds decrease). Then the government responds to that with a program, default risk on government bonds increases, credit spreads narrow and some of the money leaves government bonds (so interest rates on government bonds increase some). Then another problem crops up in some other part of the private debt market and the cycle gets repeated. What may happen as that process is playing out is government bonds bounce up and down at a low interest rate even though default risk on them is increasing. The only reason government bond rates stay down is all the other forms of long term debt are even worse investments than long term government debt.

[MnMark]

Therefore, the premise is that countries that have been in the same situation as the US is now have historically tried to inflate their way out of a burst credit bubble, but have never been successful.

I am relatively unschooled on the financial history of the British crises you discuss. But off the top of my head, one thing they all have in common, I believe, is that Britain was on a gold standard. It did not have a fiat currency. I entirely agree that on the gold standard, the sort of crisis we are undergoing would result in deflation. The difference now is that the U.S. has the option of producing as many more dollars as it wishes at the stroke of a pen. To my knowledge there has never been a scenario like this before - a world-wide fiat currency. From what I have read, every fiat currency regime in history has ended in the currency becoming worthless because the soveriegn cannot resist printing more to address financial issues instead of taking the political hits that would occur if large scale defaults and bankruptcies occurred.

The current situation is a perfect illustration of that. Rather than let these bankrupt financial institutions collapse, the Fed has stepped in with unprecedented levels of newly-created money to support them. Obama and the Democrats plan to spend like mad, on a trillion-dollar scale.

Yes, there is a collapse in asset prices. All the things associated with deflation are occuring. But that is because there is a lag in time between the collapse and the effect of the trillions of newly-printed government money. That's why I find iTulip.com's "kapoom" theory convincing: first a period of disinflation because of the credit collapse ("ka") then huge inflation ("poom") as the newly printed money takes effect.

Some say that the collapse of the derivatives will be too massively large in scale for the Fed to print enough money to generate inflation. But you could have said the same thing about Zimbabwe twenty years ago, doubting that there could ever be such a thing as a 100 trillion dollar bill. But there is. I do not underestimate the willingness of politicians and political appointees, whose jobs depend on keeping the public happy in the short term, to take the politically expedient act. And the politically expedient thing to do is to print money rather than default.

Also, you argue that Treasury bondholders do not want inflation. I agree they don't. But if the choice is between inflation, which reduces the value of their holdings, and default, which completely ELIMINATES their holdings, I wager they would prefer inflation to a default every time.

You raise many points that are beyond my level of understanding to address and may be quite valid for all I know. This is just a couple of thoughts I had when reading what you had to say.

[Higgenbotham]

Here's a story from Bloomberg today that refers to item number 3 in that list of items from last night where I said the Treasury can go down to shorter durations if demand for long term debt starts to wane. It appears that's what they're already planning to do.

The Treasury may bring back the seven-year note, which it eliminated in 1993, as part of its plan to fund the stimulus....

Pond said the 30-year bond may “struggle.”

“On the long end, demand has been reduced over the past couple of weeks. If there is a greater auction size, it may be difficult for the market to absorb the duration at once,” he said. “The three-year note may see strong demand as short-end Treasuries continue to get bid on risk aversion.”

http://www.bloomberg.com/apps/news?pid= ... refer=home

[Higgenbotham]

...But off the top of my head, one thing they all have in common, I believe, is that Britain was on a gold standard. It did not have a fiat currency.

...Some say that the collapse of the derivatives will be too massively large in scale for the Fed to print enough money to generate inflation. But you could have said the same thing about Zimbabwe twenty years ago, doubting that there could ever be such a thing as a 100 trillion dollar bill. But there is. I do not underestimate the willingness of politicians and political appointees, whose jobs depend on keeping the public happy in the short term, to take the politically expedient act. And the politically expedient thing to do is to print money rather than default.

...Also, you argue that Treasury bondholders do not want inflation. I agree they don't. But if the choice is between inflation, which reduces the value of their holdings, and default, which completely ELIMINATES their holdings, I wager they would prefer inflation to a default every time.

I believe the gold standard was introduced in Britain in 1821, but I would also imagine that there may have been gold coin in circulation in the 1700s (see comments below for another example of that). That would be something that would need to be looked into some more. In my opinion, you are right that having a gold standard does make a difference. It seems very unlikely to me that this bubble that has basically occurred since the 1930s, 1970s or 1990s depending on how it's viewed could have been created under a gold standard. In theory, since the bubble got bigger than ever would have been possible under a gold standard, it could retrace more than occurred during any of the deflationary episodes of the 1800s, or, as you say, it has the potential to continue to expand.

The part about derivatives has been one of my reasons for thinking that this bubble cannot be reflated further because the derivatives came from the private market, dwarf what the government is capable of spending, and the derivatives are now basically eating a hole in the financial system that cannot be cured until the debt is liquidated. This is something that has never happened before either, although from what I can best understand (and things were so different then that it is difficult to comprehend) the 14th Century Florentine bankers and the 18th Century British were using crude forms of derivatives to blow their bubbles. The 14th Century provinces were also using gold and silver coin, but that didn't prevent a collapse of their banking system and deflation (edit--What I mean here is that gold and silver do not always equate to a stable banking system when there is other monkey business going on. Also, as I understand it, there were wild episodes of inflation and deflation before the banking system collapsed). South Sea Company stock was basically securitized government debt as I can best understand it.

The option between inflation and default is a time dependent question in my estimation. What I think the foreign holders of treasuries would like to see is for the value of their treasuries to be maintained for a few years until they get their act together enough to be ready to jettison the dollar standard, and then to see a default at that time, which would reset the system so they can establish an alternative. I think that's what Putin has been planning all along, but they're not ready yet.

[Higgenbotham]

One last comment about that article from Bloomberg about bond durations. Apparently, they're surveying to see what investors might be willing to buy. If they are willing to buy 7 year durations, but aren't as eager for 10 or 30 year durations, that might be telling us something right there. Just a thought, I have no idea.