All the Talk About Debt Default is Just Talk
In their 2009 book, This Time Is Different, economists Carmen Reinhart and Kenneth Rogoff singled out Australia, Canada, New Zealand and the United States as countries that have never defaulted, or more specifically, have “never outright failed to meet their external debt repayment obligations or rescheduled on even one occasion.” Of course, as they later acknowledged on the same page, there are other ways to default.
There is traditional default whereby creditors experience a “haircut” or a delay in payments, and then there’s a stealth default. Looked at in terms of stealth defaults, all those countries, including the U.S., have most definitely stiffed creditors over the years.
Reinhart and Rogoff in particular pointed to a U.S. default in the 1930s. As they wrote, “the abrogation of the gold (NYSE:GLD) clause in the United States in 1933, which meant that public debts would be repaid in fiat currency rather than gold (NYSE:GLD), constitutes a restricting of nearly all the government’s domestic debt.”
In short, the U.S. defaulted in 1933, and as evidenced by the dollar’s stupendous decline in value from 1/35th of an ounce of gold (NYSE:GLD) in 1971 (in private markets a dollar bought roughly 1/45th of an ounce of gold (GLD) at the time in question) to 1/1550th today, the U.S. has been in default for most of the last 40 years.
All this bears mention in light of Treasury Secretary Tim Geithner’s hysterical comments over the weekend suggesting we’ll see “catastrophic damage across the American economy and across the global economy” if a failure to raise the debt ceiling leads to default. Sen. Pat Toomey, though not an advocate of raising the debt ceiling, said much the same as Geithner in a USA Today op-ed from yesterday. Both doth protest too much. All U.S. creditors have known since 1971 ispersistent default by the U.S. Treasury owing to its poor dollar oversight.
Of course if what Geithner and Toomey say is true, the answer is very simple. Geithner’s Treasury collects far more than enough each month to stay current on Treasury interest obligations, so if default really would be the catastrophe that he says, he should make sure to put the U.S.’s creditors first in line for monies available, after which a Congress that’s really never cut spending (thanks to Larry Kudlow for clarifying this) in nominal dollars terms would have to find a way to make do with less money to spread around.
The above naturally begs the question why the Republicans are even negotiating at all. They talk an awful lot about the importance of smaller government, they’ve been handed a legal barrier that will necessarily make it small as interest costs on Treasury debt rises, so if they truly believe their own rhetoric, they ought to hold firm.
A government that borrows less tautologically means more credit will remain in the private economy, and with investment an essential driver of economic progress, the alleged party of growth could achieve a smaller government alongside more investment in the private sector in one fell swoop. The answer to the debt ceiling question seems obvious. Do nothing.
After that, it should be said that government defaults are the historical rule, as opposed to the exception, and as such investors in sovereign debt traditionally are compensated for the latter reality through higher interest rates paid on the debt purchased. As Reinhart and Rogoff observe, “For making loans to risky sovereigns, investors receive risk premiums sometimes exceeding 5 to 10 percent per annum” or, more to the point, the “premiums imply that creditors receive compensation for occasional defaults.”
The reply to the above might that U.S. debt is the opposite of risky, but given our periodic lurches toward devaluation since 1971, not to mention our “exorbitant privilege” that allows us to print money, the U.S. has for a long time been a debt risk. Investors and markets have suffered mightily these stealth defaults, but none led to a complete freezing of credit as today’s default worriers suggest. More realistically creditors are used to debt haircuts, they’ve once again been compensated for these shortfalls in advance (if not, their mistake is not a burden the taxpayer should bear), so if Treasury defaults or delays payment, we’ll all live, and likely prosper as an even less credible Treasury is put on a diet that will very much be the private economy’s feast.
Of course there’s a hidden reason why Geithner fears a default of the haircut variety, though it’s also the reason that investors needn’t worry that one would occur. Once again banks around the world have a great deal of exposure to Treasury debt, and assuming a haircut, many would quickly find themselves insolvent. Geithner et al wrongly fear bank failures, but because they do, they’ll certainly stay current on our interest obligations and a government that’s grown too large will shrink.
All of the above about banks is unfortunate given the historical truth that economies thrive on business failure for bad ideas being starved of capital, and poor bank managers being replaced by better ones. Also, not asked enough is why U.S. taxpayers are essentially on the hook to provide the world with an asset that at least in terms of the income streams it offers, will always pay. We’re subsidizing a safe haven for capital; one that is paid for on the backs of productive workers who could doubtless find better uses for their hard-earned money assuming a less wasteful Congress and Treasury.
Still, all the talk about default is just talk since history says we’ll continue to clip our creditors through dollar devaluations that will greatly harm economic growth. As for the other kind, Geithner has made it implicitly clear that a payment default of the more traditional variety is not in the cards, thus making it essential that happy talking Republicans who claim to believe in limited government walk away from the negotiating table as quickly as possible.
John Tamny is a senior economic advisor to Toreador Research & Trading, a senior economist with H.C. Wainwright Economics, and editor of RealClearMarkets and Forbes.