The Inevitability of Default?

From Buttonwood:

While Greece continues to inch its way towards a [now completed] deal with its EU partners, the creditors of a much-larger debtor, the US government, appear to be untroubled. Ten-year Treasury bonds still yield just 2%. But the issue of how the US addresses its long-term fiscal problems is, as yet, unresolved. A series of papers from the Mercatus Centre at George Mason University in Washington DC, called “Tipping Point Scenarios and Crash Dynamics” attempts to address the issue.

Perhaps the most provocative paper comes from Jeffrey Rogers Hummel who reasons that default is virtually inevitable because a) federal tax revenue will never consistently rise much above 20% of GDP, b) politicians have little incentive to come up with the requisite expenditure cuts in time and c) monetary expansion and its accompanying inflation will no more be able to close the fiscal gap than would an excise tax on chewing gum. Most controversially, he argues that “the long-term consequences (of default), both economic and political, could be beneficial, and the more complete the repudiation, the greater the benefits.”

Why does he take this view? Allowing for the Treasuries owned by the Fed, the trust funds and foreigners, total default could cost the US private sector about $4 trillion. In contrast, the fall in the stockmarket from 2007 to 2008 cost around $10 trillion. In compensation, however, the US taxpayer would no longer have to service the debt; their future liabilities would be lower.

It’s nice to know I’m not just one lone voice in the wilderness.  But I think most readers already knew most of this. There is significant empirical evidence that when the problem is excessive systemic debt, neither austerity nor inflation are sufficient tools to really reduce the debt. Austerity tends to bring the problem to a head, while inflation tends to kick the can down the road. The latter may stabilise the system, but as we have seen in Japan, this does not necessitate recovery. If we want real debt erasure, we need measures that really erase debt.

By building a new system we can open a window onto whole new world of possibilities for reform. One possibility is the return of Glass-Steagall-style separation between investment and retail banking, and a complete ban on complex derivatives contracts.

And there is nothing morally wrong with default. Investors in government debt should do their due diligence, and be aware that for all the political bleating and obsequious promises from politicians, ratings agencies and Warren Buffet there is always a risk of default with sovereign debt. Debt is only ever as good as its issuers ability to generate sufficient revenues.

There was never any guarantee that this era of unrestrained credit creation, globalisation, job migration and American imperialism could go on forever.

19 thoughts on “The Inevitability of Default?

  1. I’m not sure humungous bubbles are the result of limited restrictions upon credit creation. More likely it’s the limitation of normal fears created in a market in which default is allowed. Natural risk should limit excessive bubbles and allow smaller ones to burst.

  2. I can pretty conclusively say that bubbles — in particular the great monetary and bond bubble of 1971-today, as well as the greater shadow banking and derivatives bubbles are a direct result of unconstrained credit creation.

    Until 1971 the money supply was constrained. Afterwards, it began to explode:

    More likely it’s the limitation of normal fears created in a market in which default is allowed.

    Where do you think the limitation of normal fears is stopped? I’d argue that it is stopped by a central bank’s promise to jump in and print lots of money and bail people out. You strip away that ability and you put the natural fear back into the marketplace.

    • Aziz, I think you are probably right but I don’t know that 1971 is so key. If you look at your chart on a log scale it appears the crazy growth in the money supply was in effect before 1971. Wish there was data going back to Bretton Woods or creation of the FED

        • Well prior to 1971 there was growth in the money supply, to the extent that other countries wanted to exchange their dollars for the contents of Fort Knox at the gold window, which Nixon decided to cut off. 1971 was the date America made a policy of currency inflation explicit, and it’s the date Ron Paul and others cite. Perhaps it is more symbolic, and it’s the whole Keynesian era, but I think the point is clear.

    • “I’d argue that it is stopped by a central bank’s promise to jump in and print lots of money and bail people out”

      Precisely my point, and what else happened in 1971 enabling central banks to print unlimited supply? Hint : It has something to do with a yellow metal and Richard Nixon.

  3. Off topic, but your picture at the bottom gave me an emotional response.

    From a psychological point of view, a montage of greenbacks is more calming and relaxing (Green) versus a montage of Reminbi (Red).

    Perhaps this is why the chinese are such good savers. They panic and get scared when reaching for the “Red” as opposed to the US consumers reaching for the “Green”.

    Just saying.

    But it would be interesting times if the US defaulted. Usually Creditors expect the Government to back their commitments with the blood sweat and tears of their Subjects.

    The Elites letting their Subjects off the hook? Not a chance.

  4. Like Greece, a lot depends on WHO is defaulted upon. Inflation is a piecemeal default on those who aren’t first at the new money trough.

    • Inflation is a piecemeal default on those who aren’t first at the new money trough.

      Exactly. Anyway, inflation isn’t even likely to really achieve a default. Just a lot of debasement; the worst of both worlds.

  5. Hello Aziz, I have been reading your blog for a few months now and simply wanted to say thank you for sharing your thoughts. This blog is well written, and well thought-out which is quite refreshing considering the prevalence of MSM mindset one mostly finds. I wish I had your ability to convey thoughts so elegantly.

  6. Default seems like such a formality, really. The fundamentals have been clear for years and years as far as the United States economy goes. More enticing is the narrative of how it comes down: The excruciating loss of reserve currency status comes first — as the world seeks to rid itself of dollarization, sending that currency flooding back into the US. Step by step. Yesterday Turkey and China created their currency swap treaty for trade. And so it continues daily between nations. And one day the US will start another war to force global wealth back to Treasuries for safety — but it won’t come. The money will flow along the side channels through the capillaries of pre-arranged currency swaps that underwrite vital trade between nations. The US will throw a war — and no one will show up; just as it sanctioned Iran and nobody really cares. Its oil trade remains robust. That’s when, I imagine, default comes into play.

    Anyway, a pleasure to read the very interesting essays and commentary here — as always.

    • Excellent commentary. In the coming months I will be looking more and more into what default will look like. I think what you suggest is a very accurate vision of what is to come. Kissinger has an article up in Foreign Affairs that mentions the future shape of U.S.-Chinese relations, where he even mentions the emerging order of bilateral trade agreements that ditch the dollar. Sadly he ignores the depth and width of the problem.

      • I am long, USA Bride websites. All pun intended!

        Just like the Russians did with US sponsored money, the Russians are building websites for US buyers. Go to Macau and see how many US girls are there as cocktail waitresses.

        It is sad but true. A majority of women look for better opportunities when their economy collapses, and their men can’t maintain them in the life they have become accustomed.

  7. Pingback: The Gold Standard? « azizonomics

  8. Pingback: Austerity & Taxation « azizonomics

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