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The Plus Side Of Debt Default

Back in September, 2008 Professor Jeffrey Rogers Hummel gave an online presentation to Sterling Futures’ clients and friends on the state of the economy. In 1993 Hummel was the first economist to go on record predicting that the U.S. government will default on its obligations. At that time the prediction was considered extreme but now a number of prominent economists have started considering a possible Treasury default and some major credit rating agencies no longer consider U.S. government debt to be risk free. A recent article by Professor Hummel on the subject of default is discussed here in the Economist.
 
First some definitions. A default is when the government stops paying interest on its debt and a total repudiation is when the government says it is not going to pay off the debt in its entirety. Hummel’s argument for the inevitability of a U.S. government default can be summarized as follows:

 
– Governments used to be able to benefit from inflation by being the first to spent newly created money before it leads to a general rise in prices. However, because most money is now created privately by banks and other financial institutions, rather than by the government, inflation is no longer lucrative, at least for governments in the developed world.

 
– Federal tax revenue has bumped up against the 20 percent of GDP limit for well over half a century indicating that 20 percent is some type of structural political limit for federal taxes in the U.S. Consequently, raising taxes is not an option.

– Politicians have almost no incentive to rein in Social Security, Medicare or Medicaid.

Faced with a mountain of debt Hummel says policy makers have just two choices – repudiate the debt or engage in hyperinflation. Faced with that choice he argues that the Treasury will likely protect the currency and default on Treasuries, although Hummel says a more likely outcome is that the U.S. will honor Treasury debt but renege on its Social Security and Medicare obligations.

Even more interesting are Hummel’s thoughts on the consequences of default or debt repudiation. While acknowledging that the short run consequences would be painful he argues that the long term economic and political consequences could be beneficial. For example, a Treasury default would make it more difficult for the U.S. government to borrow money “a default is a balanced-budget amendment with teeth”. A default or repudiation would also reduce the amount of taxes required in the future which should lead to an offsetting increase in the value of privately issued assets such as stocks, bonds and future wages. Finally, a repudiation of Treasury securities held abroad would entail a long-run net gain for Americans as it represents a transfer of wealth to America from the rest of the world. While the exact timing of a default or repudiation is unknowable Hummel concludes that “within the next two decades, the U.S. government will likely default on its explicit and implicit promises.”

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“We’re getting closer and closer to the country going into default. We could be out of money by August 2nd. How many people are surprised by that? How many people are surprised we still have enough money to make it until August 2nd?” Jay Leno
 
“Debts and lies are generally mixed together.” Francois Rabelais
 
“Debt is the fatal disease of republics, the first thing and mightiest to undermine governments and corrupt the people.” Wendell Phillips
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About Malcolm Greenhill

Malcolm Greenhill is President of Sterling Futures, a fee-based financial advisory firm, based in San Francisco. I write about wealth related issues in the broadest sense of the word. When I am not writing, reading, working and spending time with family, I try to spend as much time as possible backpacking in the wilderness.

View all posts by Malcolm Greenhill

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2 Comments on “The Plus Side Of Debt Default”

  1. joffemd Says:

    While I agree that a Treasury default is a material possibility, I would place more emphasis on its immediate negative impact. As I discuss in my blog post entitled “Pro Bono Finance” (http://expectedloss.blogspot.com/2012/04/pro-bono-finance.html) , the last two sovereign debt defaults in advanced economies (those in Greece and Argentina) have resulted in multiple deaths. I expect that the fiscal and economic crisis attendant to the default of the world’s most systematically important government will claim many more lives. A US default is something to be avoided, not welcomed.

    Reply

    • Malcolm Greenhill Says:

      Marc, this is a tough one. I agree that a default would have many bad unintended consequences but, as Jeff points out above, it would also have good unintended consequences as well. There is certainly something attractive about the possibility of being able to wipe the slate clean, starting over without the awful burden of debt.

      Reply

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