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Dee-Fault, Dee-Fault!


Martin Hutchinson

A poll last week showed that 71% of Americans don’t want Congress to raise the debt ceiling from its current $14.3 trillion, a level the total of outstanding debt is expected to hit in March. According to conventional pundits, this is extraordinarily irresponsible, leading to a U.S. default on its outstanding debt. Yet as with many ideas the Beltway pundits claim are irresponsible, when examined more closely the idea has some merits for ordinary people.

For a start, while the Fed’s policy of quantitative easing is in effect, with the Fed buying $75 billion of Treasuries each month, the debt limit does not need to be increased in respect of these purchases. Instead of buying Treasuries in large amounts, and printing money in order to do so, the Fed can simply hand the Treasury the money it prints and allow it to spend it as it wishes. That doesn’t actually require Fed chairman Ben Bernanke to back a truck up to the Treasury building and unload box after box of $100 bills – everything is done by book entry. (If it did mean that, and a provision was made that the Fed chairman himself had to schlep the boxes, we might finally have a proper control over money creation – of course the politicians would simply respond by nominating a professional weightlifter as Fed Chairman!)

This would not work for very long; within a year or two it would produce hyperinflation, turning the U.S. into the 1923 Weimar Republic. It should be emphasized however that economically it represents no change in policy from the current one. In the old days, there would have been a difference in that the Treasury would under the current system have printed up $75 billion worth of beautifully engraved bonds per month, giving employment to worthy printers and engravers. In today’s book-entry world, even this minuscule economic difference would be lost. If current policies continue, the Weimar Republic’s fate lies ahead of us anyway.

A second alternative response to the debt ceiling, with a similar economic effect, would be to fund government spending through subprime mortgages guaranteed by Fannie Mae and Freddie Mac. Since these would be guaranteed by Fannie and Freddie, not technically part of the government, they would not count against the government’s debt ceiling. It might be objected that financing say a tank or a road through Fannie and Freddie would be outside their legal mandate, and that a tank in particular would be unlikely to make the mortgage payments.

The solution is that tried with success during the home mortgage bubble, the no-doc loan. The Department of Defense or the State of Illinois would simply sign the minimal paperwork used for subprime mortgages during the bubble, and the detail that the asset purchased is not housing need never be revealed, any more than the borrower’s lack of employment was revealed during the bubble. Theoretically you could finance the whole of government expenditure this way, with HEW signing for Medicare expenditures, the Labor Department signing for unemployment benefits and each department signing for loans to cover its bureaucrats’ salaries. However if it was felt that the lack of a tangible asset made the financing technique legally questionable, its use could be restricted to cases where the government actually bought something. Bureaucrats and welfare could then be financed the old-fashioned way, through tax receipts.

Thus through the financing techniques of modern Wall Street, the debt ceiling can be got round altogether, at least for a considerable time. Certainly there is no need for an immediate default on the government’s existing debt. Nevertheless, over time the effect of engaging in these questionable tactics might erode investor confidence in U.S. government debt, as well causing inflation. The Tea Partiers and others in the 71% of citizens who wish to prevent the debt ceiling from being raised will respond that this is the point: by this method the government will be forced to live within its means.

Not so fast. It’s one thing to return to budget sanity over a 5- or 10-year period by cutting spending and closing tax loopholes, as President Obama’s Budget Commission proposed. The gap can and indeed must be closed by this means, painful though it will be. Programs can be wound down, troops can be brought home, waste can be eliminated, functions can be hived off to the private sector, bureaucrats can be fired and assets can be sold. But all this takes time, far more time than is available in the modest period of cash flow fiddling possible after further debt issuance has been prohibited. At best, spending can be cut within a twelve-month period by a mere couple of hundred billion, nowhere near enough to close the trillion-dollar gap between revenues and expenditures. (That is why it was so irresponsible by both the Bush and Obama administrations, and by both the Hastert and Pelosi congresses, to increase spending as much as they did.)

If the debt ceiling is not raised, the funding gap can be closed, but the Tea Partiers are not going to like the means by which it is done. Taxes must be raised. Raising tax rates on the rich will be wholly inadequate; there are not enough of them, and the rich have lawyers and accountants who can at least defer their higher tax payments for several years, leaving the funding gap in place. Closing tax loopholes like the deductions for charitable donations and mortgage interest will produce revenue, and produce it fairly quickly, but at most a couple of hundred billion a year, nowhere near enough to close the gap.

By cutting expenditures harshly, raising taxes on the rich by enough to bring in revenue without making them flee the country, and by abolishing the tax deductibility of mortgage interest and charitable contributions, you might get to close half of the trillion dollar funding gap, say $500 billion. To close the other half there is only one remedy available, beloved by EU bureaucrats, a Value Added Tax. In today’s economy, a VAT with an exemption for food but little else would bring in approximately $50 billion per percentage point of tax. Being levied at each level in the commercial cycle, it would bring that money in more or less immediately, providing a cornucopia of cash for the Treasury’s coffers. Thus a 10% VAT would bring in around $500 billion annually. There would be a little wastage, but combined with a modest tax increase on the rich, removal of tax relief on mortgage interest and charitable deductions and draconian spending cuts, it would more or less close the current funding gap, at least reducing it to a level that could be handled by paying a few bills late.

Thus if a debt ceiling was taken seriously, and not evaded through Wall Street or Bernanke-esque financing, it would produce a 10% VAT and only moderate spending cuts. Not at all the result the Tea Partiers are seeking.

Suppose finally that the 71% who support refusal to increase the debt ceiling were able to exert sufficient political pressure on Congress to prevent the introduction of a 10% VAT and other unpleasantnesses, what then? In that case, once the resources of dodgy financing had been exhausted, default would be inevitable.

The political class will tell you that a U.S. government default would cause untold losses to the U.S. economy, bringing untold misery in its wake. However you have to remember that the political class itself has a vested interest in painting the default picture as black as possible. No longer would U.S. representatives be listened to with respect in global congresses, no longer would the United States have the greatest influence in international institutions, no longer would the U.S. be able to threaten recalcitrant third world countries with financial and even military sanctions. The cost to high government officials, the international jet set and the elite media, used to the immense prestige and glamour that comes through being connected with the world’s leading power, would be immeasurable.

However the cost to ordinary U.S. people would be considerably less. Here the example of Argentina, which defaults on its debt every couple of decades, most recently in 2001-2, is instructive. Argentina’s latest default has been followed by a period of great prosperity for all but the wealthy landowners and the urban elite. The peso’s devaluation has wiped out savings, but most ordinary Argentines did not have much savings. The collapse in the currency’s value, combined with the rising price of commodities has produced an export boom that has both financed a corrupt and expansive government and allowed wage levels to rise as GDP has increased at a rapid rate. It will all come to an unpleasant end, no doubt, once commodity prices decline, but it hasn’t done so yet and almost a decade has passed.

A. U.S. default on Treasury bonds would primarily affect their holders – mostly banks and foreigners. The dollar’s value would collapse, because the U.S. would have to export more than it imported, as finance for balance of payments deficits would no longer be available. However for the ordinary American who buys relatively little from abroad, the main result would simply be a period of relatively high inflation. The banks would apply for a bailout, but that would be impossible, as there would be no money to bail them out with. They would thus have to survive on their ordinary business, while pretending that the U.S. Treasuries on their books were still worth 100 cents on the dollar. Over a period, the banks would make enough money from gouging their customers to replace the losses, so no long-term harm would be done. U.S. troops would be brought home, U.S. contributions to international organizations and foreign aid would be suspended, but overall the agricultural, energy and mineral wealth of the U.S., together with its manufacturing and technological capabilities would ensure that the American people would retain relatively high living standards. After all, wealthy Asians would still buy iPads, and the U.S. would now be competitive as a center for manufacturing them.

In other words, the costs of default would fall mainly on high government officials and internationally-oriented media and other elites, while the costs of forcible budget-balancing would fall almost entirely on ordinary people, in the form of higher taxes. Refusal to raise the debt ceiling would thus exacerbate the conflict between the elites and the masses – and for the masses, a U.S. debt default, rather than a forcibly balanced budget, would be the more attractive outcome.

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