On Debt And Government Default

Let's talk default. When a government spends more than it has and refuses to cut spending to bring receipts in line with expenditures, it has to go where the money is to pay the bills. Where is the money? The money is in the hands of individuals. There are only three ways to finance a deficit; tax the money needed, print the money needed, or borrow it.

Taxation is an act of what use to be called "legal plunder". Printing money, i.e. inflation, is another form of confiscation, since all existing money becomes worth less. Only borrowing is a voluntary act between both parties. It's a contract between individuals, institutions, foreign governments and the borrowing government. One party agrees to lend the other a sum certain for a specific period of time and for specific remuneration. Of the three, borrowing is the only non-coercive way of raising money.

Implicit in borrowing and lending money is risk. The creditors are not assured they will get their money back. Even with the strongest credit rating and the firmest of promises and an ironclad guarantee, creditors at times lose money. They are defaulted on. All individuals who hold government bonds are creditors. The proposition that creditors cannot and should not be defaulted on by a government defeats the implicit risk inherent to such a contract.

One reason creditors like to lend to governments is they believe they rarely, if ever, default. Or do they?

The practice of government default is in fact commonplace. The US defaulted when it devalued the dollar against gold during the depression. First, Franklin Roosevelt confiscated the gold of US citizens before raising the price of gold and thereby devaluing the dollar. With a stroke of the pen Roosevelt wiped out the purchasing power Americans had abroad. Virtually overnight, it cost consumers more to import goods. At the same time he wiped out debt held by foreigners; the dollars and debts owed to them became worth far less in dollar devalued terms.

There were also devaluations against the dollar after WWII. Under the Bretton Woods system, nations agreed to keep their currencies at parity against the dollar and gold. Competitive devaluations mounted into the hundreds between 1944 and 1971. All were forms of default.

After WWII Russia defaulted on its debts, and Europe never repaid the loans it owed under the Marshall plan. US citizens paid those loans. The majority of debts owed to America were written off at zero to ten cents on the dollar by most nations of the world. Latin America inflated its currencies into oblivion, thereby never repaying their loans in real terms. Again, in effect, these were all defaults on creditors. Cyprus just announced its intention to confiscate savers money through a deposit tax. This is only the latest attempt to default on a promise to pay.

So the practice of government default is not new but in fact has a long tradition. What has been unthinkable-until recently-is that the US government might default. You can be sure that China, our biggest creditor, has been losing sleep thinking about this option. The US is running a structural deficit which is unsustainable. Greece serves as the latest example to all nations and creditors around the world that default is always on the table for any and all debtor nations.

Raising taxes is the present option of choice for the US to deal with its debt but will be met with strong resistance as it becomes clear that everyone will have to pay more taxes. The same goes for cuts to government entitlements and subsidies; again, everyone will be targeted. So, borrowing more and more is turned to more frequently to raise money whenever possible. Borrowing however, is only a viable option to the degree we employ the other two options. If you don't tax or cut spending, borrowing increases while your ability to borrow is reduced. This could lead to the ultimate default.

Many are saying we will default via inflation and that the Fed will just print money to pay off government liabilities, resulting in progressive inflation for years to come. I doubt this will be the case. Government may attempt to inflate but everyone knows about it. At the first signs of real inflation the bond market vigilantes will flee the bond market forcing interest rates to soar, just like we have seen in Europe. An open inflation is very difficult to pull off. If inflation rises suddenly and punitively, the dollar will cave, and the stock market would likely go into free-fall. An open inflation invites chaos, and a hidden inflation is virtually impossible to get away with today.

Further, the big entitlement programs are indexed to inflation. Medicare and Social Security are the largest entitlement programs and it isn't possible to eliminate those unfunded liabilities through inflation since most prices and services are tied to the cost of living. Government is on the hook for most price increases and so wouldn't gain much by inflating. The most likely debt resolutions will be in the form of cuts in government spending, tax increases, a little "politically acceptable" inflation, and selective defaults. And it will likely be a combination of all of the above.

A calculated default may or may not be launched against foreign governments. However, domestic defaults are a certainty. The US simply cannot pay off the promises it has made. So whether the defaults are on promises to pay unfunded liabilities under present contractual agreements, or by increasing the retirement age under the Social Security program, or changes to the cost of living adjustments on Medicare and Social Security; all are breaches of contract and therefore forms of default.

The term "claw back" describes a process by which promises are broken, a process that's becoming commonplace in today's world. So, pension plans and wages may be clawed back, i.e. reduced. Or, it might come in the form of not paying all pensions or even wages in a timely manner as California did when it issued IOU's instead of paying cashable checks. It can also come in the form of cutting days worked or by restructuring and amortizing debt so that creditors are not paid as promised over time.

For example, governments have been known to pay out only the interest promised on bonds and suspend convertibility of the principal. The Europeans have entered into a debt restructuring program that changes the terms of repayment. Of course we could see outright repudiation of all debt as was the case with most of the world toward the US over the last sixty years. But this, I think, would be a last resort. There are still too many ways to con a creditor into default rather than outright confiscation.

The Treasury forgave 1.6 billion dollars Chrysler owed to the government, which is us, the American taxpayer. Debt "forgiveness" is just a fancy word for a "back door default." Whether the government defaults on private companies or governments, it all leads to wiping out individual wealth, which only adds to the forces of deflation and anti-growth.

Yet governments continue to increase spending and debt as if there is no penalty and never will be. And creditors throughout the world follow suit as they lend to nations whose spending is totally out of control. With this kind of fiscal suicide being committed, we will be hearing a lot about debt "forgiveness" and "restructuring" in the future by all the governments around the world who insist they will never default on their debts.

Calculated default domestically will eventually be exercised. It's uncalculated debt default to foreign governments that is the Pandora's Box no one wants to open. It would lead to a breakdown of the international monetary system. This is a real possibility. In this scenario money loses confidence and ceases to function as a medium of exchange. Paper currencies become worthless as individuals lose confidence in their government's ability to pay. This is not inflation, this is not a rise in prices over time, this is not the 1970's where inflation rose from 2% to 12% over a decade; this is all credit and debt priced in paper currencies being defaulted on. Money would no longer be accepted for the payment of anything. This scenario usually begins with currency wars, then trade wars, and finally bank runs and defaults.

In that worst case scenario a new currency would have to be established that would gain the confidence of all people everywhere. A government currency would not be viewed favorably in a world of collapsing government paper promises. Something more tangible would be needed. Something like gold and silver coins, perhaps?

It's not possible to avoid all of these very unpleasant options. We will, however, be forced as a nation to endure one or more of them over the next few years. We are spending money on government services that we cannot afford. And remember, there is no formal budget. They did away with that long ago and are spending as much as they can via continuing resolutions and national debt extensions year after year.

One thing we can do, other than replace the politicians in power today (in both parties), is to get our personal finances in order. In these times, that may be easier said than done. Most of us are dependent on our social security, our Medicare, our subsidies, our investments in government bonds, and our pensions being there when we retire.

Just remember that most of these services and investments we are so dependent on are backed by only the "full faith and credit" of the federal government.