Over the years I have heard a number of conservatives suggest that defaulting on the national debt wouldn’t be such a bad thing. Today Prof. Glenn Reynolds of the University of Tennessee Law School (better known as “Instapundit”) suggests
the idea once again. Says Reynolds:
“SO HERE’S A QUESTION: Would a default on Treasuries accomplish what the Balanced Budget Amendment was supposed to achieve, by forcing the government to spend no more than it takes in? With more collateral damage, of course. . . .”
There are an absurd number of false assumptions and premises inherent in this point that I don’t have time to go through, but here are a few.
1. The Treasury can never default on the debt; it’s simply impossible. (Editorial note appended below.) Here are some reasons.
-- First, unlike private borrowers who are constrained by the amount of interest they are willing to pay, the Treasury has no such constraint. It will always pay whatever the market requires, crowding out all private borrowing if necessary.
-- Second, the Federal Reserve will always step in to ensure the success of a Treasury bond sale. Although by law the Fed cannot buy Treasury securities directly from the Treasury, it can assure primary dealers that it will soak up any excess supply in the secondary market.
-- Third, long before we ever came even remotely close to a situation in which markets even suspected the possibility of default we would have economic conditions that would guarantee some sort of massive fiscal tightening. In particular, interest rates would be vastly higher than they are today, which would make even the most painful deficit reduction measures—crippling tax increases, in particular, as I have explained elsewhere
—seem painless by comparison.
2. Even if the Treasury somehow defaulted—that is, failed to make a timely interest payment—it would not achieve what Reynolds and other conservatives wish: an end to all federal borrowing and de facto imposition of a balanced budget by cutting all spending in excess of revenues. Unless one also posits that all federal taxes would simultaneously cease, the Treasury will still have cash flow with which to make interest and other payments required by law.
Not being an expert on the law regarding federal spending I don’t know the precise priority of claims. But certainly, interest on the debt would be first in line for whatever cash flow the government had. (See Stan's comment here
.) That means that interest on the debt would have to be close to 100% of federal revenues before the possibility of default would occur.
Keep in mind also that the Federal Reserve is, in essence, the federal government’s bank. When one cashes a federal check, the Fed pays it from funds the Treasury holds on deposit. In theory, the Fed could simply decide to give the Treasury some float and continue to cash federal checks even if sufficient funds were not immediately available. Since the Fed turns over all its earnings to the Treasury anyway, it could call this float an advance to get around legal restrictions. Keep in mind also that given the Fed’s vast holdings of Treasury securities, with which it conducts open market operations, any rise in interest rates will necessarily increase the Fed’s income enormously.
3. The disruption to financial markets, commerce and the well-being of all Americans from a Treasury default are really beyond my ability to fully describe. But here are a few points to ponder. Interest rates would skyrocket to unprecedented levels, which would cause a collapse of private borrowing and massive capital losses for all bond holders, which include pension funds, insurance companies and foreign central banks, among others. It might be impossible for pension funds to make payments to millions of individuals depending on them for life itself.
The economy would really grind to a halt long before interest rates got so high that default was even on the radar screen. And insofar as the Fed was forced to monetize the debt in order to support the bond market it would lead to hyperinflation. Is Reynolds really willing to turn the U.S. into Zimbabwe just to make a point?
In conclusion, the idea that we should default on the debt rather than raise taxes to deal with a looming fiscal crisis is simply absurd and, frankly, irresponsible. But considering how many absurd and irresponsible ideas are now common currency among the sorts of people who read “Instapundit,” I have to worry whether dimwits like Glenn Beck, Sarah Palin and Michele Bachmann won’t soon be parroting the idea that a default on the debt is preferable to any tax increase whatsoever. This is an idea that needs to be nipped in the bud.
In my haste to write this post I forgot about the debt limit. If Congress failed to raise it then default becomes a realistic possibility because the Treasury would lose the legal authority to issue new bonds. Since the debt limit would have to be increased at some point lest the government fail to have the cash to make Social Security payments and such, the only consequence of this temporary default would be to permanently raise the Treasury's borrowing costs due to the addition of a risk premium.
Mark Thoma thinks I am taking Reynolds too seriously. He's probably right that Reynolds himself was not serious in his suggestion. But I have heard the same idea advanced seriously on numerous occasions among conservatives. I would note that a Fox News poll on October 1, 2009 found two-thirds of Americans saying that the debt limit should not be increased.
Martin Wolf comments here.
Bookmark/Search this post with