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The Bear's Lair: Let's Get the U.S. Debt Default Over With

October 14, 2013

Why it’s inevitable and why postponing it will exacerbate its consequences.

Washington has been consumed by negotiations about avoiding a debt default. On all sides we are told how irresponsible and disastrous it would be to allow the United States to default on its debt obligations. That's quite correct: it would be irresponsible and disastrous. But given the fiscal and monetary policies of the last five years, and the slim-to-none chance of getting them reversed in the near future, such a default is inevitable in the long run. Thus we might as well get it over with, since the earlier we default, the smaller the amount of wealth and living standards that will be wiped out.

The excess of government debt isn't just a U.S. problem, far from it. The IMF's Fiscal Monitor "Taxing Times" released this week, sets out the bloating of government debt worldwide over the last five years.  U.S. gross public debt has increased from 73.3% of GDP in 2008 to a projected 106.7% of GDP in 2013, an increase of 33.4 percentage points, or 6.7 percentage points a year. That's not as large as the total deficits, because even if real GDP hasn't grown much, nominal GDP has, reducing the debt/GDP ratio. 

The 1970s, in this respect, were in retrospect a healthy period, in which the large budget deficits (but nothing like as large as recently) were wiped out by inflation, so the U.S. debt/GDP ratio actually fell. Compared to the 1970s, the last few years have seen even slower growth, low but not zero inflation and budget deficits (from the middle of this decade to be joined by rapidly growing social security and Medicare deficits) a multiple of their 1970s size. In consequence, the debt/GDP ratio has grown at a rapid clip. 

6.7 percentage points a year is a LOT; it's more than double the rate of growth of nominal GDP, which itself includes a chunk of inflation. Thus the rise in debt is swallowing more than twice as much as the economy generates in new output each year. Needless to say, this is completely unsustainable.

The problem is not confined to the U.S. Britain's problem is almost as bad; gross debt there increased from 51.9% of GDP in 2008 to a projected 82.1% of GDP, an increase of 30.2 percentage points, or 6.2 percentage points a year—again double the increase in nominal GDP, which in Britain has consisted almost entirely of inflation. This is not due to British "austerity"—policies since May 2010 have slowed the debt increase somewhat, but killed the economy, since they involved heavy tax rises and very few genuine spending cuts. 

The eurozone's performance as a whole has not been quite as bad—the debt/GDP ratio has increased by 25.4 percentage points, or 5.1 percentage points a year—still more than double the eurozone's feeble nominal GDP growth. 

Then there's Japan, with the world's worst performance other than the true basket cases like Greece. Japan's debt has increased since 2008 from 191.7% of GDP to 243.5% of GDP, an increase of a staggering 10.4 percentage points of GDP per annum, with debt absorbing around four times the feeble Japanese growth in nominal GDP. Abenomics isn't going to solve the problem either; the foolish Shinzo Abe recently announced that he was going to allow the modest increase in sales tax scheduled for May 2014 to go ahead, but would offset its effect with a special "stimulus" spending program of around $50 billion. Japanese politicians appear to have read no economist other than Maynard Keynes; far from being "stimulative," Abe's combined tax-and-spend program simply diverts massive resources from productive private uses to unproductive public uses. It will certainly shrink rather than grow the private sector, from which all tax revenues and government delights are ultimately derived.

Economic optimists will suggest we should take account of net debt rather than gross debt. By that standard the U.S. debt increase in the last five years is worse at 7.0% a year, Britain's worse at 7.4%, the eurozone's slightly better at 4.2% and Japan's also slightly better, but still terrible at 8.9% annually. However net debt isn't a very useful number when central bank after central bank is engaging in "stimulus" debt purchases; the fact that debt is located in the central bank rather than the market makes the financing problem temporarily easier, but doesn't alter the deficit that led originally to the problem, and may eventually lead to a massive new problem as the central bank's balance sheet collapses into ruin.

Skeptics will ask why this situation should end. After all, debt levels have been increasing for more than a decade, and the rate of increase has slowed considerably since the first stimulative enthusiasm of 2009-10. Current policies, with Janet Yellen likely to be confirmed to lead the Fed until January 2018 and Barack Obama President until January 2017, are presumably set for the next several years. 

On fiscal policy, the Republicans are proving themselves unable to make substantial progress, even when they want to, against the spending leviathan driven by the Democrats. On monetary policy, September's wimp-out on "tapering" of bond purchases, when you read the Minutes of the meeting, shows pretty clearly that absent a major outbreak of inflation, the Fed under its current or incoming management will always find an excuse to continue current levels of asset purchases, or even to increase them. The Fed's admirers, on monetary policy, including a substantial fraction of today's Republican Party, see no reason why this should be a problem. After all, if the Fed can sustain a balance sheet of $3.7 trillion, today's value, why should it not sustain a balance sheet of $8 trillion, its value in January 2018 if asset purchases continue as at present?

By 2018, U.S. gross debt will be 140% of GDP, at present rates of progress (the Congressional Budget Office has a much lower figure, but it assumes fiscal discipline and quite rapid growth with no recession). That's a fairly frightening number—it's higher than ever in U.S. history, above the 1945 peak. On its own, however, it does not suggest imminent default—more than a decade would still have to elapse until U.S. debt reached the levels of Japan today, or of Britain in 1815 and 1945, both of which were negotiated without default (helped by an impossibly austere government by modern democratic standards in the first case and by inflation and financial repression in the second).

However the global bond markets are interconnected and are becoming more so. Commentators on Japan's JGB government bond market remark that the vast majority of investors are domestic, but with the aging of the Japanese population, savings rates have dropped precipitously and are now very low indeed. Given the continued size of Japan's budget deficits, being increased by Abe's foolish "stimulus," an increasing proportion of Japan's debt must be financed internationally. This has two effects. First, it forces up Japanese debt yields, which in any case must rise from their current level of below 1% on ten-year debt as inflation takes hold. Second, it causes international institutions to cast a beady eye on Japan's finances. 

They won't like what they see. Based on the past five years, by 2018 Japan's gross debt to GDP ratio will be 295.3%, above the 1815/1945 British peak of about 250%, and even its net debt will be 184.5%, with a huge overhang of debt held by the Bank of Japan. That debt will have sagged in value as interest rates rise, and future prospects for international investors will be for more price declines and increasing risk. At that point, it won't matter what Japan's domestic savers do; even its gigantic government-controlled banks and insurance companies will not be able to offset a buyers' strike by the international market. Like Greece in 2010/12, Japan will be forced to default.

When Japan defaults international investors will examine much more carefully the debt obligations of other countries on a similar trajectory to Japan, just as Greece's default caused them to look skeptically at Spain, Portugal, Ireland and Italy. There will however be no sugar-daddy European Central Bank to bail out the U.S. and Britain; those countries' own central banks will be far too compromised by their gigantic debt holdings, and nobody else will be anything like large enough. A Japanese default will thus lead in very short order to U.S. and British defaults.

If default is inevitable within 5 years or so, it's much more sensible to get it over with quickly. The write-down on outstanding debt will be much less, as will the write-offs of other assets that are hopelessly overvalued in a world where the U.S. government cannot pay its debts on time. The inevitable deep recession will be correspondingly less painful. What's more, debt default will force the U.S. government to live within its means, running a budget surplus on a cash-in-cash-out basis, not created through funny accounting. 

The necessary reforms in entitlements would be made immediately, rather than being delayed until the Social Security and Medicare trust funds run out. Reforms would be made in such avenues of fraud as food stamps, whose recipients have increased from 28 million to 48 million in the last five years. (That 20 million increase compares with a 12.8 million increase in the number of unemployed, including those "not participating in the labor force.") Of course, the immense bloat in other Federal programs would be eliminated. President Obama would doubtless object and attempt to prevent this, but a government that has defaulted cannot borrow money, and must live within its means. If necessary, bailiffs from the People's Bank of China would seize the White House and evict the inhabitants.

Under current policies, a U.S. debt default is inevitable, probably within five years. Since we can't change the policies, we're better off defaulting now. Tea-Partiers, more power to your elbow!

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

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