Friday, September 11, 2009

Bruce Bartlett on the risk of a U.S. government debt default

In his column today, he says - and I completely agree:

"[M]arkets have always assumed that the federal government would raise taxes as much as necessary to prevent a debt default. That's the primary reason why U.S. Treasury securities are assumed to have zero default risk.

"This was a reasonable assumption in the past, but I'm not sure if it is going forward because the Republican Party is now totally dominated by anti-tax fanatics utterly opposed to raising taxes for any reason. Although most Democrats would probably raise taxes if they could, they are terrified of being attacked by Republicans if they do. Barack Obama is so fearful of such attacks, he insists that taxes will never rise on any group except the rich, even if this means extending most of the Bush tax cuts.

"I don't think financial markets have yet priced into interest rates the possibility that Republicans would rather default on the debt than raise taxes. Although they may not control Congress or the White House any time soon, it is clear from the health care debate that they and their allies at Fox News and talk radio effectively dominate the policy agenda even on issues like health that are generally favorable to the Democrats.

"If Republicans gain seats next year, which is very likely at this point, they will have veto power over any tax increase. Should Democrats attempt to raise taxes, we will see a replay in Washington of the budget debacle that recently transpired in California, where the state was reduced to paying people with IOUs.

"In short, the fiscal situation going forward is even more precarious than it appears at first glance--and that's extremely bad. If I am right about Republican opposition to tax increases, default on the debt has to be considered as a real possibility."

Time to get a massive short position in U.S. government bonds. Or, since that's prohibitively costly, do what? Buy inflation-indexed bonds on the view that they'll eventually be paid? (Don't bet on it.) Buy gold?

3 comments:

Andrew said...

I suspect I may have been directed to the following paper by this very blog but, in case not, I thought this would be of interest to your readership:

www.econ.berkeley.edu/~auerbach/fiscal_future.pdf

Figures 8 and 9.

Very much enjoy your blog.

Andrew said...

Since, the link appears to be cut off, the paper is: "The Economic Crisis and the Fiscal Crisis: 2009 and Beyond"

indyresolve said...

Well, my gut tells me that as an alternative to default we'll use one-off currency debasement as the traditional remedy of an over-leveraged society that gets to pay its bills in its own currency.

All the FED has to do is fail to fail to completely mop-up the tsunami of liquidity it has created in response to this crisis.

I can already hear the justifications trying to maintain central bank credibility and to keep future inflation expectations "anchored":

"We had no choice but to create all this extra cash to save the economy - and it's profoundly difficult to clean it up later, you can't blame us for that. Yeah, we've inflated 25% over 4 years, but that's a one-time phenomenon - and now we have it completely under control again.

Anyway, we were experiencing persistent imbalances with places like China (who, by the way, owned most of our foreign-held debt) and this has 'corrected' that problem.

Furthermore, so many of our citizens were over their heads with debts (and we had guaranteed the survival of the banks) that this effect solved the house-price mortgage problem. So you see, future inflation is bad, and we'll prevent it. But this recent past hyperinflation was good! Get it?"

Then again, many of our obligations are supposed to be paid out in real terms - Social Security is indexed to wage-inflation, and health care must be delivered in the form of actual drugs and medical services.

At any rate, I prefer the "total public debt outstanding" figure of 12 trillion to the 7.5 trillion "debt held by the public" number as a better measure of our future obligations. We'll be at 500 billion in interest a year soon enough - about 1/30th of GDP.

I wonder at what fraction interest to output causes countries to lose their ratings, or even what levels are typical of countries at the moment they decide to debase or default...