One claim that I often hear around the blogs and tweets is that the US could never default because it borrows in its own currency. Greece defaulted because it borrows in Euros, and other EU countries have strong objections to the ECB printing money to pay off Greece’s debts. However, when the US debt comes due, the worst case scenario is that the Fed prints up the funds to pay off the debt. Problem solved.
I don’t think the US monetary-political system works that way at all. Let’s run through some back-of-the-envelope calculations. According to Wikipedia, before Greece’s default, it owed around €350 billion; the default constituted a €107 billion reduction in debt. Let’s call that ratio 30%.
Let’s suppose that the US had to print enough money to weather a Greek-style crisis. Could it cover 30% of its outstanding debt simply by printing the funds? According to the Treasury, as of last Friday, the US owes $10,820,230,118,370.38 to the public. To do so, it would have to print and introduce into circulation $3.25 trillion.
What would that do to the economy? According to FRED, as of last Wednesday, there are currently less than $1.1 trillion in circulation at the moment. So printing enough money to weather a Greek-style crisis would result in almost a quadrupling of the number of dollars in circulation. In the long run, if velocity is determined basically by technological factors, that means that we would expect prices to almost quadruple. This would represent a seizure of assets from holders of future nominal claims, which would be damaging to the economy. However, in the short run, the story is even worse. If I were concerned that the government was going to print $3 trillion, I would try to get rid of all my cash holdings and hoard real resources. So would everyone else. This could cause a hyperinflation even before the Fed starts printing money. Banks, too, would want to convert their nominal assets into real ones. And since real resources would be hoarded, they would not be available for use in investment projects. It would be an economic disaster.
If you want to salvage the hypothesis that the US could never default, you would make two points. First, the government need only credibly commit to printing money to pay off its debts if necessary. The fact that markets believe it would do so means that interest rates on Treasurys never get high and the fiscal burden of interest payments are bearable. Second, the economic effects of a default would also be pretty bad. Since an economic collapse is unavoidable either way, it is better if politicians credibly commit to printing the money if necessary.
However, I’m not sure that the government can credibly commit to printing instead of defaulting. Almost half of the US debt is held by foreigners. If you were a politician seeking reelection, would you not counter a proposal to inflate away $3.25 trillion of debt with a suggestion to default on debts held by foreigners? This would wreak economic havoc, but the worst damage would be borne by China and Japan, not by your own beloved constituents. I’m not saying this is a good idea, but to my mind the US political system, defective as it is, cannot credibly commit to not doing this.
The other factor that makes the situation worse for the US than for Greece is that Greece has an international consortium as a backstop to make credible loan guarantees. These guarantees are worth hundreds of billions of dollars. By no one can credibly guarantee the US’s trillions of dollars of loans. This means that while Greece’s crisis has played out as a slow and steady collapse, a US crisis would be more severe because it would happen much more suddenly.
My claim is not that the US is likely to default. Rather, my point is a narrow one: people who say that the US could never default because it borrows in its own currency are mistaken. They should either stop saying that or tell me why I’m wrong, which I would be happy to be.
Wouldn’t the govt restructure or default on internal debt to itself and to the citizens before defaulting on foreign debt? What effect would that have?
There are a couple of levels to this but lets just start with this:
There is no reason to restructure your debt if you can meet your payments. To meet you payments you only have to be able to roll over debt as it comes due.
Even if the US had for some reason to meet all of its payments with printed money this would come in at slower rate than 3.25 Trillion per year. That is if the US chose to print money to pay the debt.
However, the US does not have to do this. The Federal Reserve can purchase the debt, print excess reserves and then print money to have banks hold the excess reserves. Thus it only has to print enough money to pay the interest on excess reserves to cover payments on the debt as it rolls over.
If we are thinking 1.5T a year and an IOR rate of 5% then we are looking at $75B per year for the first year. This is far less dramatic, though in theory it could rise from there.
However, there would be no need and indeed no real operational way for this to happen.
On the second level you can think of it working like this: since the Federal Reserve can creditably commit to supporting rollover, you know that the bonds will in fact be rolled over. However, if they will be rolled over then if anyone tries to sell them at less than the prevailing interest rate, someone else will buy them because they are guaranteed a profit from rollover. Thus, the bonds are always sold.
However, it actually never goes that far. The third level is that the Federal Reserve does not target the money supply. It – during normal times – targets the Federal Funds rate. The *way* it targets the Federal Funds rate is by buying and selling T-Bills until the Funds rate hits target.
So in the course of normal operations banks know that the Fed stands ready to exchange T-Bills for Funds and Funds for cash. Thus if the T-Bill rate rise above the Funds rate banks will borrow in the Funds market and use the proceeds to buy T-Bills.
This ensures that there is always a buyer for T-Bills at anything above the Funds rate. This in turn assures that the Federal government will always crowd out private investors for dollar denominated loans.
The reason this did not work with Greece is that the ECB would not stand as Lender of Last Resort for Greece and Greek Banks could not do it alone.
I argued that if the ECB promised to save Italian and Spanish banks that they would then have the incentive to hold government debt to maturity even if the ECB did not officially stand as Lender of Last Resort to Italy and Spain. The ECB did this and subsequently it looks as if yields have fallen and are staying down.
The moral of all of this is that what matters is that the structure of the system always makes it profitable for the financial sector to hold government debt.
Karl, thanks for the great comment. I am not 100% sure I am right, but here is a rejoinder.
I’m happy to agree that the debt is coming due at a rate slower than $3.25T/year. Nevertheless, for forward-looking market participants, what matters is not the flow of debt coming due but the stock of debt that will have to be extinguished to make the market return to normal, under whatever period. If this stock is large, then market participants will rightly expect high inflation, and if they expect high inflation, they will demand a high return on both Treasurys and excess reserves. I don’t think 5% interest on reserves is going to cut it; the government would have to engage in financial repression, which has its own costs.
If the preceding paragraph is correct, then I don’t think your second-level and third-level arguments apply, right? If the amount that would need to be printed is much much greater than $75B, then the Fed can’t credibly commit to supporting the rollover of debt. And if large amounts of inflation are expected, doesn’t the federal funds market implode as banks along with individuals flee dollar-denominated assets? Maybe I’m missing something here.
RE: Italy and Spain, kudos on your prediction. I am not terribly surprised that an ECB guarantee worked because Italy and Spain are a small fraction (OK, not that small, but a fraction) of the Eurozone. The amount of euro printing that would have to occur in a worst case scenario is swallowable. Therefore, the commitment is subgame perfect.
I agree that everything is OK as long as “the structure of the system always makes it profitable for the financial sector to hold government debt.” I’m just pessimistic that this is possible, at least when profits are reckoned in terms of economic resources, not in terms of dollars whose value might change wildly over the course of the game.
Just a quick reply
For the first portion, yes the Fed has to be able to commit to do this as long as market disruptions persist. Then it becomes a question of how long this is. Which means that debt dynamics come into play. Essentially, pushing the interest rate below the nominal GDP growth rate – which is effectively financial repression – will cause the tax base to grow faster than the debt which eases future ability to pay. In effect, you don’t have to inflate away the debt to reach stability you just have to inflate up the tax base. This is basically what the Fed did after WWII.
And, if you can commit to doing this then you can still rollover. So, there is a recursive time element.
Second, a dollar crash is utterly possible.
Just an asterisk: There is little ethical difference (and in the long run little economic difference) between defaulting on debt and defaulting on contractual obligations.
The United States has repeatedly committed the latter atrocity in the past, and will do so with increasing frequency and rapidity in the future.