Tag Archives: sovereign debt crisis

Could the US Default?

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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.

Keep the Debt Ceiling

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“Manufactured crisis” is the term going around to describe the near-failure of Congress to raise the debt ceiling. Mitch McConnell says that we can expect more of them in the future. It’s not surprising that big-government types want to get rid of the debt ceiling altogether, but even some of the cool people are getting in on the action. “Get rid of the debt ceiling, for God’s sake,” says Scott Sumner. “Now more than ever the debt ceiling has to be permanently removed,” says Adam Ozimek. I’m not for manufactured crises, but this seems like a severe overreaction that would have really bad long-run consequences.

The argument for getting rid of the debt ceiling goes like this: Congress has already approved federal spending. Increases in the debt ceiling merely authorize the executive branch to spend what the legislative branch has ordered it to spend, so it is redundant. Furthermore, Congress has now discovered that the debt ceiling can be used as a source of gridlock (or “hostage-taking” or “terrorism,” depending on how shrill you want to get). Most governments don’t have debt ceilings; they work just fine. So the debt ceiling creates an opportunity for political opportunism and pointlessly increases our risk of a big crisis.

This argument strikes me as shockingly naïve. First of all, to get rid of the debt ceiling would be to vastly expand the power of the executive branch. The US Constitution lists borrowing as an Article I power. “The Congress shall have Power…To borrow Money on the credit of the United States.” Giving the executive branch the power to borrow on the credit of the US whatever it interprets to be necessary could have terrible consequences. For instance, current Constitutional jurisprudence seems to give Congress the authority to declare war, but no mechanism by which to undeclare war. Wars end when the executive branch says they end. However, at present Congress can at least de-fund a war. If the debt ceiling were eliminated, once war had been declared, the executive branch could prosecute it basically forever, even if Congress disapproved. The president could borrow whatever money was necessary to do all the spending that Congress ordered, plus the money for the war. And when you factor in that the Obama administration seems to have blatantly ignored the War Powers Resolution in its action in Libya, this should be cause for serious alarm among anyone with even a modicum of sense. The left especially, which complained incessantly about expansions of executive power during the Bush administration, if it has any principles left should oppose giving the executive branch any freer rein.

Furthermore, it’s simply not true that every Congress approves of all federal spending. Congress passes a discretionary budget every year, but much of federal spending is “mandatory,” meaning it is not subject to the ordinary how-a-bill-becomes-a-law process. On entitlements, for instance, some past Congress approved a given path of spending, but the current Congress can only change that path if they can override a presidential veto (or induce a non-veto). Assuming no veto-overrides, to cut discretionary spending, you need both houses of Congress. To cut entitlement spending, you need both houses plus the President. So the structure of the spending power is in fact different with discretionary versus “mandatory” spending. Faced with an executive branch that opposes cuts to entitlement spending, Congress will never be able to cut spending if they cannot force a cut through the debt ceiling. If all federal spending were discretionary, then there would be some merit to the claim that the debt ceiling is redundant; since some spending cuts are subject to a presidential veto, the debt ceiling provides an important non-redundant tool to force those cuts.

More generally, I would remind people that decreasing the holdout problem with respect to spending increases the holdout problem with respect to cutting spending. If you agree that the US needs to drastically cut entitlements over the medium term (i.e., if you are paying attention), you should want to decrease the holdout problem for spending cuts, not for spending increases.

So what about the severe crisis that will result if the US bumps up against the debt ceiling, gets downgraded, or delays payments? I agree that this will be a manufactured crisis, but those who favor spending more seem to deserve as much, if not more, of the blame as those who oppose borrowing more. But it seems the biggest blame should be laid at the feet of those who make our economy so fragile with respect to a single security. The best way to avoid a crisis in the future is to take steps now to make financial institutions more robust. First, eliminate rules that will trigger huge sell-offs of T-bills if when the US loses its AAA credit rating. Eliminate the favorable tax treatment of debt and improve the tax treatment of equity (I facetiously call this “Islamic banking lite”). Allow checkable brokerage accounts. Increase the average maturity of US debt to give the government some leeway with respect to seigniorage in the event the crisis occurs.

And of course, the ultimate solution to the debt ceiling issue is to spend less. Even if you oppose cutting spending during a recession, it’s hard to justify a debt ceiling that is as high as the US’s. If the output gap of a recession is 8 percent of GDP for 4 years, even if there is no monetary stimulus, that justifies a debt ceiling that is 32 percent of GDP, not 100 percent or more. In reality, there can be more monetary stimulus and fiscal stimulus is pretty ineffective, so even 32 percent of GDP seems like excessive borrowing across the business cycle.

My bottom line is that the US is a big, diverse economy. As it has gotten more diverse, interests have come into greater conflict. The result will be either gridlock in Congress, consolidation of executive branch power, or devolution of power to local authorities (at which scale there is less conflict) and the market. We should take this last path, and the quickest and least painful way to get there is to keep the debt ceiling and make smart reforms to spending and the financial system. Eliminating the debt ceiling will ensure that power continues to be consolidated and that spending will be harder to cut.

Immigration as Fiscal Externality

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Many rich-country governments are heavily in debt. Some are on the verge of default; for others it’s a matter of time. One trivially simple way to lower the burden of national debts is to let in a lot of immigrants. Since the amount that the government owes does not vary with population, debt per capita and debt/GDP would decrease.

At any moment in time, population is zero-sum. More net immigrants to the US, say, means fewer people living in other countries. This means that the US can only lower its debt per capita through immigration only by raising the debt per capita of some other country.

My intuition is that this would lead to downward spirals in the fiscal situation of second-movers. The process could look like this:

  1. The US opens its borders.
  2. Lots of people from all over would move to the US.
  3. Debt/GDP falls in the US.
  4. Debt/GDP goes up in some heavily-indebted countries such as Greece.
  5. Faced with higher taxes and unemployment in Greece, more Greeks move to the US.
  6. Repeat steps 3-5 multiple times.

In the end, the US fiscal picture looks quite rosy and the Greek government ends up defaulting.

What is bizarre is that this has not happened yet. If there is a huge first-mover advantage to open borders, one would expect that governments would be eager to open their borders. In terms of a Prisoner’s Dilemma, governments are not defecting when it is in their interest to do so. They are playing the cooperative equilibrium with no outside enforcement, providing a local public good (globally, of course, immigration restrictions are a huge deadweight loss). Each government is sacrificing its own fiscal position for the fiscal position of the others.

I’m all for the study of non-coercive provision of public goods, but in this case none of the usual factors that accompany cooperation are present. It is not the case, as with Coase’s lighthouse, that this public good is tied to private goods. Nor does the repeated nature of the game seem to be the factor that holds the cooperative equilibrium together; governments do not seem to want to defect. The glue that makes immigration restrictions possible is probably just plain old xenophobia.

This makes me more optimistic about the long-term future of the world. On one hand it sucks that voters are such racists. But our fiscal/immigration equilibrium is unstable. If it is at all disturbed, it will probably unravel. If one heavily-indebted rich-country government decides to open its borders, others will almost certainly have to follow suit. In the long run, governments will have to be more open to immigrants and more fiscally responsible. Getting to the long-run stable equilibrium could be tumultuous, though.

The Fragility of Eurozone Finance

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Over at the FT, Gavyn Davies writes concerning the Eurozone,

Member states cannot print the euro, which automatically increases the risk that they will default on their debt. (Admittedly, it also reduces the risk that they will inflate their debt away. The markets are not too worried about this in these deflationary times, though one day they might be.)

I think about European sovereign debt in somewhat similar terms, but I want to elaborate on Davies’s framework a little.

First, refusing to pay up and paying up in inflated currency are both forms of default. The fact that EU member states cannot print the Euro therefore changes the form of the risk of default.

Second, the form of the risk of default matters. Think about the payout of a security under variable outcomes. When the outcome is very good, the security pays out a high amount, and when the outcome is very bad, the security pays out very little. We can imagine that in the middle of the outcome spectrum, there are a number of possible payout profiles. You can have payouts vary smoothly with outcome, or you can have a tipping point, above which the payout is high and below which the payout is low. When payouts vary smoothly with outcomes, the price of the security is not going to be very volatile. When payouts vary sharply with outcomes, the price of the security may be highly volatile when outcomes may fall on either side of the tipping point. I think this is what Nassim Taleb means when he says that debt is fragile and equity is robust: debt payouts vary sharply with outcomes and equity payouts vary gradually with outcomes.

Third, when a government can inflate away part of its debt, the real, inflation-adjusted payout can vary more smoothly with outcomes. This makes the debt a little less like debt and a little more like equity. When a government cannot inflate away its debt, the price of its securities are going to be very volatile around the outcome tipping point.

Fourth, since EU governments cannot inflate away their debt, the risk premia on their bonds are going to take a highly volatile form. This is going to lead to frequent debt crises unless the governments are highly responsible and avoid landing anywhere near the outcome tipping points.

Davies concludes his post with “Something, somewhere has to give.” I think that what has to give if people want to preserve currency union is that member countries are going to have to accept balanced budget requirements as the US states have. But at the same time, I am skeptical that the southern European countries can really be counted on to abide by such requirements if they are imposed. They failed to keep their deficits within the 3% of GDP limit the EU treaties currently require, and they have been and are going to be rewarded with bailouts.

Many commentators are talking about fiscal union, which is perhaps a subject for another post, but I am not too enamored of this option as it has many public-choicy downsides. Probably the thing to do, though difficult, is to give up on the common currency and instead focus on creating the largest free-trade and free-movement zone in the world. That is the robust road to prosperity.

Thoughts on Sovereign Default

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My new favorite website is this one, which monitors credit default swaps and displays some useful free data about them (you can pay to get more data). The most interesting statistic is the cumulative probability of default for various sovereign bonds. The site calculates these over a five-year period based on the term structure of interest rates and the price of various credit default swaps.

As of this writing, the five-year probability of default of selected EU countries is as follows:

  • Greece: 43.21%
  • Portugal: 24.25%
  • Spain: not listed at the moment, but as I recall around 18%
  • Italy: 17.18%

Looking at these numbers, you may not be alarmed. After all, what is the probability that all four of these countries will default? Multiplying the probabilities together yields 0.4321 × 0.2425 × 0.18 × 0.1718 ≈ 0.0032. That’s not so bad.

The problem is, it’s not correct. Multiplication assumes that each of these default probabilities is independent from the others. But during a financial crisis, all correlations go to one. The correct answer is about 17.18%, the probability that Italy will default. If Italy defaults, that means that the other four have probably already defaulted or are about to do so.

There is another implication of correlations going to one. The EU cannot bail out all of its members. They may be able to bail out Greece and Portugal, but I doubt they will be able to bail out Spain and Italy as well.

The other indicator I’ve been looking at is the risk premium on Greek bonds relative to German bonds. Earlier this month it went from 5.4 percent to 9.6 percent in four days. After the bailout package was announced, it dropped and is today around 5.1 percent (three years ago it was around 0.2 percent). I would not be surprised to see it spike again like it did earlier this month. If, when the crisis came, austerity was politically impossible, what makes anyone think that austerity will be politically feasible when there is no crisis? And why, when the next crisis comes, does anyone think the outcome will be any different?

In case you are wondering, the probability of the US defaulting in the next five years is around 3.51%. This means that the probability we will soon be living in caves is: 3.51%.

Finally, we have more evidence, as if we needed it, that politics isn’t about policy. Politicians say they want to regulate “systemic risk” so that we do not experience another financial crisis. What is the greatest source of systemic risk? You guessed it: government debt.

I’ve been trying to figure out the best investment strategy in light of these facts. Here’s how I’m leaning: invest in leisure—it can never be expropriated. Have a nice day.

The Economics of the Startup Visa

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For a long time, Silicon Valley types have been agitating for more immigration visas. One idea is the Startup Visa, which would enable entrepreneurs who get US venture capital investment of at least $100k to move to the United States. Today, Senators Kerry and Lugar introduced the Startup Visa Act in Congress.

I support expanding immigration in whatever form I can get it, so I am happy to endorse the Startup Visa Act. Nevertheless, this idea is clearly suboptimal.

One way the government can help the American economy is to encourage people to move to the US and start a new business which produces goods and services people want to consume. But another, equally useful tactic is encourage people to move to the US and help an established business be more productive. Startups are great; I love startups. But there is no a priori reason to favor them over other businesses, and vice versa. You can argue that established businesses tend to be more sclerotic (I do think this), but maybe what they need is someone with a different perspective to help them innovate.

Furthermore, an important ingredient in dynamic or adaptive efficiency is the process of shutting down failed ventures. An entrepreneur who relies on his business for his immigration status will draw out the process of shutting down a business that he knows to be a failure. This delays the reincorporation of the resources of the failed business into new and potentially profitable ventures. While this is less inefficient than immediate deportation or than not allowing him in the country in the first place, it would be better if immigrants felt free to close their businesses and try something new (or just get a normal job) without risking their residency status.

Finally, the bill will not bring in immigrants in nearly the numbers we could use them. During the 2008 financial crisis, I argued that the best solution would be to let in 50 million new immigrants; this would drive up the price of housing and make the ex ante malinvestments in housing ex post profitable, averting the crisis. And one way to deal with the looming fiscal crisis is to let in millions of immigrants to expand the tax base. Given that no one seems to want to raise taxes, cut spending, default, or inflate, I am surprised that more people are not interested in the immigration free lunch.

So by all means, pass the Startup Visa Act. But don’t stop there; a more liberal immigration policy would benefit both Americans and the immigrants themselves.

The VAT vs. Sovereign Default

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One of the great joys (or frustrations, depending on your personality) of being a libertarian is the opportunity to participate in the infighting. Tyler Cowen’s recent post, in which he muses about a VAT in an uncommitted fashion, has generated some of it, e.g. from Fred Sautet and Dan Mitchell. Tyler responds here.

My favorite argument comes from Mario Rizzo, in a comment on Sautet’s post:

I would prefer the harms of the collapsing welfare state due to the unwillingness to compromise rather than the maintenance of (even a semblance of) the present system through any increase in the tax-take of government. We do not have to get the advocates of the welfare state to agree to reductions explicitly. Crisis will force it. I realize this may sound crazy to some people. But I am just being candid about my preferences.

I like Rizzo’s comment because it is characteristically honest and it addresses the real question: given that a sovereign debt crisis is coming without big fiscal changes, and that cutting spending is unlikely for political reasons, would you prefer a debt crisis and all that it entails or a more efficient tax system that will give the government more money?

We can think about the issue in terms of positive liberty and negative liberty. Here is my crude model: positive liberty is positively correlated with C + I + X, and negative liberty is negatively correlated with G. We can classify libertarians as those who want more negative liberty, other things equal; that is, you are a libertarian if MUG is negative.

In the state of the world in which a VAT is enacted and a debt crisis is avoided, C + I + X is higher, but so is G. In the state of the world in which a debt crisis occurs, G is lower, but so is C + I + X. The problem can be boiled down to two issues: what is the expected magnitude of these changes, and what is your marginal rate of substitution between negative and positive liberty?

No one knows for certain what effect a debt crisis would have on GDP or its components. My suspicion is that it would be quite large. Most countries that experience debt crises have deep and painful recessions that last many years. However, we have no experience with a default by a government like the US, because the modern US is unique. The world is so exposed to US Treasuries that a US default could destroy most of the banks and bank-like institutions in the world and cause a truly global recession. It would probably be much worse than a default by, say, Argentina, which mostly hurt the Argentines.

You can acknowledge the possibility of these consequences and still oppose a VAT if you are sufficiently libertarian. The question is then how negative is your MUG/MUC + I + X? If it approaches negative infinity, then you should still oppose a VAT. If it is close to zero, then you should support a VAT.

For now, I am (like Tyler) in the anti-VAT camp. However, as the probability of a debt crisis increases, due to failed attempts to decrease spending or simply the passage of time, at some point I would prefer a VAT. If a debt crisis were a week away, I would push the VAT button. Wouldn’t you?