Eli Dourado

Could the US default?

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. But 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.