Default, debt ceilings and democracy

April 18, 2011

“The growing question is whether the exceptional role of the dollar can be maintained … The growing sense around much of the world is that we have lost both relative economic strength and more important, we have lost a coherent successful governing model to be emulated by the rest of the world … Instead, we’re faced with broken financial markets, underperformance of our economy and a fractious political climate.”

Paul Volcker
University Club of New York
November 30, 2010

There were quite a few comments in response to my last post, “Why Congress should vote no on raising the debt ceiling”, about evenly split between those who find the suggestion of deliberate, voluntary default by the US ludicrous and those who found the discussion refreshing and honest.

In that vein, let’s dissect the objections of those who say that Congress “must” raise the debt ceiling in order to avoid the “apocalypse,” (CORRECTION: “Armageddon”) of debate over it, as Republican Senator and former Texas Treasurer Kay Bailey Hutchison said. There seem to be three major objections to the idea that the US could voluntarily default on its debt. First is the belief that if the Treasury was even a few days late paying its debts the financial markets and major banks would melt down. This notion is wrong.

A year or so ago, my friend, John Makin, a fellow at the American Enterprise Institute, dismissed the idea that China or any major investor can move out of dollar assets in some meaningful way. First, there is no bid for even a tiny fraction of dollar assets in other currencies. The fact of the matter is that the dollar is the world’s chief means of exchange for trade and commerce, factors far more important than financial flows. The euro could only accommodate a small fraction of dollar assets held by non-US residents.

With the EU under growing pressure from zombie banks, as per Tyler Cowen’s timely comment in the New York Times on Sunday, global investors are hardly ready to pile into the euro from the dollar except on a short term basis. Today, many EU banks are on life support, care of the European Central Bank, which in turn is held up by the Fed’s swap lines.

If the US was a few days late paying its bills, nothing would happen. The fact is that the dollar and dollar-denominated assets are the only asset class big enough to accommodate the wealth of the world, handle trade and financial flows and is politically reliable enough to be the global unit of account. This reality is changing with the emergence of some of the states of Eastern Europe and Asia, but political concerns limit the attractiveness of such venues, even for their own people.

Want to take Russian rubles instead? Go ahead. Just be ready to deal with the periodic caprice of Russia’s rulers. America’s open markets facilitate financial and commercial transactions more than any other nation and our chaotic but open politics, not fiscal factors, is why people prefer the dollar as the store of value.

Unfortunately the flip side of being the greatest currency on earth is that there is no effective limit on debt issuance and thus inflation. The freedom of the dollar zone carries a heavy tax in terms of inflation. The natural demand for dollars as a means of exchange for global commerce is so strong that Congress and successive governments in Washington have been able to borrow to finance spending deficits and bailouts without real limit.

If Washington is late paying its debts, investors will simply have to wait. Former Treasury Secretary and Texas Governor John Connally once famously told the EU nations, “the dollar is our currency, but your problem.” Remember the dollar crisis four decades ago? This leads to the second reason observers argue in favor of lifting the debt ceiling, namely that the budget process, not default or the threat thereof, is the way to address spending. We’ve been hearing that same argument in Washington for three decades and more. But Congress has made no progress on controlling normal spending and has added insult to injury with trillions of dollars in unnecessary subsidies for Wall Street. Any arguments about the efficacy of the congressional budget process are unconvincing.

To say that the US “budget process” is broken is an understatement of vast proportions. There is no effective budget process in Congress, which is all the more reason to shake things up by voting no on the debt ceiling. Why should the people of the US allow the Treasury to issue more debt if members of both political parties are so corrupt that they cannot balance the federal  budget? We can live with and might even benefit from a few days or weeks of supposed chaos if we can restore fiscal discipline to American society.

Worse, Congress now allows the Fed to explicitly monetize the national debt, an act of depravity that begs the question as to whether investors ought to purchase US debt. As I noted last week, the bailout by the Fed for Congress via “quantitative easing” is far larger than any alms offered to the big banks.

Pundits who say that there should be no limit on federal spending or public debt reflect an ignorance of American history. The point of having legal limits on spending and debt is the same as having checks and balances, a rule which the founders of the US embraced as a check against both political and financial excesses.

By voting in favor of lifting the debt ceiling without requiring the Obama Administration to embrace fiscal reform, members of Congress vote for the status quo. Voting against raising the debt ceiling is voting against bailouts for Goldman Sachs, JPMorgan and other large Wall Street banks. If you like the idea of forcing the large banks to restructure their balance sheets and modify under water home mortgages, then vote no on raising the debt ceiling.

Perhaps the most specious argument used by proponents of raising the debt ceiling is the idea that the status quo of more borrowing by the Treasury and the skewed monetary policy by the Fed to monetize this debt is acceptable. Those who want to raise the debt ceiling do not want to cut spending, much less limit government’s ability to spend. Thus electing to simply continue the reckless fiscal policies of the past three decades is the path of least resistance.

Secretary Geithner wants to raise the debt ceiling because he says that America will fail if the US Treasury is late paying its bills. But it is fair to say that the US debt cannot ever be repaid in kind, only in nominal, inflated dollars. As former Fed Chairman Alan Greenspan once said to Senator Richard Shelby (R-AL) about Social Security, “you’ll get your check”. The question is what will it buy, a reference to the continuous erosion of purchasing power due to inflation.

Voting against raising the debt ceiling is a valid mechanism for forcing political change in Washington. No nation can call itself a democracy if it is not willing to reject the demands of convenience and use an occasional revolution, to paraphrase Thomas Jefferson, to cleanse the nation’s financial and political life. Of course, Jefferson was heavily in debt most of his life.

The debate in Congress over the debt ceiling is as much about the political fate of the US as the financial solvency of the Treasury. Members of both political parties in Congress should put aside the cowardly counsels of convenience, take their time and demand their price from President Obama before voting yes on even a temporary increase in the debt ceiling. It is time for Congress to stop hiding behind the Fed and to address fiscal issues head on — like the governments of every other industrial nation. If we have to default on the national debt, even briefly, to get this done, so be it. At the end of the day, the political principle involved here is more important than the financial issues involved.


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Contrary to liberal lies, voting to NOT raise the debt ceiling will NOT automatically make us default on our debt. What it will do however, is to force us to CHOOSE between default and cutting existing programs, savings we would then use to pay our debts. This would actually a good thing because once and for all, it would expose the liberals as the spend-mongers they are when they chose to default rather than make hard cuts they’ve resisted for 50 years…….So…if we default, it’s because the liberals would rather continue social welfare rather than pay off existing obligations. Bottom line: do NOT extend the debt ceiling and instead, make cuts to existing programs and use those savings to pay the debt.

Posted by sr71 | Report as abusive

There can be no socially responsible spending without first being fiscally responsible. Subsisting off the pay day check cashing scheme is no way to run a household, let alone a country. It is, however, a fine way to siphon the wealth of a nation.

Posted by zhmileskendig | Report as abusive

Whatever happened to the idea of RETIRING THE DEBT? Or at least a significant chunk of it? We’re heading in the wrong direction and both Parties and both Houses of Congress are leading us there because Congressional legislative constipation and self-aggrandizing rhetoric and self-serving corruption are becoming ingrained in the system. We didn’t send those people to Congress not to work with the other Party. We sent them there to figure out the best way to solve this Country’s problems. Together, with the other Party. This may be hard to believe but it’s Congress’ responsibility to regulate industry, not the other way around. And it’s not Industry’s responsibility to regulate themselves; they’ve proven themselves too unselfdisciplined just about everytime we’ve tried that. And it’s not the Fed’s responsibility to stimulate the economy; it’s the different levels of government if those in power decide it’s necessary. The US Congress needs to put the polemic BS aside and get to work solving this Nation’s problems. Now. Just shut up and do it. We the people are tired of them showing us how clever they are while not fixing anything. It’s time we started demanding more out of them or recalling them ..

Posted by Woltmann | Report as abusive

Dear Mr. Whalen,

Why do you say that the ECB is ‘held up’ by the FED’s swap lines, when those swap lines are just _mutual_ loans in which dollars are temporarily exchanged for an equal value in euros? No value changes hands in those swaps – they just provide temporary dollar liquidity to Europe (and at the same time, euro liquidity to the US) so that when demand for dollars in international business or finance is high, banks and businesses can obtain the required dollars without inflating the exchange rate too much.

As such, the swap lines function to stabilize the international exchange rate of the USD. Obviously, the ECB and other international central banks cannot create their own dollars when those are in high demand. And so, if the US wants it currency to remain the international trade and reserve currency, it will have to provide dollar liquidity in tandem with these central banks. That’s what the swap lines are for; and they do not in any way support, let alone sustain foreign central banks anymore than they support the FED.

Posted by DanVR | Report as abusive

US deficits are a result of bad tax policy (income generation) and expenditure (defense, 2 wars, the whole pentagon industrial complex). There are two issues that Republicans are adamant on and most Democrats cave into as well: more money for defense, more tax cuts for special interests and the “elite 1%”.

Simply put, the US right now cannot afford such low rates on capital gains, dividends, and other 1099 income. These rates should go up by $$ bracket as in the pre-Reagan tax days. this low fixed 15% tax rate is bankrupting the country. However, those who are bank rolling senate election campaigns know that they can stop any bill that may raise rates with the help of the Republicans.

On the expenditure side, the US Defense department’s oversized budget, plus the needless 2 wars, etc. are a huge drain on resources and do not benefit the economy long term. The best defense for this country would be internal investment (infrastructure, research, training/education) but instead $billions are spent way out of proportion to what is needed. REmember, if you add up the top 10 countries defense expenditure it would about equal the US Defense budget. That’s huge and is not sustainable.

Additionally, the US needs to see its 1% Elite pony up their fair share. How? Pass a 2% net worth (intangibles) tax on persons, corporations, trusts, foundations with assets over $10 million. That tax alone could pay off US debt in less that ten years.

Posted by Acetracy | Report as abusive

I don’t understand the lack of reasoning. It’s like everyone is making decisions based on their emotions instead of using old fashion logical deduction. We can give wall street and the big banks 650 billion,(the reason was an emotional scare tactic) but when it comes down to sustaining the services of education, we forget how to add. Instead of chopping off huge chunks on a service that has taken years to build why not take the logical approach and fix what doesn’t work while keeping the service intact to use what is working. I don’t see how becoming dumber can solve our problems. In the real world of problem solving, emotions don’t work. So take a deep breath, let it out slowly, then look over the entire problem before deciding the best solution.

Posted by brothersean | Report as abusive

I liked reading the comments from Acetracy and Woltmann. They were factual, and most of the important information today is emotionally criticized instead of factually checked.

Posted by brothersean | Report as abusive

A few questions for you, Mr Walen.

1. The dollar is valuable BECAUSE of its credit and stability. If the US government shows such hubris and subject its investors to the “caprice” of its own Congress”, do you expect the credit of the dollar to hold up?

2. “Voting against raising the debt ceiling is voting against bailouts for Goldman Sachs, JPMorgan and other large Wall Street banks. ” I would like to take you up on that. On what basis do you state this?

3. What “political principles” do you hope to expound on by a swift default? Over-optimism? Argentina had a “swift default” and it was pretty damaging for the record.

Posted by jason.lin | Report as abusive

I am soooooooo sicken by the fact that our government continues to do NOTHING to help the economic mess we find ourselves in. The fighting continues, nothing gets accomplished and the can gets kicked down the road over and over and over again. Why do we stand for this?

Posted by r.felder | Report as abusive

Just charge as much taxes as any other developed country in the world, and you will balance the budget in a few years: _Day#Tax_Freedom_Day_around_the_world

Posted by dburstin | Report as abusive

Interesting perspective with a snowball’s chance in hell of ever being adopted.

You hint at the truth with your line from Jefferson:

“No nation can call itself a democracy if it is not willing to reject the demands of convenience and use an occasional revolution, to paraphrase Thomas Jefferson, to cleanse the nation’s financial and political life…”

We are ALL ABOUT convenience and the status quo. We had our chance at “revolutionary change” in the midst of the financial crisis, and we actively shunned the opportunity. Now with the Fed contemplating writing put options on US Treasuries, the temptation to “ponzificate” for even longer will be Satanically efficacious.

Posted by blankfiend | Report as abusive

Washington is broken and it does not appear that there is the leadership and knowledge to dig the United States out of the numerous messes it is in. The states and government are in serious trouble and with politics “as usual”, the spin seems to be more important than definable actions and solutions. Talk is cheap, but actions speak louder. I am worried for this country, our children and those out of work. What are we leaving to future generations to deal with? God help our country and leaders. Amen!

Posted by Gnilhert | Report as abusive

Acetracy: Make that three wars, the latest one your buddy Obama’s idea.

Posted by Realist99 | Report as abusive

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Posted by investor awareness | Report as abusive

I’d like to know the education and financial savvy of those advocating for the default. I can’t imaging any of them knowing what they’re talking about. But then here comes Whalen.

Please read @brothersean’s comments for cues on rational thinking. They should be helpful. @Acetracy comments are good, but the rates on capital gains could be actually lowered if loopholes were eliminated. @DanVR has some seriously good points and there is also the advantage of seigniorage in the benefit of using USD for the international trade currency.

It’s befuddles me that some of the commenters have better ideas than Mr. Whalen’s attempt to correlate the potential benefit of failing to raise the debt limit with congresses’ failure to retain the conforming loan expansion. The irony is that Whalen is advocating for homebuyers ability to avoid taxes on borrowing more. I agree with him on that latter point, but not the former. As a property owner in California, I have a strong desire to keep my expensive home expensive. But its a loophole that should be closed the next time home prices start heating up and we can afford to take the hit. That’s rational, isn’t it?

Posted by LEEDAP | Report as abusive