Is there a real risk of the US defaulting?

By Felix Salmon
May 5, 2011
Binya Appelbaum is on the front page of the NYT this morning with what seems like a pretty standard examination of the effects of hitting the debt ceiling.

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Binya Appelbaum is on the front page of the NYT this morning with what seems like a pretty standard examination of the effects of hitting the debt ceiling. I think the reason is its alarming headline: “Debt Ceiling Has Some Give, Until Roof Falls In.” I’m not entirely clear what exactly a caving roof comprises — but the general story is clear: there are various cash reserves and other assets that the government can tap, and then spending has to be cut.

The Treasury secretary, Timothy F. Geithner, warned Congress in April that once those resources were exhausted, the government would have to default.

“A broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on the debt, unemployment benefits and tax refunds,” he wrote.

Among the resources to be exhausted is a whopping $400 billion in gold reserves — that’s the current value of the government’s store of 261 million ounces of gold. Selling at these prices seems like quite a good idea to me: I can’t think of any particularly good reason why the government should be storing $3,500 of gold for every household in the country.

After that, the list of things to be cut includes, buried in the middle there, “interest on the debt.” Including that item seems to be a party-political decision:

Republicans — also backed by economists and financial experts — say investors would not punish the government for failing to fulfill other financial obligations.

“I think the important thing to do would be to make it clear to markets that the government is not going to default on its debt,” said Senator Patrick Toomey, Republican of Pennsylvania, whose bill assigns priority to interest payments. “It would be easy, I think, to make it clear to the markets that they don’t have to worry about this.”

Treasury officials respond that the failure to pay any obligations would set off a crisis.

“What participant in the market would want to buy our debt as we are defaulting on other obligations?” asked Ms. Miller. “I think the markets would be completely spooked.”

I agree with the Republicans on this one. Government tax revenues dwarf its interest payments — there’s no need to default on the debt. Treasury, for reasons I don’t fully understand, is pushing the silly line that commitments to, say, Social Security recipients are somehow pari passu with T-bond coupon payments, and that there’s some kind of implicit cross-default clause which says that if tax refunds get delayed, then there will be “the same catastrophic economic consequences” as there would be with a bond default.

In fact, the Treasury markets will be fine, just so long as they get their interest payments in full and on time. And I simply can’t believe that Tim Geithner would be so stunningly irresponsible as to default on those payments just to make the point that they’re not senior to other government obligations.

The roof caving in, then, is just the government living within its means — a forced and drastic austerity program which would probably send the economy spiralling back into a double-dip recession. An outright debt default is still extremely unlikely. Still, it’s a sobering thought: we can spend no more than we receive in taxes, or we can have an economy which grows rather than shrinks. But we can’t have both.


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If the value of gold really is negatively correlated with the dollar then it may be a good asset to hold on to in case the dollar really does go to sh*t.

Posted by Britonomist | Report as abusive

Feelgood factor win: just give $3,500 of gold to every household in the country.

Posted by johnband | Report as abusive

In either event, we face catastrophe if the debt ceiling isn’t raised. Nice to know we might protect bond investors over the general population.

The 14th Amendment to the Constitution provides that the debt shall not be questioned, so we would probably have to put bond investors first.

How bond investors would react to a failure to raise the debt ceiling is not something I want to find out.

Posted by 3oosion | Report as abusive

Selling $400 billion of gold wouldn’t have any effect on market prices, would it?


Posted by 3oosion | Report as abusive

A country that can print money at will cannot default, unless its political “leaders” decide they just don’t want to pay their bills. Some might call that making tough decisions, but suicide seems more appropriate to me.

Posted by KenG_CA | Report as abusive

I don’t think the underlying reasons are all that hard to understand, Felix. Leaving aside whether bond payments should be made equally with other obligations, its about negotiating incentives.

The Republicans are taking the tack that they’d be willing to act irresponsibly in the cause of lowering non-defense discretionary spending. And because they control the House, their threat has some credibility.

The Democrats have two options.

They can put non-defense discretionary spending first on the chopping block, which you suggest. That may, or may not, avert the crisis. After all, since the spending the Republicans want cut would be cut, it gives the Republicans the incentive to drag out negotiations as long as possible and gives them a great deal of negotiating leverage.

Or, the Democrats can respond by putting interest payments on the chopping block as well. If the Republicans are bluffing about their irresponsibility, call their bluff now. If they aren’t bluffing, don’t give up a lot of territory before you find out.

I think Neville Chamberlain is often unfairly maligned by people who have 20/20 hindsight and who don’t know how devastating World War I was. But I think Munich is a useful metaphor here.

They’re threatening to drag Europe back into another war. Do you call their bluff now, and hope they don’t really want a war? Or do you give them Prague, and hope they don’t really want France?

Posted by AnonymousChef | Report as abusive

I think this is what Britonomist is saying, but I view the gold as a hedge against a particular kind of tail event (which becomes less likely if we hold a public hedge against it).

Posted by dWj | Report as abusive

You are quite right in this post. What a debt ceiling really means is sudden, forced austerity in terms of government spending. Would this shrink the whole economy? I am not sure.

It is an interesting thought experiment what would happen if the government suddenly went into forced balance.

Some positive possibilities:
* Commodities might actually fall if the flight-to-safety trade ends. Gas prices might come down substantially. A big boost to consumers results.

* All that money pouring into the bond market might need seek another home. In the late 1990s with our budget in balance, the stock market soared. You had two things which are supposedly contractionary, namely increased taxes and limited government spending. Yet those times are remembered as halcyon days. It seems that savings poured into the private sector rather the treasury market and jobs soared.

Possible downside
* Perhaps there would be contraction in money supply if there is a reduction in government borrowing. But Fed tools up to and including quantitative easing should be able to counter this.

Posted by DanHess | Report as abusive

I understand your point, Felix, but I disagree. Treasury is correct that, unless Congress legislates otherwise, all of the government’s obligations are pari passu.

Treasury doesn’t and ought not have the authority to unilaterally “prioritize” the payment of certain obligations over others. For Treasury to do so would wrest powers from the legislative branch.

Reasonable people may argue, as you have, that debt service ought to take priority over, say, entitlement spending. But unless you ascribe to a tortured reading of the 14th Amendment (and some do; e.g. Bruce Bartlett), only Congress can make that call. Hence the Toomey bill.

Posted by Sandrew | Report as abusive

“Still, it’s a sobering thought: we can spend no more than we receive in taxes, or we can have an economy which grows rather than shrinks. But we can’t have both.”

Felix, that a hairs-breatdh away from understanding MMT.

If people would just understand that that’s the way it’s always been. Our “debt” is simply the net financial assets of the Private Sector.

For a thought experiment, imagine if we aggressively tried to pay down all of our debt. It would necessarily bring the economy to its knees as the Private Sector is drained of NFA.

And the idea of an ISSUER of a sovereign currency defaulting is beyond absurd.

Posted by petertemplar | Report as abusive

You’re missing a key (and I think obvious) element of the argument: if the US starts defaulting on some obligations, but not its obligations to investors, investors will have every reason to fear that they are next.

Firstly, it will be obvious that the US will have hit a wall on cash flow, so whether it will be able to make its next payment will be in some doubt.

Secondly, if the US is unilaterally prioritising some obligations over others, it becomes conceivable that bond investors will cease to be the favoured creditor.

Both of these will make rational investors demand higher yields to hold treasuries, rather than (say) Gilts or Japanese sovereign debt.

Posted by DrFuManchu | Report as abusive

According to William Simon, historically most sovereign defaults weren’t because there wasn’t enough income to pay down debt, they came about because the public was convinced it couldn’t raise enough tax revenue to pay down debt.

Republicans refusal to raise taxes and revenue eventually will convince the public (including the investing public) that the US can’t raise enough revenue to pay down debt. The stage is being set for our default.

Posted by Beezer | Report as abusive

I am shocked that with the trillions of U.S. dollars floating around the world that the government only holds $400 billion. Clearly we are no longer able to have a gold standard currency.

I consider myself to be fiscally irresponsible, my money has always burned a hole in my pockets since the time I was a child. But I already hold over $3,500 worth in a safety deposit box.

Posted by RichlandDavid | Report as abusive