I’ve assumed that the profligate spending and borrowing planned by the Democrats in Congress and the White House will run up a debt that we and our children just can’t pay, so, in the time-honored tradition of banana republics, the Obama administration or its successors will inflate our currency and repay its creditors (China, mostly) in devalued dollars. Thus, I’ve been buying gold. I’ve assumed that an actual default by the United States government is unthinkable.
Jeffrey Rogers Hummel, however, disagrees. He writes: Why Default on U.S. Treasuries Is Likely. HIs thesis is that times have changed, and it isn’t so easy to inflate our way out of debt:
Many predict that…the government will inflate its way out of this future bind, using Federal Reserve monetary expansion to fill the shortfall between outlays and receipts. But I believe, in contrast, that it is far more likely that the United States will be driven to an outright default on Treasury securities, openly reneging on the interest due on its formal debt and probably repudiating part of the principal.
Hummel explains that most money is now created privately by banks and other institutions, not the government, so that “[o]nly in poor countries, such as Zimbabwe, with their primitive financial sectors, does inflation remain lucrative for governments.”
A steep tax increase won’t really work for the Obama administration either. This chart shows federal spending and receipts as a percentage of GDP since 1936; click to enlarge:
Two things stand out. First is the striking behavior of federal tax revenue since the Korean War. Displaying less volatility than expenditures, it has bumped up against 20 percent of GDP for well over half a century. That is quite an astonishing statistic when you think about all the changes in the tax code over the intervening years. Tax rates go up, tax rates go down, and the total bite out of the economy remains relatively constant. This suggests that 20 percent is some kind of structural-political limit for federal taxes in the United States. It also means that variations in the deficit resulted mainly from changes in spending rather than from changes in taxes. The second fact that stands out in the graph is that federal tax revenue at the height of World War II never quite reached 24 percent of GDP.
Compare these percentages with that of President Barack Obama’s first budget, which is slated to come in at above 28 percent of GDP. Although this spending surge is supposed to be significantly reversed when the recession is over, the administration’s own estimates have federal outlays never falling below 22 percent of GDP. And that is before the Social Security and Medicare increases really kick in. In its latest long-term budget scenarios, the Congressional Budget Office (CBO), not known for undue pessimism, projects that total federal spending will rise over the next 75 years to as much as 35 percent of GDP, not counting any interest on the accumulating debt, which critically varies with how fast tax revenues rise. However, the CBO’s highest projection for tax revenue over the same span reaches a mere 26 percent of GDP. Notice how even that “optimistic” projection assumes that Americans will put up with, on a regular peacetime basis, a higher level of federal taxation than they briefly endured during the widely perceived national emergency of the Second World War.
A grim scenario? To say the least. Hummel continues:
We all know that there is a limit to how much debt an individual or institution can pile on if future income is rigidly fixed. We have seen why federal tax revenues are probably capped between 20 and 25 percent of GDP; reliance on seigniorage is no longer a viable option; and public-choice dynamics tell us that politicians have almost no incentive to rein in Social Security, Medicare, and Medicaid. The prospects are, therefore, sobering. Although many governments around the world have experienced sovereign defaults, U.S. Treasury securities have long been considered risk-free. That may be changing already. Prominent economists have starting considering a possible Treasury default, while the business-news media and investment rating agencies have begun openly discussing a potential risk premium on the interest rate that the U.S. government pays. The CBO estimates that the total U.S. national debt will approach 100 percent of GDP within ten years, and when Japan’s national debt exceeded that level, the ratings of its government securities were downgraded.
There’s more, just follow the link. Hummel’s bottom line is rather cosmic:
[A] century of experience has taught us that the client-oriented, power-broker State is the gravity well toward which public choice drives both command and market economies. What will ultimately kill the welfare State is that its centerpiece, government-provided social insurance, is simultaneously above reproach and beyond salvation. Fully-funded systems could have survived, but politicians had little incentive to enact them, and much less incentive to impose the huge costs of converting from pay-as-you-go. Whether this inevitable collapse of social democracies will ultimately be a good or bad thing depends on what replaces them.
The end of the welfare state would be a good thing, and I don’t doubt that it’s coming. It’s hard to think that the federal government’s repudiation of its debt would be a good thing, too.
A very sophisticated reader who sent me the link to Hummel’s column writes:
This is excellent…Quite thorough discussion of the strategic end-state of the middle class entitlement welfare regime.
I asked King Banaian, a PhD economist and chairman of the Economics Department at St. Cloud State University (not to mention a member of the Northern Alliance Radio Network) to comment. He replied:
Yes, I had read some of that column earlier today and hadn’t finished it until now. It’s plausible.
Suppose you had a credit card. Each month you charged enough more that your minimum payment never covered the entire amount of interest on it. At some point your debt escalates to a point where the bank stops you. You declare bankruptcy, which effectively is repudiating your personal debt. This is what the government is doing. Its deficits are so large that even if you net out the interest charge, there is still a deficit (we call this a primary deficit.) No government can long endure with a fiscal policy that does not bring the primary deficit into long-run balance. Given that the federal government has never long sustained taxes greater than 20% of GDP, you have to bring the share of government spending down to that level, or else you get investors to believe the debt is a Ponzi scheme. When that happens, you either pay more and more interest, or you go bust.
Governments can’t declare bankruptcy in the same way people do, but they can decide not to honor their debt. They can also decide to inflate away the nominal value of it. Unlike Hummel, I think the inflationary route is more likely. (I note that I own TIPS — Treasury Inflation-Protected Securities — in my tax-protected retirement account.) An outright repudiation would bring the wrath of foreign governments, particularly China, down on the US like nothing you’ve ever seen before. It would also ruin my inflation hedge, but that’s the least of my issues if that happens.
We’ll let it rest there: hyperinflation or default. One or the other is the inevitable result of the unprecedented irresponsibility of Barack Obama’s administration. Either one is a disaster, not so much for us, but for our children. Obama and his advisers are gambling, evidently, that we don’t care much what happens to our children and grandchildren, or to our country after we’re gone.