“Will the U.S. Treasury repudiate its obligations to its creditors, be they citizens or investors around the world? Most observers would answer "no" without hesitation. But Congress, with the complicity of the White House and the Fed, has arguably embarked on a stealth repudiation.
In his famous treatise, "The Wealth of Nations," Adam Smith noted there had never been a "single instance" of sovereign debts having been repaid once "accumulated to a certain degree." We may have reached Smith's threshold.
The bond markets are certainly not protecting creditors from the risk of what Smith called "pretended payment" through inflation. Nor did they do so until far into the great inflation of the 1970s. Not until late 1977 and into 1978 did the bond market fully incorporate the reality of the debased dollar, by demanding higher long-term interest rates.
How can this happen? Markets are supposed to be forward-looking and efficiently price in all relevant risks. Yet monarchs have been repudiating debt explicitly and implicitly throughout recorded history.
Many years ago, the Austrian economist Ludwig von Mises offered an explanation. He suggested that while you can't, in Abraham Lincoln's words "fool all of the people all of the time," you can fool all of the people at least some of the time. And this is easier to do if a central bank has in the past earned credibility in fighting inflation.
In the 1980s, Ronald Reagan and Paul Volcker worked together to get inflation under control. They were greatly assisted by the "bond vigilantes," traders who were by then exerting discipline in bond markets by bidding up interest rates to double-digit levels. The outcome of the Reagan/Volcker policy of tight money and low marginal tax rates was not only a great economic expansion, but also a great boost to the Fed's credibility. The Fed proved it was able and willing to withstand political heat in the fight against inflation.
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The markets have long assessed the debt of [Fannie Mae and Freddie Mac] at AAA because of the Treasury's guarantee, now explicit. But no one has ever seriously assessed the Treasury's creditworthiness with Fannie and Freddie on its books. The public guarantee is entirely open-ended and unbounded. The appetite of the two companies to balloon their balance sheets and take on risk has not been curtailed. Meanwhile, Congress spends apace with new programs for constituents in an election year.
We are at a Smithian moment, in which the temptation for the Fed to spend its last dime of credibility may prove irresistible. Investors are already being taxed by inflation and can rationally expect that tax rate (the inflation rate) to be raised going forward. Wages are not keeping up. Main Street is being taxed to fund Wall Street excess. Anyone who works, saves and invests is exposed to confiscation of his capital and earnings through inflation.
If the Fed maintained its independence of action and said no to the inflationary finance of Congress's profligacy, we wouldn't have reached this point. But the Fed has forsaken that independence amid an absence of leadership.
Perhaps, as rarely happens, Adam Smith will be proven wrong. Let us hope so, because hope appears to be all we have.”
Gerald P. O’Driscoll, Jr., “Washington Is Quietly Repudiating Its Debts”, Wall Street Journal (22 August 2008).
Mr. O'Driscoll is a senior fellow at the Cato Institute and a former vice president and economic adviser at the Federal Reserve Bank of Dallas.
In a post on his blog, Marginal Revolution, at the end of July, found here, Tyler Cowen of George Mason University reviewed the cost of the mortgage agency bailouts undertaken by the Federal government in response to the financial crisis now affecting the U.S. economy. Among the points he made was that the bailouts themselves, should they prove to be necessary, represent a transfer payment to debt holders from taxpayers, not an actual economic cost to society since no resources are destroyed. However, in the event of a bailout, there would be a deadweight loss to the economy in terms of the actual cost to effect the transfer from taxpayer to debt holder. Moreover, the burden of the tax necessary to pay the bailout would probably be regressive, in the sense that those that would be taxed to pay for the transfer are less wealthy than the debt holders who would be reimbursed. He also pointed out that the equity holders would no doubt be wiped out and that the borrowing costs required to implement the bailout would depend on how quickly it was undertaken. In other words, even if a bailout does not entail the actual loss of real productive capacity, it still places a very big burden on the economy.
Professor Cowen also expressed the view that the government has no real choice but to bail out the debt holders of the mortgage agencies. The alternative would be financial chaos and a run on the dollar, which he termed “the end of the world”. By this is meant a financial collapse where the Treasury could not sell its bonds, the dollar would drop on world markets, credit would dry up to the private sector and interest rates would rise greatly, and the economy could enter a deep recession as business firms, government agencies and households all found themselves without the ability to borrow the funds they need to continue their regular operations. The adjustment would be incredibly painful and it would take many years to restore confidence in the financial markets, both those here and those abroad. Professor Cowen has said did not believe “the end of the world” was upon us but noted the possibility of ongoing financial problems.
In this article, Gerald O’Driscoll asks the question of whether the accumulating debt obligations of the Federal government are now reaching Smith’s threshold and the process of debt repudiation through inflation is about to begin. In the view of O’Driscoll and others, even if the Federal Reserve does not resort to the printing press to pay the Treasury’s growing obligations, , the Fed is now constrained in raising rates to fight inflation by the negative effect rate increases would have on the mortgage-backed securities in the portfolios of these government-sponsored agencies. This gives an inflationary bias to the Fed’s monetary policy at a time of rising inflationary pressures. One might add to this the fact that the economy appears to be faltering, and if it continues to slow mortgage delinquencies will rise, placing even greater pressure on Fannie and Freddie and other financial institutions. Given our dependence on foreign sources of financing for the Federal government's budget deficit, we are at a time of vulnerability to the uncertainties of world financial markets. Finally, we are at the start of a Presidential election season and any agreement between the Treasury and the Fed and the Administration and the Congress will be hampered by the uncertainties and confusions surrounding the election.
Even if “the end of the world” does not occur before Inauguration Day, the next President, whoever he is, will come to office at a time of a very bad economy with a bleak short-term outlook, a banking system weakened by housing price declines, foreclosures, and bankruptcies and requiring a large-scale bailout, and growing financial imbalances in Social Security, Medicare and Medicaid. Add to this the demands created by a slowing world economy and a deteriorating international political environment. Why, one might ask, would any sane person want to be President of the United States at this time?
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