With Debt Burgeoning, Could the U.S. Default?
Washington Post - June 14, 1992
Picture Uncle Sam telling you what a number of foreign governments have told their creditors and bankers: "I'm not going to pay you."
Unthinkable?
Not to Christopher Whalen, 34, a Washington-based financial consultant who worked for three years as an analyst at the Federal Reserve Bank of New York.
Whalen, whose heroes include economists Milton Friedman and the late F.A. Hayek, doesn't like the prospect of the United States defaulting on its debts. But he says defaulting is preferable to a long, painful slide that will only postpone the day when the United States returns to economic and financial health. By doing it now, he contends, the nation could swallow all the bitter medicine in one big gulp, and get on with rebuilding.
"Let's just admit the reality that the {national} debt will never be repaid, or will be repaid in inflated dollars, and start over," he said. "It would be beneficial to the economy because you would cripple the government's ability to borrow. I think that would be wonderful because then the government would have to go to the people every time they wanted to spend money."
He added: "If it's good enough for Brazil and Mexico, why not us? After all, doesn't the world owe America one debt forgiveness?"
How could a default work?
According to Whalen, the government could announce that it would no longer pay interest to holders of U.S. Treasury bills, notes and bonds. Then the Federal Reserve Bank system could agree to buy back these securities for their face value, in cash. To do this, the government would have to print as much as $2.7 trillion, the portion of the total national debt now held by foreigners, investors and anyone other than the government or its agencies.
Such a measure would be extremely painful. The printing of reams of money would, in the short term, cause unprecedented inflation. Millions of Americans, especially such groups as college students and the retired, would have to forgo the money they count on from government fixed-income securities. Insurance companies, which are big holders of long-term bonds, would find their assets drastically devalued.
Nevertheless, Whalen believes that given the inability of Congress and the Bush administration to deal with the continuing deficits, it would be the quickest way to put the U.S. economic house back in order.
The national debt would be gone, and the government wouldn't have to borrow several hundred billion dollars a year to pay the interest on it. The government would have to balance the budget - taxes would have to equal spending - because nobody would be willing to lend it money for the time being.
Longer term, the clean slate could help business and promote rapid growth by creating a climate of low inflation and low interest rates. As confidence in the U.S. government returned - it might be buttressed by its bold action, once the initial shock of what it had done had passed - some federal borrowing might be possible. But it would be for productive investments, such as education, infrastructure, science and space exploration, not for repaying interest.
In short, the risk of economic turmoil would be outweighed by action that "would wake up the nation and tell taxpayers what the story is," Whalen said. "The only way politicians have gotten away with this is that the consequences of over-borrowing have come out in dribs and drabs."
One result of the steadily rising annual interest payments on the federal debt is a core rate of inflation of about 3 percent a year, Whalen contends. When the government goes in debt to fund current spending, it makes the economy run faster than it would if it couldn't borrow. Excess dollars chasing goods and services causes inflation.
In a default, the country takes the entire inflationary impact of its excesses in one blow, instead of spreading it out over many years. Over 15 to 20 years, Whalen believes, the current inflation rate will have the same ruinous effect on the U.S. credit rating as a one-time default now would have.
"If the government doesn't move soon for an orderly reduction of debt, we're headed for a repudiation of interest," he said. "It'll be Third World economics time. It would destroy a lot of wealth. It would put us in the ranks of Brazil."
Such talk of default is dismissed as dangerous and irresponsible by most Washington fiscal experts and economic policy makers. But on Tuesday, House Speaker Thomas Foley (D-Wash.) uttered the "D" word - not to endorse the idea but to describe the possible consequences of a balanced-budget amendment.
"It could create problems with forfeit," he said on the Public Broadcasting Corp.'s McNeil-Lehrer News Hour. "I should say a problem in the sense of not meeting our obligations, and we {could} have a default on U.S. government obligations in a year when Congress and the president could not come to agreement and not meet the obligations that the full faith and credit of the United States is pledged to."
James Dale Davidson, chairman of the National Taxpayers Union, wrote in the Wall Street Journal recently, "If we continue to ignore this degraded balance sheet and let the deficit skyrocket, the day will come when the escalating cash demands of government will inevitably overwhelm credit markets, resulting in a downgrading of all government securities."
Davidson said that the Social and Economic Congress of Japan has warned Japanese investors that the U.S. Congress may default on the national debt.
A less drastic step than declaring an outright default, according to Whalen, would be for the government to impose a higher federal tax on the interest earned on Treasury securities, recouping some of the interest costs without officially announcing a default.
In fiscal 1991, the U.S. government paid out $196 billion in interest on the $2.7 trillion in debt held by the public. This annual budgetary expense will grow to $280 billion by 1997 under present scenarios. (Not included in this liability are outstanding U.S. government guarantees on pension funds, student loans and home mortgages.)
The annual interest payments on the debt account for nearly half of this year's estimated budget deficit, and are the third-largest item in the federal budget after defense spending and Social Security.
Some of Uncle Sam's debt is at extremely high interest rates - up to 15.8 percent. When interest rates were at record levels in the early 1980s, the U.S. government-issued bonds had to offer such premiums in order to finance the deficit. Unlike many borrowers, the U.S. government cannot refinance most of its long-term loans at today's lower interest rates, because that would upset the financial markets.
The creditworthiness of the U.S. government, which enables the Treasury to pay the lowest market interest rate available to its creditors, has been a given for decades. Treasury securities, long considered the closest thing to a risk-free investment, serve as the benchmark for stock, bonds and currencies. To undermine faith in the U.S. Treasury would risk global financial instability. Therefore, most observers agree that a repudiation of the debt is unlikely in the foreseeable future.
The day the government defaults on even a penny promised a bondholder, said Edward Yardeni, chief economist for C.J. Lawrence in New York, "that's the day you'd be talking about the U.S. being in the same camp as Brazil. Before we'd let that happen we'd raise the tax on gasoline by $2 a gallon."
Yardeni said the bond market carries more clout than other special interest groups, and wouldn't let it happen. For if the government defaulted on interest, bond prices would collapse and interest rates would skyrocket and that would induce a depression. Nonetheless, he said, "There's a compounding effect of interest, so something has to happen."
"I don't think a default is likely," agreed James Grant, editor of Grant's Interest Rate Observer and one of Wall Street's most pessimistic analysts of the stock market and economy. But some of Grant's views echo Whalen's. "Is the state of the public financing reaching some serious point of no return? Yes," he said.
Where Grant parts company with Whalen is in his belief that "government will conjure up some way to pay... ." He suggests jestingly that the government in theory could repay its debts with assets other than dollars - failed savings and loans or cans of tuna fish included.
Default and debt restructuring has been a favorite tool for the likes of Donald Trump, Latin American countries and others who borrowed too much money in the 1980s. The decision of Bridgeport, Conn., to file for bankruptcy last year showed that local governments are not beyond drastic measures to cut expenses.
Whalen takes exception to the idea that defaulting on interest payments would throw the markets into intolerable chaos, dismissing that as a "quaint notion of the 1950s" that has been overwhelmed by the depth of the country's current economic woes.
The U.S. government's vaunted creditworthiness has had its negative side, he suggests, enabling the country to borrow excessively from investors who didn't ask tough questions about the underlying health of the country's finances.
"Debt is bad. It's always been bad," Whalen said. "And public debt is especially bad because it carries the pernicious illusion that the state can carry it forever."