August 11, 2022

Economix: Will the United States Default?

Today's Economist

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

Three views emerge on whether the United States will default on its government debts, as I talk to people on and close to Capitol Hill. The first is, hopefully yes, and this August offers a good opportunity. The second is, possibly yes, but this would be bad, so we need some form of fiscal austerity. The third is, under no circumstances, and any talk of a need for austerity is a hoax.

The first view is mistaken. The second view hides a dangerous contradiction. And the third view borders on complacency. So how can we find our way to fiscal responsibility? We need tax reform.

People in the first camp think that the United States government has become too big and the only way to cut it down to size is to limit its ability to borrow. A constitutional amendment to limit the size of government relative to gross domestic product or to require a balanced budget could work, but experience suggests a future Congress could always find a way to escape any such constraint.

A big part of the underlying problem is that the world has a taste for American assets. Foreign citizens and many of their governments like the ability to buy and sell dollars in liquid markets, and they are particularly fond of American government debt as a place to keep their rainy-day money. Private investors and government wealth managers around the world wring their hands about the trajectory of deficits and debt in the United States – and then buy more of that debt.

So, in one interpretation of this view, the only way to remove the ability of the federal government to borrow is to miss some payments, thus convincing the financial markets that the government is not really a good credit risk.

Such thinking is part of the strategy to threaten not to extend the debt ceiling for the federal government. That would lead to defaulting on some debt. But default, as the Greeks are finding out, is an all-or-nothing enterprise. Doing just a little default is not possible,  because, in the view of the market, your country pays its debt in full and on time, or it does not.

The consequences of a United States default would be severe, not just for world markets but also for the ability of every American business and household to borrow, lend or make just about any financial decision. So threatening to blow up the current government debt system is not a credible threat, unless you sincerely believe that this would be a good thing ultimately for all concerned.

From the hearing I attended in June of the Joint Economic Committee of Congress, my distinct impression is that some leading legislators are leaning this way. In coming votes on raising the debt ceiling, we’ll find out how many members of the House support such views.

The second camp represents the mainstream of American politics today. Genuinely worried about future insolvency, people on both sides of the aisle propose ways to cut future budget deficits. On the Republican side, people prefer spending cuts; the Democrats would rather raise taxes.

Everyone in this camp fully intends to allow the government to pay its debts. Yet increasingly it appears that some people on the left and the right might be attracted to the idea of a government shutdown, at least for a while, assuming that they can effectively blame the other side.

The point is not to change the nature of government or its ability to borrow, but rather to position ideas and personalities for the 2012 presidential election. The government will be able to make its debt payments, but only if it does not pay wages or keep some nonessential parts of government functioning.

The good part of this thinking is that mainstream politicians are increasingly talking about budget constraints and the need to live within our means. The bad news is that these same people extended the so-called Bush tax cuts at the end of 2010, at a stroke not just refusing to deal with the deficit but also significantly contributing to what they now say is our most pressing problem.

The net impact on debt in 2018, relative to what it would have been otherwise, is an increase of $3 trillion. The Congressional Budget Office says in that year nearly a quarter of total outstanding federal debt will exist because these tax cuts were extended last December. (In these pages, James Kwak and I have made the case for opposing the extension.)

For both parties, the gap between rhetoric and policy actions within the mainstream is not closing. And the presidential election is unlikely to help very much. The Bush tax cuts are up for renewal in 2012; are any candidates likely to run on the platform of not extending them?

The third position is that the United States cannot default on its debts. People in this camp offer various explanations, mostly having to do with the fact that long-term interest rates are at their lowest in 50 years. Clearly someone is happy buying United States government debt.

But how long will this continue? Will foreign investors seek to shift out of dollars in the foreseeable future, perhaps because the euro becomes more appealing? And if the Federal Reserve steps in to buy whatever government paper is not wanted by private participants, this surely can become inflationary.

We have put our head into the mouth of the financial markets lion. Ask Greece, Ireland or Italy what happens when the lion’s mood changes.

You will note that none of these three views addresses tax reform, except in passing. Left and right agree that as a country we spend too much relative to our income. It would make sense, therefore, to find ways to tax consumption more and income less.

This could be done in a way that is not regressive, that does not punish people at the lower end of the income scale. Some of the most progressive tax systems in the world are based in large part on consumption taxes.

Such tax reform could support either a smaller government or a larger one. With a stronger tax base, the size of government is a good debate to have, but that issue that can be completely separated from whether our current and future deficits can be sustained.

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