🔋Debt Pt. 3: Sovereign Default
As nations trend irresponsibly toward debt crisis, there are only few solutions left - good, bad, and ugly.
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A few weeks ago in part 1 I talked about the ballooning federal interest payments on debt. As many of you know the government reached another one of its debt ceilings around that time and has been running up massive deficits for decades exacerbated by the COVID pandemic response. As the overall debt relative to GDP (or productivity within the economy) increases along with higher interest payments, the debt becomes more of a drag on the economy than a stimulating tool. Throughout history, when debt levels get too high and a country cannot meet the obligations to who they owe, they default. A debt default is nasty to anyone involved as it means you lose something of value that you were using debt to pay for, similar to an individual missing a house or car payment. In such case the property will be repossessed by the lender.
In todays world things are manipulated with interest rates like I discussed in part 2. The central banks in control of the monetary policy will manipulate interest rates towards the zero bound where borrowing money is essentially free. It is difficult to convince people to purchase negative yielding bonds so historically the central banks tend to purchase more of the debt which causes problems. As prominent macro analyst Lyn Alden says,
The zero bound is where the magic starts to happen, and things change.
The US and other central banks hit the zero bound after the financial crisis in 2008 until 2015 and again for two years following the COVID pandemic. Countries and their central banks have slightly different options that individuals in a debt default however. A nation has a few options - austerity, taxation, productivity boost, traditional default/restructure, or financial repression. I will briefly discuss each and give a real world example of when it happened or what it may look like today.
Austerity
Before a country fully defaults, there are a few things it can do to avoid the default. Austerity means that the government reigns in spending to at or below what it brings in for revenue. This involves lower spending for military, social programs, other federal spending, and perhaps lowering corruption in some cases. Taxation is the largest portion of government revenue. What could the government fail to fund if spending were limited by tax receipts today? This is clearly an unfavorable option politically and even most citizens. People demand programs that will benefit them or their groups and there is near infinite demand for “more stuff/money”. It is not common for federal governments to take this route unless their hand is forced. This option goes against the prevailing Keynesian economic theory where the governments role is to spend more to stimulate when aggregate demand during a recession is low. Current political conservatives are more known for advocating this route, however their track record shows there is no difference in the rising deficit under conservative or liberal parties in their current form.
Example: You have to go back to the roaring 20s which followed massive government monetary expansion during WW1. During that time, president Harding cut federal spending by 50% and was able to reduce the debt by 30%. Keynsians’ argue that this spending reduction and the failing to stimulate early into the 30s was a reason for the great depression (disputed by Austrian economists). Nevertheless, it was an effective strategy at changing the federal balance sheet, which since then has only gone up.
Taxation
This is another obvious route where the governments are in trouble and raise taxes or tariffs to try to increase revenue. Often times this can help in the short run but ultimately can stifle productivity and future revenue in the process. This approach is often combined with austerity and depends on the ruling political party at the time.
Example: Another often ambiguous and controversial one. Often paradoxically, tax reductions implemented by Harding or Reagan can increase revenues over time due to the simulative effect of lower taxes. On the other side, tax increases can directly increase federal revenue all else equal, especially with a generally growing economy. The IMF says that tax based efforts are riskier and can suffer more deeper recessions than austerity based efforts. As such, they are generally a last resort because of that risk. Today, different tax plans like wealth taxes and higher taxes on the rich are increasingly popular strategies to increase federal revenue. This way the working class can still contribute and the wealthy who already more well off can take the brunt of the increases.
Increased Productivity
If the country were able to simulate the economy somehow and increase productivity that then yielded a greater return than before, the government could bring in more revenue and pay off the debt faster than it accumulates. This is sort of the idea of fiscal stimulus packages. If we can stimulate with debt a little now, the return in the economy will be great enough to offset the initial spending and help in the long run. If this always worked then we wouldn’t have a debt problem and we could trust where politicians spent money. The reality is that government spending tends to overtime become less productive and not go towards optimal purposes. This could be considered malinvestment where the free market likely could have placed the money to better use elsewhere. The other option is a technological development, but these are out of the control of the government for the most part.
Example: One example is the hydraulic fracking breakthrough which made natural gas cheaper in the US. This technological achievement was synergistically encouraged through government incentives and low interest rate debt which resulted in a boom of cheap resources for much of the last 20 years. While many benefits came of this, could the intervention have caused a disruption of market forces that would have favored other technologies like nuclear or renewables? We can only speculate. The printing press, the combustion engine, and the internet are all technological breakthroughs that while not purposefully lowering government debt, net-net increase the productivity and the subsequent tax receipts that the government receives may increase. Let me know what tech you think could boost GDP going forward?
Traditional Default/Restructure
In a traditional debt default the original debt obligation gets wiped/restructured, collateral (if any) gets seized, and the nations debt gets a downgraded credit rating and less favorable lending in the future.
Example: Greece is a prime example of a debt crisis in recent memory. Many factors led to the IMF bailout in 2010 including federal spending exceeding revenue from the 2004-2009 time period. Spending to GDP went bananas and Greece’s sovereign bonds were downgraded to a abysmal junk rating along with lowered confidence in the Greek economy. Austerity measures and tax increases were implemented in an attempt at control. The economy suffered akin to a depression, there was social unrest, and eventually a 50% debt haircut restructure was negotiated because the burden was still too intense. At one point the debt to GDP ratio actually rose, not because of new spending, but significantly lower GDP. Even in the US, deflation in assets like stocks and real estate along with unemployment caused massive panic in millions of people during and following the financial crisis. These types of deflationary events are nightmares to governments and their citizens because of the pain they cause which is why central banks spend like mad to avoid them at all costs.
Financial Repression
That brings us to the final type of debt crisis avoidance strategy, financial repression. It is by definition the negative real interest rates that I mentioned earlier. And yes, that means for much of the 20th century we have been living in financial repression even in the US. Like I mentioned before the value of the savings and bonds are devaluing faster than the rate of return so you lose real value and get poorer. There is often a flood to purchase anything including goods/services, stocks, real estate, commodities etc. when it gets bad enough. Although we have been in a soft financial repression for the last ~20 years in the US and Europe, we have not seen this mass panic with the currency.
Example: The most poignant example of financial repression is post-WW1 Weimar Germany. To anyone unfamiliar, the book When Money Dies is a fascinating and detailed account of the financial repression that occurred in Germany between WW1 and WW11. In short, due to high foreign debt obligations in large part due to mandatory war reparations, Germany hyperinflated its currency to pay down debt and stimulate the economy. This destroyed the wealth many had accumulated in stocks, savings, and real estate, made most wages unlivable, and pushed the country toward a barter economy. The value of a mark went from 5 marks/dollar to over 1 trillion marks/dollar by the end.
In the case of the US who is lender and debtor with the most powerful “printing press” in the world, in a simplistic analogy the lender just gives the debtor (itself) more money to keep paying the debt. Even as the US accumulated more debt, it is relied upon by most of the world to trade in dollars. There is -at least currently- huge demand for US bonds and currency from around the world. Confidence in the US bond and stock market may be the best of any country as well. These factors combined with the largest military, ‘less bad’ demographics, and good natural resources make it difficult to imagine the US struggling with debt like other countries do. That being said, it is true that crazy things occur near the zero bound for interest rates. With debt/GDP ratios over 100 and lower interest rates nearly a guarantee in the future, there is likely some weirdness to ensue. Although traditional default unlikely for the US and its close allies, we are likely to see a number of the schemes outlined above in the coming years/decade as things progress. What shape and form they take is pure speculation but an outline from historical precedence we do have. Until next week.
-Grayson
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A solid analysis. In the US we are devaluing as the way to handle the debt. For most of the post WW2 period, revenues were ~ 20% of GDP regardless of tax rates and outlays were ~22% of GDP. We allowed ~ 2% inflation which stabilized the economy. That ended in 2008 when the Obama government basically bailed out the financial wizards just as the FDR boomer time bomb of retirements took over. The debt and debt service exploded and Fed interest rates were cut, an attempt to export inflation. We are now at the crossroad where the Fed had to put a real value on capital and the debt service is now a major factor, certain to squeeze all outlays. Citizens will not be pleased at the situation the politicians have created. There has never been free anything. A lot of people will be quite angry.