Fifty Ways to Leave Your Lender

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It was Otto von Bismarck who explained that “politics is the art of the possible.” We can thank him for that much, but he didn’t tell the whole story. I’ll give you the rest of it. Politics is the art of the possible fictions you can get away with.

Politics is mostly dissembling, and the dissembling is mostly about dodging personal responsibility for the messes governments make. It works out that way because making messes is most of what governments do. So when we ponder how the U.S. government will go about defaulting on its debts, a good way to approach the question is to consider how a default might be presented.

At this point there is no room for doubting that the government will renege on the commitments it has made to give people money. The $9.2 trillion in Treasury securities held by the public is just the tip of the iceberg. Estimates differ, but if you add in the unfunded obligations for Social Security and Medicare, it’s hard to avoid getting a total that exceeds $80 trillion. That works out to $260,000 for every man, woman, and child in the country, including the two-year olds. It can’t be paid, so it won’t be paid. 

But don’t expect any clarity about the matter. Whatever happens, you can count on it not being called a default. No one in the U.S. government is going to say, “Tough luck, Treasury bond investors. We’re not going to pay you another dime. Go pound sand.” And no politician is going to tell the 51 million Americans on Social Security, “If you’re fit enough to pump that rocker, you’re fit enough to work.” It will all be done far more diplomatically.

Entitlement Euthanasia

Defaulting on Social Security is a lesser public relations challenge than defaulting on U.S. Treasury securities because the promise of a monthly Social Security check has always been a promise in flux. Payout rates have been raised repeatedly and now are indexed for inflation. On the other side of the ledger, the rates and ceilings on FICA tax have been raised repeatedly, as have the eligibility ages. It’s easier to renege on a quid pro quowhen neither the quid nor the quo is ever allowed to come to rest.

Also helping to make a default on Social Security politically manageable is that each participant has been promised something different. Some people are owed a lifetime annuity right now. Others are owed something that isn’t scheduled to start until 40 years from now. So the politicians have a way to focus the default on the groups who aren't inclined to complain too much – the people who are aren't expecting to receive anything soon.

One way to focus the default on the far tomorrow is to steadily increase the eligibility age. For example, the eligibility age could be raised by one month every calendar year.

The government already has some practice at this. When the program began, the age for eligibility was 65. Now the eligibility age for full benefits depends on when a person was born. If you didn't open your eyes before 1960, your eligibility age is 67.

A secular rise in the eligibility age would shrink the government's Social Security debt to whatever size the government is actually able to pay. It could even be used, with little pain, to eliminate the program altogether. You could call it euthanasia for Social Security, although your congressman surely won't.

The trillions in unfunded Medicare promises can be shrunk to a manageable size in much the same way – gradually raise the age for eligibility. And it all can be done in the name of "protecting the system so that the elderly can count on receiving every dime they have been promised."

Shrugging Off Treasury Debt

Defaulting on U.S. Treasury securities while denying the fact is a bigger challenge, but it can be done.

One avenue would be default through inflation. Pay all the dollars that have been promised, but make those dollars smaller and smaller in purchasing power. That would be simple to accomplish if all the Treasury securities outstanding were 30-year bonds. Over a period of 30 years, a price inflation rate of just 10% per year would vaporize 94% of the purchasing power of a 30-year bond. Poof! No more debt problem.

But in fact the trillions in U.S. Treasury securities aren't all 30-year bonds. The average maturity of Treasury debt (bonds, notes, and bills) is only six years. As debt comes due, it can be refinanced only by issuing new bonds, notes, or bills at then current interest rates – which would be rising to match the market's experience with inflation.

So for the government to default on its debt through inflation, it wouldn't be enough for the Federal Reserve to engineer a high inflation rate and stick to it. The default would require progressively higher and higher inflation rates, to outpace the rise in interest rates that the preceding year's price inflation would constantly be fueling. 

Eroding the dollar's value may turn out to be an important element in shrugging off debt, but given an average debt maturity of just six years, the shrinking-dollar strategy couldn't accomplish enough without pushing inflation rates toward triple digits. To rely on inflation as the primary means of default without going near triple-digit territory, the government would first need to lengthen the average maturity of Treasury debt, for example by replacing maturing T-bills with long-term bonds. The cover story would be about the prudence of issuing long-term debt with a fixed, known interest cost, rather than being subject to the interest rate volatility of the T-bill market.

Another maneuver to lengthen the maturity of Treasury debt, in preparation for a slow default through inflation, is for the government to announce that while it is committed to paying everything it owes, it just can't pay it on time. But not to worry, because the government will continue to pay interest – at whatever rate was promised when the security was issued – for as long as the delay persists. That would in effect turn T-bills and Treasury notes into long-term T-bonds. That seems heavy-handed, but it still leaves room for denying the fact of a default. And it's been done before by a number of countries, under the label of "rescheduling."

A Political Triple Play

If the government decides to take any of these approaches to a deniable default, it would be politically more advantageous to stiff foreigners rather than U.S. investors. That would require getting most of the outstanding Treasury securities into the hands of foreigners. It could be done.

The U.S. imposes withholding at a rate of 30% on dividends and other types of investment income paid to non-U.S. investors. But there is a very broad exemption for interest payments. So under current rules, foreigners can invest in most types of bonds issued in the U.S. without losing anything to withholding. 

A simple way to stick foreigners with the pain of a default would be to extend the withholding system to cover corporate bonds but not Treasury bonds. Non-U.S. investors would then have a compelling motive to replace their holdings of U.S. corporate bonds with Treasury bonds. T-bonds would flow out of the U.S. and corporate bonds would flow in. Most of the portfolio adjusting would be done within a year or so. Then the government would change the rules again. Withholding would be extended to Treasury bonds, at 30%, or at some higher rate, say 40%.

Most of the value (and most of the debt burden) represented by a long-term bond is in the interest payments, not in the principal. Imposing withholding on the interest at a rate of 40% comes close to a 40% default on the debt. It would be done in the name of balancing the budget (everyone’s for that) and as a counterattack on tax havens (where devious rich people hide their money), and it would be done to foreigners (many of whom are Chinese exporters that have been taking advantage of the U.S. for far too long). A political triple play.

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About Terry Coxon

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