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by Free Market Duck

Default Now, or Suffer a More Expensive Crisis Later

by Rep Ron Paul

(Jul 24, 2011)

Washington, DC -- Debate over the debt ceiling has reached a fever pitch in recent weeks, with each side trying to outdo the other in a game of political chicken. If you believe some of the things that are being written, the world will come to an end if the U.S. defaults on even the tiniest portion of its debt.

In strict terms, the default being discussed will occur if the U.S. fails to meet its debt obligations, through failure to pay either interest or principal due a bondholder. Proponents of raising the debt ceiling claim that a default on Aug. 2 is unprecedented and will result in calamity (never mind that this is simply an arbitrary date, easily changed, marking a congressional recess). My expectations of such a scenario are more sanguine.

The U.S. government defaulted at least three times on its obligations during the 20th century.

-- In 1934, the government banned ownership of gold and eliminated the right to exchange gold certificates for gold coins. It then immediately revalued gold from $20.67 per troy ounce to $35, thus devaluing the dollar holdings of all Americans by 40 percent.

-- From 1934 to 1968, the federal government continued to issue and redeem silver certificates, notes that circulated as legal tender that could be redeemed for silver coins or silver bars. In 1968, Congress unilaterally reneged on this obligation, too.

-- From 1934 to 1971, foreign governments were permitted by the U.S. government to exchange their dollars for gold through the gold window. In 1971, President Richard Nixon severed this final link between the dollar and gold by closing the gold window, thus in effect defaulting once again on a debt obligation of the U.S. government.

Unlimited Spending

No longer constrained by any sort of commodity backing, the federal government was now free to engage in almost unlimited fiscal profligacy, the only check on its spending being the market’s appetite for Treasury debt. Despite the defaults in 1934, 1968 and 1971, world markets have been only too willing to purchase Treasury debt and thereby fund the government’s deficit spending. If these major defaults didn’t result in decreased investor appetite for U.S. obligations, I see no reason why defaulting on a small amount of debt this August would cause any major changes.

The national debt now stands at just over $14 trillion, while net total liabilities are estimated at over $200 trillion. The government is insolvent, as there is no way that this massive sum of liabilities can ever be paid off. Successive Congresses and administrations have shown absolutely no restraint when it comes to the budget process, and the idea that either of the two parties is serious about getting our fiscal house in order is laughable.

Boom and Bust

The Austrian School’s theory of the business cycle describes how loose central bank monetary policy causes booms and busts: It drives down interest rates below the market rate, lowering the cost of borrowing; encourages malinvestment; and causes economic miscalculation as resources are diverted from the highest value use as reflected in true consumer preferences. Loose monetary policy caused the dot-com bubble and the housing bubble, and now is causing the government debt bubble.

For far too long, the Federal Reserve’s monetary policy and quantitative easing have kept interest rates artificially low, enabling the government to drastically increase its spending by funding its profligacy through new debt whose service costs were lower than they otherwise would have been.

Neither Republicans nor Democrats sought to end this gravy train, with one party prioritizing war spending and the other prioritizing welfare spending, and with both supporting both types of spending. But now, with the end of the second round of quantitative easing, the federal funds rate at the zero bound, and the debt limit maxed out, Congress finds itself in a real quandary.

Hard Decisions

It isn’t too late to return to fiscal sanity. We could start by canceling out the debt held by the Federal Reserve, which would clear $1.6 trillion under the debt ceiling. Or we could cut trillions of dollars in spending by bringing our troops home from overseas, making gradual reforms to Social Security and Medicare, and bringing the federal government back within the limits envisioned by the Constitution. Yet no one is willing to step up to the plate and make the hard decisions that are necessary. Everyone wants to kick the can down the road and believe that deficit spending can continue unabated.

Unless major changes are made today, the U.S. will default on its debt sooner or later, and it is certainly preferable that it be sooner rather than later.

If the government defaults on its debt now, the consequences undoubtedly will be painful in the short term. The loss of its AAA rating will raise the cost of issuing new debt, but this is not altogether a bad thing. Higher borrowing costs will ensure that the government cannot continue the same old spending policies. Budgets will have to be brought into balance (as the cost of servicing debt will be so expensive as to preclude future debt financing of government operations), so hopefully, in the long term, the government will return to sound financial footing.

Raising the Ceiling

The alternative to defaulting now is to keep increasing the debt ceiling, keep spending like a drunken sailor, and hope that the default comes after we die. A future default won’t take the form of a missed payment, but rather will come through hyperinflation. The already incestuous relationship between the Federal Reserve and the Treasury will grow even closer as the Fed begins to purchase debt directly from the Treasury and monetizes debt on a scale that makes QE2 look like a drop in the bucket. Imagine the societal breakdown of Weimar Germany, but in a country five times as large. That is what we face if we do not come to terms with our debt problem immediately.

Default will be painful, but it is all but inevitable for a country as heavily indebted as the U.S. Just as pumping money into the system to combat a recession only ensures an unsustainable economic boom and a future recession worse than the first, so too does continuously raising the debt ceiling only forestall the day of reckoning and ensure that, when it comes, it will be cataclysmic.

We have a choice: default now and take our medicine, or put it off as long as possible, when the effects will be much worse.  – FM Duck

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