Time for another default?

Should the U.S. declare a default on its governmental debt?

I never imagined I would suggest that the U.S.A. renege on its borrowings, but I'm starting to entertain the idea as a "lesser evil". Federal debt was about 55% to 65 % of GDP at the start of 2007; now, with all then new government spending and "rescuing", it is slated to rise to 90% of GDP by 2011.

This 90% number understates the magnitude, because the government has also taken on large, new "off balance-sheet" obligations. For instance, in 2007, the government's official position was that it was not responsible for money borrowed by Fannie and Freddie. A CBO report, from 2001, said this:

A typical disclosure from a Fannie Mae prospectus states, "The Certificates, together with interest thereon, are not guaranteed by the United States. The obligations of Fannie Mae are obligations solely of the corporation and do not constitute an obligation of the United States or any agency or any instrumentality thereof other than the corporation."

However, when push came to shove and the U.S. government (ex Treasury Secretary Paulson) did not dare insist on the explicit provision in the prospectus. Instead, late in 2008, the government decided to make the guarantee of Fannie/Freddie debt explicit. Later, the government also guaranteed debt of certain banks.

The US is in the exact position in which many poor borrowers find themselves: they don't know how they'll repay their debt tomorrow, but they really, really need the money just now. It is always easier to push the problem to the future, and borrow now. This does not work unless lenders evade too. Politicians are usually happy to evade this way, and to push any problem beyond the next election. In this case, the major lenders are politicians too, with foreign central banks holding large amounts of US government debt.

As a U.S. taxpayer, I will end up paying for this evasion. Continued evasion simply means that the U.S. will be encouraged to borrow more, and to inflate more, and waste more. The solution is simple: recognize the problem now, and begin to deal with it. A default would be a rude wake-up call: something that nobody could evade. It would make the poor creditworthiness of the U.S. government explicit. If we need a default to scare everyone into action before things get still worse, a default would be a lesser evil.

Fannie/Freddie debt was different from direct U.S. government debt, because it did not have an explicit government gurantee. This is debt the government did not have to take on. This debt would have been the ideal candidate for a default, because it could be done while upholding true government debt. Even a small gesture -- for instance, if the government had said they would guarantee a part (say 80%) of the Fannie/Freddie debt -- would have put lenders on notice.

Major lenders to the U.S. governments are not idiots! Until recently, with debt around 60% of GDP, they could have held up hope that future U.S. taxpayers would foot most of the bill. Some evasion was involved, and the big lender of the recent few years --the Chinese government -- had its own political reasons to evade. However, the recent U.S. government spending has worried them, and the Chinese have been scolding the U.S., saying the government needs to be more careful with spending.

This week, we saw a small example of the pressure that lenders can bring to bear. Secretary Geitner has just gone to China and is reassuring them that the U.S. will try not to exceed an annual deficit of 3% of GDP. These are promises, promises... If the U.S. had insisted that the lenders to Fannie/Freddie at least take a "haircut", that would have been something concrete, a real loss rather than a probable one.

What would have happened if the government had not backed Fannie/Freddie 100%? It is possible that the recession would have got deeper faster. Instead of being able to keep interest rates low, anything like a default would have sent interest rates up. Home prices might have dropped even lower than they did, unemployment might have risen higher, the stock market may have gone lower. However, the economy would have readjusted to the new realities rapidly. That is what happens when the amount of evasion is lessened: people not only adjust to the new reality, but -- in terms of real wealth -- build up from that base more rapidly than from an economy propped up by inflation.

It is less than a century since the U.S. defaulted on its debt, when F.D.R. brazenly rescinded its promise to pay its debts in gold. A dollar used to be a promise to pay about 1/21th of an ounce in gold. In about a year, it was changed to a promise to pay 1/35th of an ounce. The SCOTUS upheld this as being constitutional. Creditors would only get 57% of their loans back! It was a dishonorable act.

I think the U.S. should pay back its creditors. This is a rich country, that produces a great deal of wealth every year. If the government did not fritter away such a large portion, we could easily do the honorable thing. I fear though, that we have to choose between a small dishonor today that serves as a wake up call, or a much worse fate in the future.