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In the first installment of this series on government default, we examined the ethical status of the public debt and debt repudiation. Since the debt represents an unjust imposition on the taxpayers, we concluded that the moral thing to do would be to repudiate it and refuse to pay even one cent more to the state’s creditors. In this installment, I will examine what the economic consequences of such a radical policy will be. Such an examination is necessary, because prudence dictates that we cannot suggest a course of action, however ethical and noble it might appear to us, without examining what its consequences are likely to be. As I hinted already in the introduction to part I, however, government default will be very beneficial to all of society. Let us now investigate why that is.
The Nature of Government Debt
People holding public debt will list such debt among their assets, alongside other financial assets. The public debt, thus, at first glance looks like it is part of people’s capital invested in productive endeavors, and from the point of view of the individual investor, this is indeed the case. Investors do not necessarily look at what their funds are used for when making an investment. They are focused on the security of their principal and the expected return. However, the economist takes a different view of credit and can distinguish two general kinds of investment: consumer credit and producer credit.
Consumer credit is loans made for purposes of present consumption. Investors transfer saved funds to people who spend them on present consumption. The saved-up capital is thus destroyed or transformed into durable consumer goods such as houses and cars. Producer credit, on the other hand, is lent to entrepreneurs who wish to expand their production. If the entrepreneurs are successful, the result is a lengthening of the structure of production and an increase in the general productivity of the economy. Both kinds of loans need to be repaid out of present income. Entrepreneurs, if they are successful, repay the loans out of the increase in revenue made possible by the additional investment, while consumers must reduce their savings and consumption to repay the loans. Producer credit therefore leads to additional capital accumulation and increased productivity and wealth for all of society, whereas consumer credit reduces the amount of capital for productive investment below what would otherwise have been available. Consumer credit is a form of capital consumption, in other words.
When it comes to evaluating the public debt, the question is whether it is a form of producer or of consumer credit. Murray Rothbard argued cogently that all government spending, including what is called government investment, is in fact at best a form of consumption spending. While it might seem that government spending on fixed assets such as dams or roads constitutes a kind of investment, this is not in fact the case:
In any sort of division-of-labor economy, capital goods are built, not for their own sake by the investor, but in order to use them to produce lower-order and eventually consumers’ goods. In short, a characteristic of an investment expenditure is that the good in question is not being used to fulfill the needs of the investor, but of someone else—the consumer. Yet, when government confiscates resources from the private economy, it is precisely defying the wishes of the consumers; when government invests in any good, it does so to serve the whims of government officials, not the desires of consumers. Therefore, no government expenditures can be considered genuine “investment,” and no government-owned assets can be considered capital.
Government “investment” must therefore really, concludes Rothbard, be considered a form of consumption, and an antiproductive form of consumption at that. This is true also for expenditures that are initially financed by loans to government, since the repayment of such loans invariably depends on future tax receipts, not on the productive employment of government “assets.”
We must therefore conclude that the public debt is a kind of consumer loan contracted to finance the consumption spending of politicians and bureaucrats. Repudiating it thus does not interfere with and disarrange the production structure of society. On the contrary, since the taxpayers will no longer have to pay taxes to finance the debt, they will have higher net incomes and more funds available for investment than would otherwise be the case. While the public debt appears as capital to the investors holding it, it is clear that it is not real capital, but rather a claim on the forcible extraction of resources from productive citizens. We can perhaps appropriate a Marxist term and call government bonds “fictitious capital” to underline the fact that they are not a part of the productive capital structure of society but really a detraction from it.
An immediate effect of government default will therefore be an increase in true capital accumulation, although the elimination of the public debt may well give people the impression that their personal savings—to the extent that they were invested in government bonds—have been reduced. This impression will only reinforce the tendency toward capital accumulation, since the rate of saving partly depends on how much people have already saved. If their savings are reduced by the government default, they will tend to restrict current consumption and increase their rate of savings.
A second effect of default is that the government’s credit rating suffers. Government debt is often considered a very safe investment, but when a government defaults, investor confidence is severely shaken. It will therefore be much more difficult for a defaulting government to raise funds through borrowing in the future, and it will only be able to do so at a penalty interest rate. This, again, means not only that there will be fewer funds available for government expenditure, but also that it will be more likely that the extra funds made available for investment by the act of default will be invested privately and not in new issues of government bonds.
Repudiating the US Government Debt
Government default would then be economically beneficial, but how would it look in the real world? Let us take the case of the US government. According to the debt clock, the US debt is at about $28 trillion. With current dollar GDP for 2020 at $20.93 trillion, this means a level of indebtedness of about 133 percent of GDP. A lot of this debt is owed to various government agencies, and this debt can simply be cancelled—after all, debt that the US government owes to itself is both its own liability and asset. The official figure for intragovernmental holdings is about $6 trillion, but this is in fact an extreme understatement. Under the heading of “debt held by the public,” the Government Accountability Office (GAO) lists state and local governments. Depending on what constitutional theory one subscribes to, either these governments are creatures of the federal government or the federal government was created by the states; in either case it is clearly a kind of intragovernmental holding. In fiscal year 2019, state and local governments held 6 percent of $16.8 trillion held “by the public” at that time, or roughly $1 trillion. It is unlikely that they have increased their holdings since, and I think it’s reasonable to assume that they also haven’t reduced them.
The much larger item hidden under debt “held by the public” is debt held by the Federal Reserve. While yes, it is true that the Federal Reserve Banks are owned by the private member banks, at the end of the day this is simply window dressing. The Federal Reserve is clearly an agency created by the government, whose board of governors is appointed by the government, and which is tasked with managing monetary policy on behalf of the government. It might formally be private, but in reality the Federal Reserve is a government agency. The debt held by the system should therefore be added to intragovernmental holdings that can in principle simply be canceled. On February 11 the Federal Reserve held almost $4.8 trillion in US government debt, a result of it having effectively monetized the huge deficit of 2020 in addition to the debt accumulated through the various rounds of quantitative easing before that.
All told, then, $11.8 trillion is held by government agencies and state governments and can simply be canceled. The real debt held by the public is “only” $16.2 trillion, or about 77 percent of GDP. Eliminating this debt will still be a huge shock to the system. US households and nonprofits owned $98.7 trillion in financial assets in the third quarter of 2020. Disregarding the $6.8 trillion owned by foreigners, repudiation would mean a $9.4 trillion reduction in the financial assets of US citizens or a decline of about 10 percent. All this is assuming that valuations of other financial assets would not be affected by repudiation, but this is unlikely. The resulting uncertainty will, at least in the short term, lead to a spike in interest rates and hence a general fall in the value of financial assets, exacerbating the impression of a decline in savings.
The result will be, on the one hand, that most Americans will discover that their savings are significantly lower than they thought they were, but, on the other, that the elimination of interest payments on the public debt will reduce the burden on the taxpayer and make it easier for him to increase his savings. Since he is unlikely to again be foolish enough to invest in government bonds, this will mean an increase in the availability of productive capital, an increase in productivity, and in short order an increase in the real incomes of the general public.
In addition to the debt of the federal government, local and state governments have also accumulated a large debt of $3.2 trillion. The effects of repudiating these debts will be similar. The benefits to the taxpayers will be more concentrated in the most heavily indebted states and municipalities, but the elimination of fictitious capital will have the same effects on the economy as a whole.
Government Default and Privatization
Debt repudiation will jeopardize the incomes of retired people too old and frail to rejoin the productive workforce, since private pension funds and insurance companies have invested heavily in government bonds. As I suggested in the previous installment dealing with the ethical questions involved, there would in principle be no objection with these entities receiving government assets in exchange for their bonds. This is especially true for those jurisdictions where workers are forced to have their savings in specific pension funds. Surrendering ownership of government assets—what Rothbard calls waste assets—to pension funds would mitigate the impact on pensioners and increase the amount of producer goods available for productive employment.
This possibility is of particular significance for Japan and European countries. The Japanese public debt is one of the highest among developed countries at nearly 177 percent of GDP according to the International Monetary Fund (IMF). It is also held principally by Japanese investors and pension funds. The benefits of default will therefore be even greater in Japan than in the US, but if repudiation is not to mean destitution for many elderly, pension funds will have to be compensated with government assets. Privatization of government assets as part of the default will in this context be essential. This is also true for European countries, although European debt levels are not as high in Japan. But in Europe as in Japan pension funds invest heavily in government bonds, so the same problem arises here.
Conclusion
Government default will reduce taxes on productive members of society and purge the economy of fictitious capital. As such, it is clearly beneficial. People invested heavily in government bonds risk losing out, but this can be mitigated by transferring government assets to bondholders. Whether it should be so mitigated is an ethical question; those who are forced to hold bonds via their pensions are certainly not collaborators with evil and may reasonably be considered innocent bystanders. Compensating them for their lost income therefore cannot be ruled out on moral grounds, and prudence may dictate some form of privatization of government property to ensure that pensioners are not left destitute. Our ethical analysis in part I makes clear that compensation can only legitimately be paid to bondholders who are innocent bystanders, as it were. Those who knowingly invested in government debt can have no claim to compensation. Determining exactly who should be counted an accomplice of the government and who an innocent bystander is a practical matter to be determined in each particular situation.
The economic analysis of repudiation applies to the debt of all levels of government and to all countries. The central question is not how big the government is or how much it owes, but rather whether the debt is funded by taxes. If this is the case, then paying off the government debt instead of repudiating it is in fact destructive of real wealth.
So far, I have not mentioned the effects of debt repudiation on financial markets and on the monetary system. Modern financial orthodoxy has it that markets need a “safe” asset and that governments are charged with providing this asset in the form of a risk-free bond. Havoc would result if financial markets were suddenly deprived of government bonds. Given the popularity of such thinking, as well as the real importance of government bonds in modern finance, we cannot conclude our case for government default without also examining these contentions. That is the subject of the final installment.
