The Economics and Ethics of Government Default, Part III
In the previous installments of this series (part I, part II), I have argued that government default is not only ethical, it is also beneficial to the economy and society as a whole. The one question I left open at the end of part II was the possible consequences for financial markets and the monetary system in the case of a government default. In the following, I will as in the previous installments focus on the US government debt, as claims against the US government are the most important for the international financial system.
The Role of Government Debt in Business
The most obvious use of government debt, specifically short-term debt, in finance, is by companies, who hold it because they consider it a safe, highly liquid asset. By holding US securities instead of money, they can economize on the need for cash and earn a small return on their holdings. They consider it what Mises called a secondary medium of exchange and Rothbard a quasi-money. As Mises explains:
He who owns a stock of goods of a high degree of secondary marketability [i.e., liquidity] is in a position to restrict his cash holding. He can expect that when one day it is necessary for him to increase his cash holding he will be in a position to sell these goods of a high degree of secondary marketability without delay at the highest price attainable at the market…. The size of cash holding and the expense incurred in keeping it can be reduced if income-producing goods of a high degree of secondary marketability are available.
Quasi-money is not, it must be emphasized, used in exchange against other goods. They are primarily simply held by a company’s treasury instead of money, in order to earn a small return from the coupon payments or expected appreciation. When the funds are needed, the US Treasurys and other quasi-money are sold against money and the money is then used in normal business transactions.
The reason US Treasurys are used in this way is twofold: the market for them is very liquid, and they are considered a very safe, or risk-free, investment. These days, the deep market for US Treasurys is largely an illusion, however. As I pointed out in part II, about 40 percent of US government debt is owed to various government agencies, from the Federal Reserve to local governments. It is fair to say that, at this point, the market for Treasurys is only liquid because the Federal Reserve stands ready to buy them all up. At this point, central bankers are openly discussing this aspect of their operations: the central bank needs to act as “market maker of last resort,” meaning, in practice, that bond prices can never, ever, be allowed to fall.
That Treasurys are considered risk-free is clearly connected to their high liquidity, since safety in this sense simply means being always able to sell at the price one expects. It is also clear that this kind of safety simply does not exist in the real world of constant change. What the theorists of risk-free assets claim is essentially that men have the right to enjoy a stable and secure income, and that it is the task of government to provide this income-generating asset free from the laws of the market. Mises described this attitude long ago:
The state, this new deity of the dawning age of statolatry, this eternal and superhuman institution beyond the reach of earthly frailties, offered to the citizen an opportunity to put his wealth in safety and to enjoy a stable income secure against all vicissitudes…. He who invested his funds in bonds issued by the government and its subdivisions was no longer subject to the inescapable laws of the market and to the sovereignty of the consumers…. He was no longer a servant of his fellow citizens, subject to their sovereignty; he was a partner of the government which ruled the people and exacted tribute from them.
That corporations, and not simply an elite of parasitic rentiers, have been enticed by the state into using government securities for their liquidity needs does not change Mises’s analysis. It is still an absurd pretension to think that such a thing as a risk-free asset exists, let alone that one has a right to it, or that the functioning of the market depends on it.
The only way government bonds can be judged as risk-free assets is if the central bank stands ready to buy them with newly printed money. Social democratic economists realize this, and they make no secret of who really benefits from the risk-free status of bonds: government itself. As the German economist Fabian Lindner writes: “Only when government bonds are sufficiently default-proof that investors don’t fear losses will they lend money to governments at low interest rates. Only then will governments be able to increase spending … ”
The socialists have an unlikely partner in their quest for risk-free bonds: what we by a somewhat dated expression may call high finance.
Government Debt and Finance
In this age of hyperfinancialized markets, the use of government debt is central to the functioning of financial institutions. As the highest-quality collateral used in repurchase transactions, government securities are an essential ingredient in the functioning of modern repo markets.1
Repos are essentially collateralized loans and highly liquid. In the case of open or daily maturing repos, the loan can be redeemed daily. There is a debate over whether repos should be counted as a form of money substitute, a point argued by Gabor and Vestergaard, but for present purposes, we need not settle this point. Repos, even if they are only a form of quasi-money, are still very liquid assets and highly sought after.
The link between government bonds and repos goes deeper than this, however: the same security can be used multiple times in repo transactions, meaning that the supply of repos is a multiple of the securities that serve as collateral. Thus, it is understandable why investors bemoan the “shortage” of government debt: not only is it deemed a risk-free asset in itself, it can be used to generate a never-ending stream of such assets.
The Financial and Monetary Effects of Default
This brief overview should be enough to make the financial importance of government-issued securities apparent. Since no one, in our current inflationary system, wants to keep more money than he absolutely has to, corporations and financial institutions instead hold quasi-money of different kinds in their treasuries. The confusion between money and highly liquid assets is so great that financial managers will routinely refer to their holdings of Treasurys as “cash.” This is not simply a question of pedantry, as there is a very great difference between cash, which can be used outright, on the one hand, and claims that first must to be redeemed and assets that must be sold before the proceeds can be used, on the other. Under normal circumstances markets are likely to be liquid and there is no problem in realizing one’s holdings of securities. But it is precisely when one is likely to need one’s cash reserves the most—i.e., in a financial crisis—that markets will become illiquid and the prices will drop. The reliance on quasi-money is thus one of the hallmarks of the modern fragile financial system and one of the reasons that this system would cease to function if central banks were not always ready to intervene as market makers of last resort.
What, then, would be the consequences if the government debt were repudiated and the supply of government-issued securities simply disappeared? If it happened from one day to the next, without warning, it is clear that a major liquidity shortage would ensue. Not only would the government securities themselves become worthless, so would all the repos backed by them. Many financial institutions would thus face a major reduction in their balance sheets.
This is not so different from what we already detailed in part II: people wake up to discover that their holdings of public debt turned out to be only so much “fictitious capital.” However, the eradication of a major class of quasi-money has more consequences than this. Since one holds such assets for their liquidity, the result of the disappearance of a major class of quasi-money will be a scramble for liquidity. Demand for money and for the remaining quasi-money will shoot up as market actors attempt to replenish their company treasuries. This extra demand will result in a fall in prices across the board and a rise in interest rates as demand for present goods—money—rises abruptly.
The mayhem that is likely to result across financial markets will only be somewhat mitigated by telegraphing in advance that a government default is impending. As it becomes more certain that the debt will become worthless, its utility in finance will fall and market actors will try to get rid of it. However, this can only soften the fall; the reliance of finance on safe assets is built into the system and it is hard to see how one can remove them without bringing the whole structure crashing down. This is a problem for the financial system, however, and not for the economy as a whole.
Indeed, it is rather a welcome bonus of getting rid of the debt that it will also mean an end to financialization and a return to sounder forms of credit intermediation. The crisis will be mainly financial, since the supply of real capital will not have changed. Indeed, as we already emphasized in part II, the elimination of fictitious capital will increase savings rates and lead to more capital formation, some of which capital will naturally be available for the reconstitution of the financial system along sounder lines.
This series of essays has examined the issue of the public debt from the most important viewpoints. We have found that it is an ethical atrocity, that it is an economic burden, and that it props up an unsound financial system. The conclusion can only be that the public debt is not for the common good; it is an imposition on all society, and especially on its most productive members, to the benefit of irresponsible politicians and financiers who believe themselves entitled to a “risk-free” asset.
The public debt, as Mises said, “is a foreign and disturbing element in the structure of a market society.” That modern finance is one of the main beneficiaries of its existence does not change this fact; it only shows how far removed the financial system is from its role in a free society. Having examined the issue every which way and found government default to be good, let us then be rid of public debt, once and for all. It is not simply a question of it being too high, or the taxes and inflation used to support it being too onerous. The thing! The thing itself is the abuse!
- 1. Note that I’m here only referring to private sector repos and not repo transactions engaged in by the Federal Reserve as part of its monetary policy interventions in the market.