Originally published on August 18, 2011
For over a year now we have been hearing about the government debt problems in Europe; especially in Greece, but also in the larger economies of Ireland, Portugal, Spain, Italy and even France. Greece’s outstanding public debt is now about 150% of its annual GDP. In Italy it is over 120%, in Ireland about 95%, France 85%, Portugal 82% and Spain 65%.
These worries and figures invite comparison to the US. In the US, total Federal outstanding debt to GDP is almost 100%. Another figure sometimes presented though is Federal debt held by the public, which stands at about 60%. The second figure eliminates the public debt purchased mostly by the Social Security Administration. The so-called trust fund – this is the excess of SS tax revenue over SS disbursements (which have been substantial in past years) – has been invested in US Treasuries.
In any case, because many observers keep mentioning default in Greece and other European countries, and because of the debt ceiling debate in the US, it is worth asking whether the US is in danger of becoming another Greece. The short answer is no.
There is virtually no chance the US will default and be unable to pay back principal and interest on its maturing treasury bonds. This conclusion was no different a month ago before the debt ceiling deal and before the S&P downgrade. As I have explained elsewhere, even if we had not raised the debt ceiling, the US would have continued to pay back principal and interest on its bonds. Other bills would not have been paid, but these bills would have. The simple proof of this lies in the fact that the US treasury market faced no disruption leading up to the debt ceiling deal. That means that the collective opinion of bond holders, which is whose opinion matters most, was that there was no chance of imminent default. In fact, even after the S&P downgrade, which was mild at best from AAA to AA+, demand for US Treasuries rose, indicating that they continue to be viewed a safe haven for investors.
Greece, on the other hand, (and Ireland, Portugal, and Spain), could conceivably default. (Although Greece is perhaps the only place where default is plausibly imminent) But one might ask, if US debt as a percentage of GDP is on a path to the same level as Greece, won’t the US eventually face the same default potential. Again the answer is no!
The important difference is the currency the outstanding loans are denominated in and the source of that currency. In the case of Greece, it has borrowed Euros mostly. However, Greece does not control the number of Euros that are issued; that is controlled by the European Central Bank (ECB). In contrast the US debt is denominated in dollars, and it is the US Fed that is the issuer of those dollars.
Consider an extreme case. Suppose one day the US Treasury needs to issue $50 billion of new debt in order to finance the government budget deficit and pay back maturing securities. Suppose further that our debt has risen so much that tax revenues alone don’t even cover the repayment of maturing bonds. Suppose also that nobody wants to buy newly issued government bonds – which would allow us to rollover and extend repayment – without demanding an oppressively high interest rate. Well, if the US ever reached that situation, and I should point out that we are nowhere near this kind of scenario, then the problem could be immediately ”solved” and default avoided if the US Fed under Ben Bernanke simply purchased the $50 billion in new bonds. To pay for it the central bank must merely make an accounting notation that says the government now has a $50 billion credit on its account. In this way money is created out of thin air to finance the government’s borrowing and to rollover the outstanding debt. (Note: This power is what drives Ron Paul nuts!)
Now one could say that because the Fed is independent of the federal government, it could refuse to make the transaction. This is true, however, given the problems associated with outright default and the simple ability to “solve” the problem by printing money, it is reasonable to expect that the Fed would relent and money would be printed in this case. This is about as dire a situation we could imagine in the US and in this case it is reasonable to conclude that the US would not technically default.
The same is true in any country that borrows in its own currency and controls the issuance of that currency. Thus it applies to Japan, whose government has debt over 200% of GDP. Japan is unlikely to default on its debt. However, this conclusion does not apply to any country that borrows in a currency that it does not issue. Since Greece does not issue Euros its excessive debt makes it a viable candidate for outright default. The same was true for many other countries in the past: Argentina, Brazil, and Mexico to name a few.
The ECB could offer to buy all the debt that Greece needs to issue to maintain its large budget deficits, however, this would result in an increase in the overall euro money supply and those euros would circulate throughout the euro zone. The ultimate effect of extra money circulating in an economy that is not growing sufficiently fast is inflation. Too much money chasing too few goods puts upward pressure on prices of goods and services. And this would negatively affect all countries in the Euro-zone acting much like a tax on all of the EU’s citizens.
Indeed, any country that finances its deficits by printing money is using inflation as a hidden tax. The alternative to printing money is to raise taxes to balance the budget (or decrease government spending). However, inflation lowers the purchasing power of everybody’s money, which essentially shifts buying power from all citizens to the government in this case. It also effectively lowers the real value of the outstanding government debt. This is because inflation lowers the purchasing value of the repaid principal and interest and creditors get back less than was originally expected. This is sometimes referred to as a partial default. We might also think of it as a “stealth tax” because no one can easily connect the loss of purchasing power to the actions of the government. It is also why it is always the most politically expedient exit strategy for governments.
As a quick example, suppose someone lends the government $1 million for one year at the interest rate of 3%. At the end of the year this person will receive back $1,030,000. But suppose inflation during this period unexpectedly turns out to be 10%. This means that it will now cost $1,100,000 to buy what last year cost $1 million. Thus the $1.03 million returned by the government is actually worth less than enough to keep even. The debtor gains at the expense of the creditor.
Back to the EU, this is one reason the ECB doesn’t want to bail out Greece, Portugal, Ireland, etc. The more it does, the more inflation is likely eventually and the more everyone in the euro-zone have to pay for the excesses of the minority.
One other solution for Greece is to drop out of the Euro zone. In this case they would reestablish the drachma as their national currency. But then what would they do with their Euro debt? The most likely recourse would be to renege on euro repayment and convert them to drachma. Thus a creditor might be told they won’t get paid back in euro but in the equivalent in drachma instead. Of course this would be less valuable to the creditor since drachma could only be used to buy goods in Greece, not in the wider EU, and because the new Greek central bank would be able to lower the value of these drachma by printing money and creating inflation in the economy. In this way the burdens of excessive government borrowing would be shifted to the creditors holding Greek bonds and to the Greek people. Because money is printed, causing inflation, this amounts to a partial default. Again, this is not a technical default because all the bonds will be repaid in full, but they will be repaid with currency that is worth less than originally expected.
Now back to the US. Since the US borrows in its own currency, there is no reason for it to ever technically default. It will always find a way to pay back its outstanding principal and interest. However, because the US can print money to finance budget deficits, it could default partially via inflation. A stealth default is possible. In this case, everyone gets the nominal value of their money back as promised, only those repayments won’t buy as much as originally expected. This is a real worry that China has: the fear that their more than $1 trillion of US debt is eventually paid back with dollars that will not purchase as many goods and services.
