Debt: An Inescapable Concept Part 4: Government Debt

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Debt is an
inescapable concept. It is never a question of debt or no debt.
It is always a question of which kind of debt, owed to whom, when.

In theory,
civil governments do not need to issue debt. Yet they do, century
after century. In the history of the United States, the national
government was debt-free only in 1835, in the midst of an economic
boom during the second term of the presidency of Andrew Jackson,
who had campaigned on a platform of reducing government debt. He
fulfilled his promise. He even went beyond his promise. He also
refused to re-charter the Second Bank of the United States, which
lost its monopolistic Federal charter in 1836. It went bankrupt
five years later, unable to compete in a free market.

Governments
in the West have been going heavily into debt ever since the fifteenth
century, beginning with the Italian city-states. They have worked
hand in hand with government-licensed fractional reserve banks,
which then buy the debt instruments of the governments. Eventually,
all of the governments of the Italian city-states defaulted, taking
down the banks with them.

Governments
see that they can gain political support from the rich when they
owe great sums of money to the rich. The rich in turn regard governments
as solvent borrowers because governments possess the power to tax.
Investors assume that governments will not default because governments
do not have to face a competitive market. Investors believe that
the power to tax is more reliable than market competition. They
buy government bonds in preference to corporate bonds.

This assumption
holds good for most periods. But when it doesn’t hold good, investors
lose everything. In times of war, governments build up debt. In
times of peace, they are supposed to reduce the level of debt. But
in the twentieth century, governments did not reduce debt in peacetime,
while accelerating it in wartime.

The modern
world is a world built on government debt. Government debt is the
economic foundation for the central banks of the world. Government
debt in the coffers of central banks establishes the legal reserves
for fractional reserve commercial banks. When debt becomes the legal
basis of money, there can be no reduction of debt without universal
bankruptcy: massive deflation. No government is willing to accept
this outcome. This is the great curse of modern banking. The world
has marched into a lobster trap.

THE LOBSTER
TRAP

A lobster trap
is an ingenious device. A lobster enters the trap in search of some
alluring goodie to eat. The trap is a one-way device. The further
into the trap the lobster pushes, the tighter it gets. It cannot
back out, so it pushes forward, on the assumption that relief lies
ahead. In fact, complete entrapment lies ahead.

This is how
government debt works. Those who lend to the government see that
the debt is not going to be repaid. The modern theory of government
explicitly states that government debt should not be repaid. So
does the modern theory of debt-based money. There is no income-producing
sinking fund that will enable the government to reduce its debt.
No matter how large the debt moves along its one-way street, there
are investors who think they will be paid interest. They will then
roll over the debt when it matures.

So great is
men’s confidence in the power of government coercion to produce
rabbits out of fiscal hats that investors continue to buy the debt.
They recognize that corporations can become so indebted that they
are at risk of default. They do not often recognize this with respect
to national governments.

There are debt-rating
services that make public assessments of the credit-worthiness of
corporations and governments. But they rarely announce that a national
government is on the verge of default. This is because national
governments do not openly default. Instead, a national government
turns to the nation’s central bank to buy its debt, and the central
bank does so, inflating the money supply, thereby lowering the market
value of the bonds. The default is indirect.

The ultimate
debt lobster is therefore the central banking system. National central
banks buy bonds with money they create, to be held as legal reserves
for the nation’s commercial banks to use in the multiplying of accounts.
Central bankers do not invest their own money. They invest money
which their own institutions create. They want the interest received
to be worth something, but their primary goal is to avoid seeing
these bonds redeemed by the government. They hold government bonds
as their main source of revenue. Modern monetary and tax theory
agree: governments need not and should not repay debt.

PROMISES
AS BONDS

"A man’s
word is his bond." This is an ancient and once-familiar slogan
in the United States. A bond is a relationship initiated by trust
in someone’s promise to fulfill an obligation. This is what a debt
is.

The politicians
in Washington have sold far more bonds of this kind than there are
T-bills and T-bonds in existence. The official on-budget debt of
the United States, which does not count Social Security and Medicare,
is in the range of $9 trillion. You can monitor this on one of the
debt clocks that are on the Web.

The cost of
the long-run promises made by politicians and signed into law cannot
be calculated directly. This is an advantage for the politicians.
The national government’s main promises in the United States are
these: Medicare, Social Security, other Federal pensions, the ERISA
private pension default insurance fund, the legally implied future
bailout of banks and savings & loans (which cost the government
hundreds of billions of dollars in the late 1980′s), and mortgage-issuing
non-government agencies: Fannie Mae and Freddy Mac.

Medicare and
Social Security are legal liabilities, but it is not clear what
their magnitude is. This depends on statistical assumptions regarding
birthrates, personal health, price inflation, average lifespans,
medical costs, immigration rates, and numerous other factors. Of
course, the crucial assumption does not appear in the statistical
summaries produced by the Social Security Trust Fund. That assumption
is that future taxpayers will abide by prior legislation guaranteeing
payments to retirees.

The most frightening
estimates place the
unfunded liability of Medicare and Social Security
combined
above $70 trillion.

Because the
Trust Funds are filled with nothing but non-marketable U.S. government
bonds, there are no funded liabilities at all. So, who will pay
off these debts? The official answer is "the government of
the United States." But that is a legal entity which has existence
only insofar as it can tax, borrow, or create fiat money through
the Federal Reserve System.

Every other
Western industrial nation is in a similar situation. None of them
has taken steps to use tax revenue to invest in productive capital
that will be used to pay future beneficiaries. The entire Western
economy is awash in debt — not just on-budget debt with specific
payment dates, but open-ended debt that is based on yesterday’s
promises and today’s reassurances.

WHEN
PROMISES ARE BROKEN

A bankrupt
corporation may or may not revive. Its shareholders are ruined.
They bear the brunt of the loss. Creditors also suffer major losses.

A bankrupt
nation has no creditors who can demand payment if the nation’s courts
do not grant relief to creditors. The bankrupt nation runs the court
system.

So, the bankruptcy
only rarely results in the permanent demise of the government. The
USSR did disappear, but there is nothing to match this in human
history. A giant empire simply folded without bloodshed. It was
a smart move for the Russian bureaucrats. Today, instead of being
$60 billion in debt to the West, as it was in 1991, it has $350+
billion in foreign reserves, thanks to income from oil and gas sales.
It is third internationally behind Japan and Communist China in
official reserves.

The promises
of dead politicians do not cause problems for the deceased. They
do cause immense problems for politicians who reassured older voters
that the government would never default on its obligations. They
also cause immense problems for all those oldsters who trusted the
official reassurances.

DEFAULT
THROUGH INFLATION

Incumbent politicians
do not want default to occur while their careers are still at stake.
So, they seek ways to postpone default. In the case of retirement
programs, they increase the age limit at which benefits begin. This
violates the promise of earlier politicians, but because this is
piecemeal default, there is no well-organized opposition. This has
already happened to Social Security.

Another way
to default is to impose a means test. If you have an income above
a specific level, you must pay more into the system in premiums
or receive less in return. This policy has begun this year with
Medicare.

At some point,
piecemeal default becomes politically risky. The opposition party,
on the outside, will hold incumbents’ feet to the fire. "Vote
for us if you want your promised money." This brings the economically
unsustainable promises into prominence.

The point is,
current budgets are hard political realities. They are not promises.
They are immediate liabilities. The politicians cannot announce,
"Let them eat promises."

The least controversial
way to default is to create money to send to the beneficiaries,
as promised. The central bank can do this easily enough. It buys
the government’s debts. This provides money for the government to
send checks to beneficiaries.

One result
is rising prices. This unwanted result can be blamed on speculators
or on greedy businessmen. The public is unfamiliar with economic
theory. Voters are ready to accept the official explanations. They
do not monitor central bank statistics.

When default
takes place through monetary inflation, default affects not just
the government’s budget. It affects every debt-credit relationship.
Investors in corporate bonds see their rate of real return fall.
The same is true of investors in mortgages.

As prices increase,
long-term interest rates rise. Lenders demand an inflation protection
premium in their promised interest rate. Borrowers see that price
inflation will enable them to pay off with a cheaper currency unit,
so they agree to the higher rate of interest.

As long-term
rates rise, the present market value of existing long-term promises
falls. This has negative effects in the capital markets.

So, default
through monetary inflation has negative effects outside the government
promises market. If continued, this policy becomes default through
the destruction of currency. It becomes universal.

MACROECONOMIC
DEFAULT

When sons default
on their implied social contracts by refusing to support aged parents,
this is microeconomic default. It happens, of course, but the practice
is not widespread. Social pressures against such default are applied
to those who break these unofficial contracts.

The parents
usually have warnings in advance. Sons may not be reliable. They
may not be productive. Parents can search for other agents to accept
the role of "reliable sons." They can transfer the inheritance
to these new agents. They can buy an annuity from an insurance company.
They can go to other relatives and create a trust where the trustee
will direct the inheritance to those who support the aging parents.

In other words,
there are ways to reallocate responsibility when the government
is not the promisor. But when the state has issued promises and
then taxes workers to fund the government’s promises, the ability
of the dependents to find alternative arrangements falls dramatically.
No one outside the government except expensive tax lawyers and tax
professionals can find ways to reallocate the risk of default. The
default then becomes macroeconomic. It applies to everyone in the
economy who pays taxes or receives the promised tax benefits.

This is the
situation which Western taxpayers and oldsters are facing over the
next two decades. Economist Ludwig von Mises was once asked what
his inflation hedge was. He had a one-word answer: "Age."
It paid off. He died in 1973, before the decade’s inflation had
done its corrosive work.

The free market
decentralizes defaults of all kinds. A few people are harmed. This
sends signals to others to pay closer attention to the details relating
to the default. There is strong economic incentive to find solutions
to the problem.

In contrast,
when a government defaults, the default is centralized. The default
affects people throughout the society. The grand experiment fails
in full public view. Government agents then blame others. There
is no quest for cause and effect, for such a quest must eventually
identify the culprit: the state. The state’s agents do not want
this. Neither do most of the victims.

Most voters
do not want to admit that they were sucked into voting for a doomed
program of coercive wealth redistribution. That would call into
question their morals as well as their wisdom in trusting elected
thieves and liars. This would make them unidicted co-conspirators.
They resist such a suggestion. They do not want a thorough investigation
of failed government programs generally, let alone one in which
they became victims — first as taxpayers, then as dependent recipients
of tax revenues.

So, unlike
private defaults, not only is the default universal, it is not self-correcting.
Like investors in Latin American bonds since the 1820′s, voters
return again and again to be sheared. They refuse to accept this
lesson of history:

"Government
promises are not safe to trust long-term."

In rare and
extreme cases, the public does identify the culprit. This can lead
to a political revolution. The most famous is the French Revolution,
which took place because Louis XVI could no longer pay his debts
in 1789. He had to call the long-dormant Estates General into session
to approve new taxes. Newly elected lawyers then took over the government
and created a far more oppressive system of default through inflation.
They confiscated church property and then issued bonds against this
property. These bonds became the country’s currency.

When the reign
of the lawyers failed, there was another revolution. Napoleon was
the winner, but only until 1815. Again and again since then, political
revolutions have replaced bankrupt regimes. Inflation has marked
the rise and fall of these regimes.

CONCLUSION

Western industrial
countries became enamored of government promises in the twentieth
century. These regimes issued promises to the working population.
The government promised to tax future generations if existing generations
would just consent to mild taxes today. The result is familiar.
The outcome is reported in I Kings 12, the story of King Rehoboam’s
tax increases in Israel.

And he said
unto them, What counsel give ye that we may answer this people,
who have spoken to me, saying, Make the yoke which thy father
did put upon us lighter? And the young men that were grown up
with him spake unto him, saying, Thus shalt thou speak unto this
people that spake unto thee, saying, Thy father made our yoke
heavy, but make thou it lighter unto us; thus shalt thou say unto
them, My little finger shall be thicker than my father’s loins.
And now whereas my father did lade you with a heavy yoke, I will
add to your yoke: my father hath chastised you with whips, but
I will chastise you with scorpions (1 Kings 12:9—11).

The result
was a successful political revolt. The ten northern tribes separated
from the king’s rule.

Political rulers
never seem to learn this lesson. Neither do their counsellors. But
in today’s world, the victims — taxpayers — are also very slow to
learn this lesson. They wind up stung by scorpions.

There
will be a tax revolt at some point. There always is. But the damage
to the economy between now and then will be substantial. The school
of hard knocks imposes high tuition.

May
17, 2007

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible
.

Gary
North Archives

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