Debt: An Inescapable Concept Part 4: Government Debt

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.

May17, 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.

Copyright © 2007 LewRockwell.com

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