The Great Default

Recently by Gary North: Baloney


To cheer your day – maybe your year – click through to this chart on tax revenues.

The U.S. Government has hit a tax revenue ceiling. It is in the range of 16% of GDP.

The government is spending about 24% of GDP, which is down slightly from 2009, which was the all-time high since 1945.

There is gridlock in the negotiations over the increase in the debt ceiling. The House Republican majority seems unwilling to vote for any increase in the ceiling that includes tax hikes. The Democrats vow that they will not accept spending cuts without getting tax hikes on the rich.

Geithner and Bernanke warn of a disaster if the government has to stop making interest payments to the non-Trust Fund holders of Treasury debt.

Social Security and Medicare are both running deficits, and these deficits will get worse if the government ceases to make interest payments on the debt held in their Trust Funds. So, temporary default is no escape hatch here. The payment of interest is merely an accounting device. The payments from the general fund must continue, whether they are called interest or not, if the two programs are not to be modified to send out less money or else have their respective taxes raised, effective immediately.

The Obama Administration can ignore the debt ceiling and keep borrowing on its own authority, forcing House Republicans to do something about it. But there would be political consequences for such a decision. If the President does this, Republicans will cry “foul,” and take their case to the voters in 2012. The government will not shut down any departments, so the Republicans will not get blamed for the political pain caused by such a shutdown. Meanwhile, they can target Obama as a man who violated what is perceived to be the law.

The Democrats could invoke the 14th Amendment of the Constitution, which forbids any questioning of the debt of the U.S. government. The amendment reads: “4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” Which are the key words: “validity of the public debt” or “authorized by law”? Then there is section 5: “The Congress shall have power to enforce, by appropriate legislation, the provisions of this article.” But Congress is in gridlock; it cannot pass such enabling legislation. It therefore cannot authorize the President’s action to keep making payments. Some Democrats are threatening this action.

So, we may be heading into a Constitutional crisis to match the fiscal crisis. That will surely make the election of 2012 even more interesting.


If the Republicans buckle on the issue of not raising taxes in order to get a settlement with Obama, then they will be seen by the swing voters – Tea Party members – as betrayers. The anger of the Tea Party is obvious to Republicans in Congress. These voters will not compromise on taxes. Some of them, especially older ones who are more likely to vote in 2012, are willing to see Republicans raise the debt ceiling in order to keep Medicare and Social Security sending out checks. So, I see the Republicans as more willing to buckle on the debt ceiling than buckle on their resistance to higher taxes. The negative sanctions would be less severe for any capitulation on the debt ceiling in what will be perceived to be an emergency.

The Democrats want to tax the rich. This has been true ever since 1933. This will not change. But they are unlikely to get the House to accept this. So, they will be willing to put on hold their demands for higher taxes on the rich. They want to be able to go to their constituents with this message: “We held the line against the Republicans, who were ready to stop checks going out to old people.” The House Republicans are deathly afraid of being uncaring for the needs of old people.

The fear of negative political sanctions is the greatest fear of politicians. Members of the House want to avoid the systematic, well-organized wrath of any voting bloc in their districts that may have the swing votes in the next election. This is surely the oldsters.

The Tea Party is an “unknown quantity.” It seems to be growing. To the extent that run-of-the-mill voters are tired of taxes, a hue and cry over tax increases offers a threat to the re-election of incumbents. This is why I think that Republicans will take a stronger stand against raising taxes than raising the debt ceiling.

This is very good news for taxpayers.

Any increase in the debt ceiling will send a message to Tea Party voters: this government is out of control on spending. Most voters are becoming vaguely aware that something very big and very bad is on the horizon, but they are not sure exactly what.

Most Tea Party voters are not direct owners of Treasury debt. They do not perceive the degree to which they are indirect owners: pension funds, money market funds, local bank holdings. They will not resist an increase in the debt ceiling with the same ferocity that they will resist an increase in Federal taxes.


An increase in the debt ceiling is good short-term news for holders of Treasury debt. There will be no default on the debt. But, in the long run, it is bad news for holders of Treasury debt. If the government can dodge the bullet this year on the debt ceiling, this will lead to a decade of huge annual deficits and an ever-greater Federal debt.

An increase in the debt ceiling will send the same negative message to holders of Treasury debt. But these people are overwhelmingly optimistic about the short-term future of U.S. government solvency. They do not care about the long term, because they believe that they can always sell their T-debt positions to willing buyers. They have faith that their personal optimism regarding Federal solvency will be widely held when they decide it’s time to sell and buy some other asset. They think that they can become pessimistic ahead of the masses of holders of T-debt. They think they will be smarter and swifter than the market for T-debt. They think they are very smart indeed

Basically, they think they will be as agile as PIMCO, which has sold Treasury bonds. They assume that liquidity at today’s low interest rates will prevail. They do not fear the consequences of rising long-term bond rates on the market value of the bonds they hold. They believe that there will always be a ready market for their holdings at today’s market prices or close to them. They define Treasury debt as AAA. This has been true for so long that they cannot imagine that there will ever be a default.

This widespread faith in Treasury debt, despite the frightening balance sheet of the U.S. government and the equally frightening balance sheet of the Federal Reserve System, is remarkable. It is widespread. It is the basis of the retirement plans of millions of Americans. It is the basis of the solvency of banks and money market funds.

The problem with this optimism is that it undermines any resistance by voters to a meaningful solution to the deficit, which must begin with massive spending cuts. The voters think that there will always be a market for Treasury debt, irrespective of deficits.

In this sense they are like Democrats and their ideological allies, who say that the debt ceiling may be ignored by the President because of the 14th Amendment. Democrats think that an 1868 amendment is the meaningful reality. They think the free market may safely be ignored. After all, investors have always bought Treasury debt. This will not change, they believe, just so long as the President decides to ignore the debt ceiling. They believe in their hearts that, because it is Constitutionally illegal to undermine the solvency of the Federal government, free market forces will not create interest rate conditions that will undermine the full faith and credit of the United States government.

The same is true of investors in euro-denominated assets. Until 2010, it was true of the highly sophisticated investors who bought Greek government debt. They believed the cooked books of the Greek government. Today, the books are far less cooked, but there is still a market for Greek debt, although at high rates.

These supposed experts were dead wrong in 2009. They did not see the Greek debt crisis coming, any more than they saw the financial crisis of 2008 coming. They see themselves as ever so clever, and then they lose hundreds of billions of dollars. Then they call on governments to bail them out, which (so far) governments have done.

The voters may not like this, but the voters have proven unable to stop their representatives from running up the national bills in the name of the voters. There is no real understanding of the nature of the exponential increase in government debt since 2007. They think someone is minding the store. Someone is: the biggest banks and their dutiful representatives, the politicians.


Americans are not going to experience any increase in their tax burden this year or next year. The Democrats would have to gain a clean sweep of Congress and the White House in 2012 for taxes to be raised. If the Bush rates are allowed to lapse, we have until 2013 to escape new taxes.

The political case for government deficits has never changed: the ability of politicians to increase spending without facing outraged voters at the next election. Taxes are understood. The pain they impose is understood. The goal of politicians is to conceal this pain, preferably by deferring it. They have done so by the following techniques.

1. Taxing a minority of voters2. Imposing hidden taxes, including inflation3. Making payment less painful (e.g., withholding)4. Borrowing

It is obvious that #4 is the prevailing strategy for politicians all over the West. The central bank of China has made this the path of least resistance. The politicians of China, mercantilists economically and Communists politically, have chosen to tell the People’s Bank of China to inflate the yuan, buy Western currencies, and then buy government debt. This keeps the price of the yuan low, which subsidizes exports from China. The residents of China buy fewer China-produced goods. The central bank buys IOUs from governments that can never repay, in order to subsidize the owners of export industries. The losers are Chinese citizens, who subsidize Western buyers.

The problem is this: addiction. The Communist politicians are addicted to a domestic boom funded by monetary inflation. The Chinese exporters are addicted to Western consumers. Western consumers are addicted to low-cost goods from China. Western politicians are addicted to Chinese central bank purchases of Western government IOUs.

This is all proclaimed by Keynesian economists as sustainable economic growth. Keynes was the great apostle of government debt as a way to increase government spending to stimulate economic growth. The modern economy is a testimony to Keynes’ commitment to government debt. For as long as there is no mass price inflation, no depression, and no government defaults, most voters are content. Economists can continue to draw their salaries in tax-funded and government-accredited universities. They can continue to receive grants from the Federal Reserve, which is the nation’s licensed counterfeiter. All seems safe and sound.

But this illusion of safety is being challenged by the threat of default by governments. This is an immediate threat in Europe. It would be an immediate threat in the United States if the debate over the debt ceiling reflected unyielding intransigence by House Republicans.

Tax relief is more likely than debt relief. The game of “defer the pain” will go on. The politicians will continue to do what they have done for centuries. They will evade the fiscal requirement of raising taxes and then actually collecting them.

They have run out of two alternatives. They cannot make taxes easier to pay (#3). But they can impose the hidden tax of monetary inflation, which redistributes wealth toward those citizens who get early access to newly created central bank money (#2). In the United States, they are not able to collect taxes from the rich (#1). The rich will find ways to evade paying new taxes. This leaves #4: borrowing. So, #2 and #4 are the paths of least resistance.

This is why I think there will be tax relief, in the sense of no increases of tax pain. This will be paid for, as it has for centuries, by an increase in government debt.

This will defer the crisis. That is the #1 function of government debt. It always has been. This is why debt crises hit all nations.

The problem is, they do not hit very often. The voters are not alert to the negative implications of the policies of massive government debt.

The most effective way to eliminate government debt is to lose a major war. The central bank inflates during the war, so all pre-war debts are wiped out. Rising prices are blamed on the war, meaning the bad guys in the other side’s trenches. The loser of the war then defaults. (The only exception, most of the time: Japan.) The citizens on the winning side are now saddled with massive debt. The losers escape.

Historians don’t mention this in the textbooks that are written for citizens in the winning nations. Historians in the losing side also don’t mention it. They know there will be economic recovery. This will create lots of new opportunities to fund new wars that will be funded by massive debt.

The sinews of war are strengthened by central banking. This is why textbooks praise the Bank of England. It let the British fight longer wars and more destructive wars. The message: get a central bank for your nation, so that your politicians can declare war more readily and stay in that war far longer.

The West’s voters have believed this since about 1900. The result: the worst years in history and the worst inflations.


There will be no tax increases in the USA before 2014. There will be great increases in Federal debt.

We see that the governments of the West are incapable of reducing massive deficits. There is no significant political resistance to the vast expansion of debt. We are in the final stage of the politicians’ addiction to debt. On behalf of future generations, they are buying votes by buying time.

Future generations will elect new politicians who will stiff the trusting, naive holders of government debt. There will be a Great Default. There is no escape. There is no way to grow our way out of this.

There will be winners and losers. In the transition phase, there will be more losers than winners. But, once the deck has been cleared of unsustainable promises issued by generations of lying politicians, there will be a recovery.

Your assignment, if you accept it, is to be a winner and then participate in that recovery (if you are young), or at least survive the transition period if you are older.

July 21, 2011

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North