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February 20, 2005
What does it mean to default?
PGL at Angry Bear critiqued a recent Charles Krauthammer article for essentially calling the IOUs in the Social Security trustfund worthless. Specifically, Krauthammer says,
Let's start with basics. The Social Security system has no trust fund. No lock box. When you pay your payroll tax every year, the money is not converted into gold bars and shipped to some desert island, ready for retrieval when you turn 65. The system is pay-as-you-go. The money goes to support that year's Social Security recipients. What's left over is "loaned" to the federal Treasury. And gets entirely spent. It vanishes. In return, a piece of paper gets deposited in a vault in West Virginia saying that the left hand of the government owes money to the right hand of the government.
These pieces of paper might be useful for rolling cigars. They will not fund your retirement. Your Leisure World greens fees will be coming from the payroll taxes of young people during the years you grow old.
And PGL replies,
If you really believe piece of paper called financial assets are worth nothing, I’ll gladly take all of your cash, funds in your bank accounts, and other financial assets. In turn, I’ll even buy a week’s worth of groceries.
Dave at macroblog posts a detailed response that defends Krauthammer's essential point while pointing out the comingling of positive and normative analysis in Krauthammer's article.
I'll go one step further. Krauthammer is setting up a straw man with the "worthless IOU" argument. But really folks, we've been over this before. This is a variation on the topic that Dave, PGL, and I addressed a couple weeks ago. Click here for my post which has links to the others.
Dave appears to remember that discussion since he correctly points out the positive/normative distinction. Here's what I said back then,
The trust fund is a social contract. In that sense, it's fully funded politically and morally. But I see nothing in the accounting structure of Social Security to suggest that it is fully funded in the strict economic sense.
The meaning of a default here is a breakdown of that social contract. That has real political/economic implications just like a default through the financial markets.
I also called the trust fund a "useful fiction." It's clearly not worthless, but it's just not fully funded in an economic (or accounting) sense. And I can say that with a perfectly straight face while refusing to accept Krauthammer's straw man the way he clearly intends it. Actually, I just read the whole article again leaving out those two paragraphs. It's much better that way. He actually makes a good point about the need to enact reform now, before the outgo exceeds the income in 2018. He doesn't say so in so many words, but I think his argument fits quite well with the view that the Social Security problem is really a general fund problem. (That's a view that I think PGL could accept.)
Dave's explanation of the distinction between Treasury securities and Federal Reserve notes is an interesting way of lifting the discussion to a more abstract level.
But if, for some reason, there has been a miscalculation, a change in economic circumstances, a change in policy, the government may find that it has to raise my taxes to obtain the revenues to honor those payments. In doing so, it has effectively reduced the return on that security. Distortionary price effects aside -- granted, a major qualification -- why should it matter to me how it happens? Lower my social security benefits, raise my income taxes, whatever. It all amounts to a haircut on that Treasury payment to me.
PGL still doesn't totally buy it (see the update at his post), but Dave responds directly to PGL in this comment to his own post.
The thing is, it is seemingly much easier to find your road to collapse by trying to finance imbalances with inflation than it is from explicit taxation or spending reductions. So we appear willing to countenance more "little defaults" with Treasury securities than we are with money. And I'll repeat myself -- if the government raises taxes and reduces the return to the debt I hold in the process, they default. We put up with it (a) because we can verify the state of the world and identify cause and effect; and (b) we can throw the rascals out of office for getting us into the situation if we want to (an idea I know you can embrace).
I think that captures the essential idea. Allow me to just add this point (saying the same thing in different language). PGL asks,
So if the Federal government defaults on its IOUs, what does the Federal Reserve rely on to honor its commitments?
If the Fed is really independent, it can honor its commitment without regard to the Federal government defaulting on its IOUs. The Fed would "simply" have to refuse to be complicit and maintain the value of the dollar (perhaps by allowing interest rates to rise--not pretty, but then refusing to be complicit in a default entails sacrifice). The reverse is the real problem. If the Fed is not independent, that's when its commitment to price stability goes out the window. If the government defaults on its commitments, the Fed is either complicit or not. If it is complicit, we've got all the problems PGL is worried about and then some. If not, then we're ok. I would further state that if the executive and legislative branches believed in the independence of the Fed, they will be less likely to default (in Dave's sense of many "little defaults") because they know they will bear the political cost (part b of Dave's comment).
Thoughts?
Posted by William Polley at February 20, 2005 8:41 PM
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Comments
Krauthammer nailed it. Your sophistry doesn't change that.
Posted by: Brian at February 21, 2005 12:45 AM
All true. Note your standard of trust is not Krauthammer's standard of having gold in them there vaults. There is not much in the way of other assets on the FED's balance sheet, but then I agree with your standard. Which really goes to my complaint about Krauthammer's.
Posted by: pgl at February 21, 2005 8:35 AM
Continuing the dialogue - just now over at Angrybear.
Posted by: pgl at February 21, 2005 12:39 PM
PGL asks, "So if the Federal government defaults on its IOUs, what does the Federal Reserve rely on to honor its commitments?"
The ficticious "Trust Fund" does NOT contain "IOUs." It contains "IOMEs." It is the federal government writing notes to itself...NOT notes to the general public.
"I also called the trust fund a 'useful fiction.'"
In other words, it's OK to lie. As long as it's for a "good cause."
"It's clearly not worthless,..."
It clearly IS worthless. The exact same things will happen whether or not the "Trust Fund" exists or doesn't exist. That is the very definition of worthless.
Posted by: Mark Bahner at March 10, 2005 11:47 AM