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February 21, 2005
What does it mean to default? (Part II: The rhetoric of default)
The discussion that started at Angry Bear and macroblog (not to mention the others that have piled on) got me thinking.
We use this word "default" a lot in these debates over the appropriate way to pay for war, pay to restructure Social Security, and otherwise finance our debts. When most people hear the word "default," they probably think of firms which have gone out of business without paying off its debts. Bonds from companies that face this kind of risk carry the adjective "junk" due to the fact that you may not see any return if the firm goes under. Perhaps some people relate default to third-world debt crises. But are the third-world debt crises or the kind of default that results from a firm going out of business appropriate models for the U.S. economy?
I don't think so.
(*I can hear the shuffling of feet and clearing of throats out there in blogland*)
Let me explain. The part of Krauthammer's piece that had everyone in an uproar was the part about the IOUs in the trust fund being worthless. OK, he doesn't say "worthless," he says,
These pieces of paper might be useful for rolling cigars. They will not fund your retirement.
Whatever. This is the rhetoric of default. This is the (overly) dramatic statement of how bad things are. This is the heart of the "worthless IOU" argument.
But it doesn't fly. Krauthammer himself follows with,
To cover retiree benefits, the government will have to exhaust all of its FICA tax revenue and come up with the rest -- by borrowing on the world market, raising taxes or cutting other government programs. (emphasis mine)
And in so doing, he reveals that this is a General Fund problem. The worthless IOU argument was just a distraction. Whether he meant it to be a distraction or not, I can't say. It's an easy trap to fall into, but I'm sure that some writers have set the trap deliberately.
The real problem is not some theoretical point in the future when the U.S. repudiates its debt. Not likely to happen. What we need to be on guard against is the prospect of the insidious default that is caused by inflation (if the Fed becomes complicit in the borrowing and becomes the buyer of last resort for the IOUs). Another version of default was pointed out by Dave and I will repeat the two paragraphs that make the point extremely well.
Suppose I hold a Treasury security. That, of course, is a payment the government owes to me, and I have every expectation that it will be made. 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.
Because the distributional aspects of these things can matter, blanket haircuts are probably a pretty bad idea -- foreigners, for example, finance a good chunk of our collective borrowing, and they aren't likely to appreciate the opportunity to finance our fiscal imbalances on an ongoing basis. Changes in tax and transfer policies are the way we go because they can be targeted (which gets us to positive versus normative questions, which I'll address below.) But the basic economic distinction is one without a difference.
Precisely.
Bottom line: We need to be careful about what we mean when we discuss (or imply the possibility of) default lest we fall into rhetorical traps. The "worthless IOU" argument is itself worthless. There are undoubtedly other cases where it has been used to get the attention of the reader and then been cast aside when it has served its purpose. Better to be upfront about the more likely (and just as troubling) consequences of too much spending, if that's the point you would like to make.
Krauthammer's argument does not require the "worthless IOU" concept and would be better off without it. And I think we should keep the discussion of Social Security reform honest by refraining from using that argument unless you are willing to apply it to the General Fund problem as well. I am not. I'm more inclined towards Dave's comments noted above.
Posted by William Polley at February 21, 2005 11:38 PM
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