April 8, 2011
Would Federal Default Be So Bad?By Stephen Mauzy
Bill Gross, fixed-income cognoscente and Pacific Investment Management founder, is bearish on U.S. government bonds. Gross revealed in a recent missive that his fund had dumped Treasury holdings greater than 12-months maturity in February because he saw little value given the nation's debt burden. Though he thought default wasn't imminent, he thought it was possible if deficit spending continues unabated.
Anything is possible, of course, statistically speaking, and default at this juncture is a faint possibility. But would it be so terrible if default were probable, even likely? To holders of U.S. government-issued debt, the response would be a neck-cricking nod. An equally vigorous response would be forthcoming from bureaucrats, central bankers, geriatric warmongers, welfare recipients, and everyone who depends on a continual government-debt float to ensure their livelihoods.
What about everyone else? Surprisingly, the majority would benefit -- greatly. A default would be cleansing and salutary to those who value freedom over tyranny, ownership over confiscation, honesty over duplicity.
A default would settle who owns output. Economists cavil on what government debt load is serviceable and beyond what percent -- 50 percent, 75 percent, 100 percent of GDP -- trouble ensues. These economists speak of the government's leveraging privileges as if they are equal to those of a private enterprise, as if it is within the government's prerogative to leverage the nation's balance sheet up or down as it sees fit. These economists are acknowledging, without actually saying, government owns all property, and property is government's to leverage as it sees fit.
As the government sees fit is at odds with sound financial management. Responsible finance managers match asset and liability maturities. Responsible managers have low time preference; they are owners or must abide by owners' dictates, so they plan for the future. Government, in contrast, is populated with the infantilized -- individuals with neurotically high time preference who focus myopically on today. Who other than a government bureaucrat would float a 30-year bond in order to subsidize a purchase of a Chevrolet Volt, to provide a septuagenarian with a stipend, or to bomb a dictator in Northern Africa?
"Investment" is a deceptive euphemism. The purchaser of a private bond enables a corporation to buy machinery and technology to increase its output of goods it believes the market wants. The interest paid on the bond is part of the increased production the bond makes possible. Government, however, does not allocate bond proceeds to production in order to increase future output; it spends money on current consumption. Interest is paid from a tax fund that the bondholder is forced to pay into. In effect, the bondholder is paying interest to himself.
An investment confers ownership. In the private sector, investors can transfer or sell their investment. In the private sector, an investment returns principal, interest, or dividends from profit. The value of the investment is determined by market prices and is easily gauged. Financial statements reveal if bond-sale proceeds enhanced or weakened the firm. No such measure exists in government. Sure, government attempts to defend its spending with statistics, but statistics aren't prices; they are estimates, which are always wrong.
By borrowing instead of taxing and inflating, government can use the proceeds to benefit posterity, so one deceptive argument goes. Instead of placing the entire burden of meeting the cost of its beneficence on the living, government proposes to demand of the unborn their share of the cost. After all, future Americans benefit from today's "investment."
The rationale is absurd; it is the impossible doctrine of control of the living by the dead. Future Americans, once reaching the age of majority, should bristle at the impertinence. Loading future Americans with obligations they had no voice in accepting, and which they will likely resent, means today's Americans are deserving of all the ingratitude and calumny their unborn progeny will muster.
To be sure, many Americans oppose the federal government's spendthrift ways, but for the wrong reasons. A subset of citizens prattles piously about debt like 17th-century Calvinist ministers, invoking the opprobrium "debtor nation" at every chance. They believe debt is inherently bad, and really bad because China and Japan own $2 trillion of the U.S.-government strain.
They are wrong. Foreign ownership of government debt doesn't make a debtor nation; it makes a debtor government. A debtor nation is a nation of companies that secure financing for capital investments from foreign lenders and investors. By that definition, the United States has a long, proud history of being a debtor nation, which is why we enjoy the living standard we have today. If foreign companies are willing to lend and invest in domestic companies, more power to them.
China's and Japan's governments, in contrast, are simply financing U.S. government profligacy and political vote-buying ability. Concurrently, China and Japan use our debt to manipulate their domestic currencies vis-à-vis the U.S. dollar in order to adhere to the specious mercantilist mindset.
Americans buying U.S. government debt is no better. "We would owe it to ourselves," the provincials declare. When the federal government issues debt, it doesn't move money from the right pocket to the left. When a citizen buys a Treasury security, the federal government stamps a lien on that citizen's property and every other citizen's property too. When government issues debt, property rights are weakened and government claims against property are increased -- just like a tax. Whether purchased by foreigners or citizens, money the government siphons from others is money that could have been invested in productive private enterprise.
Unfortunately, many Americans equate Treasury securities with patriotism. They reason that bond-owning citizens have a financial stake in government; therefore, they are more involved in public affairs. Love of country is contingent on the probability of returns, which smacks of the sort of patriotism that motivated the money lenders of the Middle Ages: once they invested in the king's ventures, they could ill afford to wane in their allegiance.
With their portfolios packed full of government bonds, financial institutions are the contemporary version of the Middle-Ages money lenders; they are junior partners whose self-interest compels compliance. An allotment of bonds to a bank carries weight because the bank's holdings would lose value if doubt were thrown on the credit of the United States. A slice in the prices of federal debt would shake the financial system to its foundation; hence new issues are always promoted to protect old issues.
Let the foundation shake, because it would leave the citizenry only private-sector options. The marketplace would become healthier and more vigorous. Current bondholders would lose, but since they, too, are citizens, they would benefit by the improvement of the general economy.
Default would raise taxes and curtail spending, but the connection between taxation and spending would become more palpable. Even the most doltish among us could connect a reduction in take home pay to the profligate politician. The reality of no-free-lunch becomes more perceptible.
Default would crimp the government's ability to manipulate money. Supply rises and falls by a central bank buying and selling government bonds and by loan demand in a fractional reserve banking system. Government could still print money through the Treasury Department, but direct printing is a blatant apparatus, unlike the elliptical process of banks buying debt from the Treasury and the Fed buying debt from the banks.
Given Bill Gross' many purchases and profits from government bonds through the years, he was likely lamenting the possibility of the government defaulting when he wrote his admonition. The rest of us? We should be rooting for it.
Stephen Mauzy is a financial writer, analyst, and principal of S.P. Mauzy & Associates. Send him e-mail at firstname.lastname@example.org.