On Debt Repudiation

The US Debt, a national blessing in the words of Alexander Hamilton, continues to rise in size despite an economy as strong as its going to get. Over recent decades it has risen as a share of gross domestic product.US-Debt-GDP-Ratio



We can discuss causes: decline in revenue due to recession and tax cuts; increased spending due to interest on the debt (which is a positive feedback system), economic stimulus during recessions, and defense spending. While it is not at the World War II record high, it’s higher than its been in the post-war period. While interest rates have been low for the past few decades (especially the last decade), there is no guarantee this will continue. And when interest rates rise, the debt will be more and more difficult to repay.

Who owns the debt? The $21T debt ($65,000 per capita) is owned both by Americans and by foreigners. About 28% of the debt is owed to the government itself (think about the Social Security Trust Fund). Of the remainder ($14.8T) half is owned by foreigners. China owns a bit over $1T. That’s a lot of money of course. The interest on that at 2% per year is $20B/year (you can do the math at different interest rates). So far, that’s hardly enough to break the economy over, though you can easily imagine an unwise President doing so.

In olden days, a superpower could send troops into a foreign country to seize assets when debts were unpaid, such as the US invasion of The Dominican Republic in the early 20th century.  Instead today it is the most powerful that is becoming increasingly financially strapped.

An historic example is England’s King Edward I whose populace was in debt to Jewish money-lenders (since Jews were not bound by Catholic prohibitions on usury but were prohibited from other activities), choose to issue the Edict of Expulsion in 1290. Only after the Monarchy was deposed by Oliver Cromwell were Jews readmitted to England in 1657.

Imagine it’s 2030 and there is a financial crisis of some form. Interest rates rise because confidence in repayment collapses. The economy locks up. The US is no longer the world’s most trustworthy economy. However, the US still has the strongest military. The US can choose to issue still more debt at ever higher interest rates, or it can turn the table over and no longer play the game. What might a populist President and Congress do?

So instead of the debt-holders being compensated, they are repudiated. The US stops paying interest on all bonds, or selected bonds, or bonds held by selected parties (non US nationals, Chinese) under some trumped up excuse.

Obviously the US can no longer borrow internationally in these circumstances, or even domestically, not for many decades until financiers forgive and forget. But if the interest on the debt is sufficient, this may be a trade-off worth making. Should the US continue to pay, say, $100B annually to its lenders, and borrow more, and get deeper in debt, or just keep the $100B and live within its means going forward.

The US in 2030 is not likely to be the Dominican Republic of 1916, foreign powers cannot simply invade to collect their debt. At best they can declare a trade war and impose tariffs.

I obviously don’t know if something like this plays out, but I do know the market is undervaluing the possibility.

Trust as a positive externality

A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King
A Political Economy of Access: Infrastructure, Networks, Cities, and Institutions by David M. Levinson and David A. King

NB: I am not a macroeconomist (IANAM)

A few years ago, Francis Fukuyama put out a book called Trust, a summary of some arguments are presented at: Social Capital and Civil Society – Prepared for delivery at the IMF Conference on Second Generation Reforms

He argued that social capital was a positive externality that produces trust, and civil society only succeeds if people have trust in the words of others, i.e. they believe others will do what they say, and of course that only emerges if people do if fact do what they say.

The recent economic meltdown in the world economy has resulted apparently in banks being unwilling to lend to other banks for fear they won’t be paid back. That fear arises because, in fact, some banks now defunct, did not pay back loans. They lack trust. One (or in this case a few) bad players shattered the system of trust that had a positive externality in encouraging lending.

The economy only works because of beliefs that a small piece of paper (a dollar bill) will be redeemable by complete strangers for something far more valuable than a piece of paper. Through this belief, we can replace barter with a money economy, we can lend money we don’t have (a la banks) and create wealth by investing in wealth-creating instruments now rather than waiting until sufficient resources are acquired.

It is hard to say how many years advanced economically we are because of borrowing, but one imagines it is probably decades. If the ability to borrow collapses, not only can we not grow faster, we will grow slower as old debts still need to be repaid out of current income leaving little available out of current fund for investment.

Positive externalities operate in two ways, as virtuous circles (more of ‘a’ begets more of ‘b’ which begets more of ‘a’) or in reverse as a vicious circle (less of ‘a’ begets less of ‘b’ which begets less of ‘a’). Changing direction requires an external shock (a collapse of trust for instance, or a major infusion of trust through a government intervention).

The classic examples of virtuous and vicious circles in transportation and public transport ridership and service, which grew as virtuous circle from the 1880s until the 1920s, and where after the past 60 years of vicious circle operation, most of the US has very little service and ridership left (despite 30 years of very expensive investments). In the US, transport is “pay as you go” at the federal level, which may very well be a source of for our under-investment, as there is an unwillingness to capitalize now our benefits from investments due to the positive gains they will provide in the future. If we don’t want the entire economy to follow the path of public transport in the US, something must be done.

As suggested above, the collapse of trust is warranted if the players are not trust-worthy. Even if there is an external insertion of funding, if the behaviors of the players reveal their true preferred actions, and these are not regulated in a transparent way, the system cannot necessarily be restarted without new rules to establish trust. As Ronald Reagan was fond of saying “Trust but Verify” (doveryai, no proveryai”).

The same I am sure will hold true of bankers, who not only seemingly distrust each other, but also should distrust the previous failed systems of verification (bond rating agencies) that were insufficient in providing advance warning of emerging problems.

Verification only works with transparency, where the actions of players are observable by all. This occurs on open regulated markets, rather than over-the-counter trades.