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Your Guide to the National Debt (Part 2)

"I am not among those who fear the people. They, and not the rich, are our dependence for continued freedom. And to preserve their independence, we must not let our rulers load us with perpetual debt. We must make our election between economy and liberty, or profusion and servitude." - Thomas Jefferson, written in a letter to Samuel Kercheval on July 12th, 1816.

In part one of this series, I provided a technical overview of the national debt and a brief description of the problems caused by a large debt. Now, I want to discuss the possibility of defaulting on the debt.

Will we default on the national debt?

Probably not. It's important to understand that the national debt is held in U.S. dollars, not a foreign currency. Why does that matter? Well, let's say that a foreign nation demands to cash in their Treasury securities because they don't believe that our federal government is spending at a sustainable level, or for any other reason. Unfortunately, our government is basically bankrupt, and we simply can't find the funds amongst our current resources to honor our debt.

If the debt were held in, say, British pounds, we would have no recourse and therefore default on the debt. Essentially, this is what has happened to Greece. The reason that their sovereign debt crisis is so severe is that the Greek national debt is held in euros. When Greece abolished its national currency (the drachma) in favor of the euro, they surrendered their monetary policy and the power to print money to the European Central Bank. Enormous sums of aid from the International Monetary Fund and other nations in the Eurozone is the only reason that Greece hasn't already defaulted on its debt.

However, because our debt is held in U.S. dollars, that's not what would happen to us. Since our federal government has the authority to issue more U.S. dollars, we can always print the money to repay our debts. There's a minor hurdle to jump over in that Congress has delegated this power to the Federal Reserve, but that could be changed. If we wanted to, we could simply print $16.4 trillion and pay off the debt today, just like that. Sounds simple, right? And easy?

In truth, the problem of default is a little more complicated than that. Technically, we can always print as many dollars as necessary to repay our creditors, but this "solution" would result in serious problems. Namely:

  1. Rapid inflation
  2. A damaged reputation
  3. An infringement on our honor

What is inflation?

The primary economic problem caused by printing our way out of a debt crisis would be inflation. Inflation is a rise in the price level of goods and services over time. For example, if we experience 2% inflation over the course of 2013, a product that costs $1.00 on January 1st will cost $1.02 on January 1st of 2014. Of course, I am generalizing to some degree. Inflation occurs unevenly across the economy, so the price of some products or services may rise by one cent, three cents, or not at all. Here's another way you can understand inflation: Inflation occurs when there is more of a currency chasing the same amount of goods and services in an economy.

The effects of rapid inflation on a nation can be severe, if not ruinous. The purchasing power of money falls, serious disincentives to save and invest arise (remember from part one that economic growth is a result of savings and investment), and people may begin to hoard goods if they fear that their money will continue to lose value, thereby causing shortages. Those on fixed incomes, such as Social Security recipients, are hit especially hard by inflation.

Ultimately, inflation is a tax and should be understood as such. After all, as the government continues to print money, the purchasing power of the money you're holding will continue to drop. In extreme cases, hyperinflation can destabilize countries and topple regimes. So, that's why we don't see many serious people arguing that the solution to our looming debt crisis is to start printing money hand over fist.

There are always exceptions, however, such as Representative Jerry Nadler (D-NY) and polemicist Paul Krugman. Those two are pushing for the Treasury to issue a trillion dollar platinum coin to avoid another fight in Congress over the debt ceiling. Although Krugman endorses this painfully stupid scheme that sounds more at home in a Saturday morning cartoon than in our nation's capital, even he admits that this would eventually result in "a sharp rise in inflation."

Simply put, debasing our currency is not a good solution to the problem of debt.

How would this affect our reputation?

If you want to start a business or to purchase a home, you'll probably need a loan from a bank, investor, or friend. Unfortunately, if you have a reputation of welshing on debts, you'll probably have a hard time finding someone to lend to you. Perhaps your friend may be willing to overlook your bad reputation, but even he will probably have doubts about giving you a loan. People who bear the title of "bad credit risk" don't have the easiest of lives.

Governments can have the same problem. If you own a few thousand dollars worth of Treasury securities and the federal government ends up defaulting on the debt instead of repaying you, you probably wouldn't buy Treasury securities again in the future, right? Even if the government does repay you, but does so by debasing the currency and repaying you in worthless dollars, wouldn't you still feel cheated? Wouldn't you still consider the government fundamentally untrustworthy and refuse to loan it more money in the future?

A bad reputation is difficult to shake. Defaulting on the debt or repaying our creditors with worthless dollars will ruin ours.

What's the honorable thing to do?

This is more of an abstract point, but I doubt that any of us want to default on the national debt. When someone gives you a loan, you feel a duty to pay them back. Call it honor, dignity, or even morality, some instinctual common-sense sentiment tells you to honor your debts. In our very first days as a country, the Founders faced a serious problem along these lines. The enormous cost of waging the Revolutionary War forced the fledgling nation to incur massive debts. These debts were owed to foreign nations such as France, but mostly to American citizens who held Continental bonds.

As a young nation devastated by war, it isn't surprising that some of the Founders wanted to repudiate the debt, or to pay creditors only a fraction of what was owed. Others supported repayment of what was borrowed, but without interest. However, President George Washington and his Treasury Secretary Alexander Hamilton insisted on full repayment of the debt in order to establish the fundamental character of the new nation. We would be a nation of honor and integrity. Today, few of us hope to violate that sense of honor and to forgo fulfilling our national debt.

Considering default

Technically speaking, the United States will never default on its debt unless we decide to do so by not printing more dollars. However, realistically speaking, relying on the printing press to avert a debt crisis has many of the same negative consequences as default. Besides, our creditors aren't fools: If we give them worthless dollars in repayment for their loans, they'll know that we've basically cheated them. In effect, it would be similar to defaulting and not giving our creditors anything at all.

Neither default nor inflation are desirable "solutions" to the debt crisis. Yet, President Barack Obama and many Congressmen appear unwilling to address the national debt or to put us on a path toward balancing the federal budget (or in the case of Senate Majority Leader Harry Reid (D-NV), even creating a budget). With that in mind, my next post will ask whether the problem of the national debt is insurmountable.

part three

back to part one

Terry Manker

Your article is good but forgets that the dollar is traded in the open market. It is a guarantee at some point once the debt goes over $20 trillion and beyond, the markets and the rest of the world will eventually realize this debt will never be paid back and the dollar will crash. Game Over. OR by know choice of its own the Federal Reserve will start buying our debt by issuing $ which results in hyperinflation. Either way you end up with a dollar crash, and where the USA goes from there, if somehow possible, is anyones guess.

D.G.'s picture
Don Gibson

I don't think "default" is the right word. Constitutionally, we must honor our debt. If the Congress or President failed to honor the debt, they would be removed from office by another branch. Also, there is plenty of cash flow to pay interest. The political risk in the near-term is a "government shutdown" or reduction in services/payments in authorized activities. That is a big deal, but it is not a default. Long-term, default is very unlikely, since we have lots of room for more taxes. However, based on current projections, our spending will lead to high taxes and lower standard of living. That is the opposite of prosperity.