Free Markets, Free People

Dale Franks

Dale Franks’ QandO posts

The markets are telling us things

Let’s see how today went, shall we? We got our debt ceiling deal, but the Dow dropped 266 points, and the S&P 500 fell 33 points, so it’s now negative for the year. The yield on the 10-year T-note dropped to 2.61%. Gold, meanwhile, hit a fresh record high of $1,644.50/oz. So, I guess this year’s Recovery Summer is over.

None of this, by the way, has anything to do with the debt limit battle in DC. No one on Wall Street really thought a deal wouldn’t be struck. At the end of the day, everybody was pretty confident that the debt ceiling would be raised, and a default avoided.

Stock prices are volatile, of course, so one day’s movement doesn’t mean much, but we have lost about 800 points on the Dow since 22 July, so the trend isn’t good.  What’s worse is the steady decline on treasury yields and the climbing price of gold. When you couple that with the 0.4% 1Q GDP increase, and the danger of downward revisions to the lackluster 2Q GDP over the next two months, the evolving picture doesn’t look pretty. We’ve also has a few weeks of unremittingly bad economic releases, showing the economy might be heading back towards recession, and unemployment getting closer to 10% than 8%.

So then what’s the problem? I mean, we’ve had our big stimulus, and our TARP and our Quantitative Easing I and II, and we’re still not only barely budging into positive GDP territory, but now all the signs are showing the economy slowing. What’s happening? Why isn’t any of this working?

I think the answer can be found in what I wrote in my previous post about debt levels, and how over the last several years…

…a body of peer-reviewed work has been developed (PDF) that shows that an excess of government debt serves as a drag on the economy, shaving at least a full percentage point off of annual GDP growth. And we’ve learned that this negative economic effect has a non-linear effect on economic growth as debt increases.

What seems to happen is that, as you begin to approach a debt-to-GDP ratio of 100%, economic growth slows. As you add debt, there’s a non-linear decrease in economic growth. and each additional increment of debt slows growth more than the last. As I also pointed out, this has some pretty scary implications for Keynesian policies, because as you add debt, you’re no longer stimulating growth, you’re hindering it ever more strongly.

That puts policy makers in a pretty bad spot.  For instance, right now, real short-term interest rates are effectively zero, so the interest rate tool is no longer of any use to the Fed. You can’t lower rates below 0%. With that tool gone, the only thing left to try and stimulate the economy is to add more debt. Conversely, cutting spending will result in more government workers and contractors being moved over to the unemployment line, and the economy still slows. It’s a trap, where all the standard policy moves result in a slowing economy.

Back in the 80’s my fellow Econ and Business undergrads would debate about all the debt Reagan was adding, and trying to figure out when all that debt would begin crowding out private investment and slowing economic growth. As it turned out, it took far longer than any of us believed it would, but I think we finally have the answer.

The really scary this is that, if we decided that we had to bite the bullet, and impose some austerity, it really wouldn’t help much.  We could cut discretionary spending by half, and all it would do is gain us a few years of breathing space before the coming explosion in Social Security and Medicare entitlements—about $60-76 trillion worth of them—eat up any short-term savings and debt reduction we might acquire.  After all, discretionary spending—including defense—is only about 39% of the current budget anyway.

What part does economic growth play in all this?  Well, it’s clear that 2% per year isn’t going to help much.

It is a generally accepted truism that the trend rate of growth in a mature economy is 3%. There are a lot of reasons given for this; slower population growth in developed countries, large sunk costs in plant and capital, blah, blah, blah. But why should any of that matter? Just because population growth is slow, it doesn’t necessarily follow that the growth of wealth or human ingenuity is hampered.

Here is a reason for that slow growth that’s almost never given.  You see, one of the things that mature economies all seem to have in common is large government expenditures, extensive entitlements, massive regulatory oversight, and increasing debt. All of that is financed by taxation to remove money from the productive portion of the economy. So, one of the primary reasons we have slower economic growth is because we trade it for public goods.

Now, we may love these public goods. And they are certainly nice to have if you can afford them.  But the evidence is increasingly that we cannot.  if we could, we wouldn’t be racking up a level of peacetime debt that’s nearly 90% of GDP. Not only do we give up a lot of economic growth to sustain these public goods, but, apparently, we eventually give up all of it…at which point, we have to give up the public goods as well.

If we really want to climb out of this hole, then what we really need to do is to radically rethink what government should be, what it should be allowed to do, and how it’s funded. It’s not enough any more to cut budgets, while leaving the regulatory, entitlement, taxation, and spending structure intact. A truly radical solution would be to limit government spending and revenues to no more than 10% of GDP in peacetime. Replace the income tax with a 10% VAT. Eliminate the departments of Education, Commerce, Labor, Transportation and Agriculture. Repeal most Federal criminal laws. Privatize social security. Enforce free markets, rather than the crony capitalism we have now.

*sigh*

No one in our current political class has the slightest interest in any of those suggestions. Drastically reducing the size and scope of government is the only solution that can possibly increase economic growth substantially, and give us a shot at paying off our ever-increasing debt, but our current political class will never embrace that.

The thing is, reality doesn’t care what the political class—or anyone else for that matter—wants. It just is what it is. So, no matter what happens, we won’t have to worry about the deficit or government spending for much longer. Either we’ll fix the problem by electing a political class that’s devoted to cutting government across the board and paying down the debt. Or we won’t fix the problem, and the resulting bankruptcy and hyperinflation will allow us to monetize our debt, wipe out the life savings of every person in the country, and we will start over from scratch with a bright shiny new currency!

But the problem will get solved. The only question is how much control we’ll retain over the process, and how much government we’ll retain at the end of it.

~
Dale Franks
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The Death of Keynesianism (Updated)

Sen. Dick Durbin is an angry man, because he sees the debt deal as the death of Keynesian economics. For some reason, he appears to see this as a bad thing.  In his comments today, discussing the debt ceiling deal, he noted:

“I would say … that symbolically, that agreement is moving us to the point where we are having the final interment of John Maynard Keynes,” he said, referring to the British economist. “He nominally died in 1946 but it appears we are going to put him to his final rest with this agreement.”

That’s a bit of hyperbole, but even if true…well…so what?

Lord Keynes had some valuable insight into how fiscal and monetary policy can work inside certain parameters­, but outside those parameters­, it fails. And I have no doubt whatsoever that even Lord Keynes would recognize that, once a country has accumulate­d enough debt, the debt itself becomes a drag on economic growth, and attempting to inflate your way out of it by piling on more debt is a solution worse than the disease.

We’ve actually learned quite a lot about how the economy works since the General Theory was published in 1936, not the least of which were the limitation­s of Keynesian theory in the 1970s. Keynes famously noted that politician­s are almost always influenced by the opinions of some long-dead economist. Like John Maynard Keynes.

Keynesian economics should be dead. If nothing else, the existence of stagflatio­n in the 1970s should have shown that Keynsian policy prescripti­ons were ultimately unworkable­. Indeed, the very existence of Stagflatio­n shows that several central tenets of Keynesiani­sm are simply flat wrong. The response to this is usually that the 70s were an aberration due the oil shocks of the Arab Embargo, and the subsequent price hikes enforced by OPEC.

I am, of course, quite well aware of this. I did, after all, live through it.

I am also aware that Keynesiani­sm regarded inflation and recession as being mutually exclusive-­-an idea that fostered a reliance of the Philips Curve, and constant seeking by the Fed to find the NAIRU. I am further aware that the Fed’s response to the oil shocks was a highly expansioni­st monetary policy that ultimately kicked off a wage-price spiral in a recession, rather than causing an economic expansion. Apparently, we found the limit at which expansionist policy ceased to be expansionary, and became merely inflationary.

What solved that problem was Paul Volcker’s Fed adopting an explicit Monetarist policy at the Fed to essentiall­y ignore interest rates and concentrat­e on money supply growth. As hard as it may be to believe now, markets would almost shut down on Thursdays waiting for the M1, M2, and M3 numbers from the Fed. We mostly ignore that Thursday money supply release now. It took a fair amount of pain, and back-to-ba­ck recessions in 1981-82 with 11% unemployme­nt to solve the inflation problem, but it did wring inflation out of the economy.

What we learn from all this is that Keynes had some serious policy limitation­s in the real world. I believe that we are currently discoverin­g more of those limitation­s.

We’ve actually learned quite a bit about how economies actually work in the 75 years since The General Theory was published. Over the last decade, for instance, a body of peer-revie­wed work has been developed (PDF) that shows that an excess of government debt serves as a drag on the economy, shaving at least a full percentage point off of annual GDP growth. And we’ve learned that this negative economic effect has a non-linear effect on economic growth as debt increases. I would submit that in light of this, that no matter how workable Keynesian theory may be in a regime of moderate public debt, with judiciously applied counter-cyclical monetary and fiscal policies, that it simply falls apart as the debt approaches 100% of GDP.  One of the key problems is, of course, that we’ve rarely seen the high levels of public indebtedne­ss we’re currently experienci­ng, so prior to this decade, much of the work in this area was theoretica­l, except for data from highly indebted emerging countries, which may not be entirely applicable to mature economies.

Sadly, we’re collecting that empirical data now.

I’d also point out that we also don’t have to rely solely on 1970s stagflatio­n to note the failure of Keynesian prediction­s in the real world. One merely has to look at the wide-sprea­d Keynesian prediction­s in the immediate Post-WWII era that massive budget cuts to pay down the war debt, coupled with the demobiliza­tion of 12 million soldiers, would lead to a return of the US to a depression economy. Of course, no such depression occurred. Quite the opposite, in fact.

It was clear, even a decade after the General Theory was propounded, that it was…incomplete.

One more thing that relates the current level of indebtedne­ss is that attempting to apply Keynes over and over again–but only the deficit spending part–is that, in effect, you’re arguing that the Keynesian solution is to spend, spend, spend, not matter what the level of debt.

There’s simply no evidence at all that even Keynes would have bought into that sort of argument. Indeed, quite the opposite is true. Lord Keynes never argued for increasing public spending as a matter of course, but rather tempering spending with budget-cut­ting at the appropriat­e time. Properly applied, even Keynesiani­sm tends towards a balanced budget over time. What we’ve done over the past three decades isn’t Keynesiani­sm, it’s a perversion of it. We’ve spent like drunken sailors attempting to stimulate the economy, but we’ve never actually gotten around to cutting budgets and paying down the debt in the good times.  We’ve simply accepted the new level of increased spending as the baseline.

My argument  is that we’ve reached beyond the outer bounds where Keynes is applicable­. However relevant his observatio­ns may be in a regime of limited public debt and counter-cy­clical fiscal and monetary policy–wh­ich we’ve never really applied by the way, as we’ve ignored the budget-cut­ting bits–we’v­e simply passed the point at which his policy prescripti­ons can be relied upon, even if they are correct in other contexts.

If Keynesianism is dead, it’s mainly because we’ve killed it.

~
Dale Franks
Twitter: @DaleFranks

UPDATE: From Billy Hollis in the comments:

One of the main reasons I have disdain for experts that are part of the political class is the Honors Economics course I took in 1975-76. The professor (an excellent one, and one of the few non-collectivist professors in the department) had us read and contrast John Kenneth Galbraith, who was the leading Keynesian proponent of the time, and Milton Friedman. Galbraith sounded like nonsense to me, and Friedman seemed logical and reasonably clear…

Pumping up the money supply artificially increases demand, trading present good stuff for future bad stuff (inflation, high interest rates, etc.). The only way you can believe that such a technique works in the long term is to assume people are stupid and will fall for the same short term thinking every time you try it.

I’d respond that what JKG called Keynesianism…wasn’t.

Keynes said that in recessions or depressions, the government should use deficit spending to pump more money into the economy. This extra spending would increase the money supply, and stimulate the economy.  In addition, the government could cut taxes, allowing people to keep more of what they’d earned.

In good economic times, he said the government should operate at a surplus. That would keep the economy from heating up too fast, and set aside a store of money to be spent in the recessionary times. It would also reduce the money supply, and erase the inflationary pressures bought about by increasing the money supply during the recessions.  Taxes could also be raised to help make up the previous budget shortfalls.

So, in a perfect world, the budget would balance, over the course of a business cycle. You’re still trading present good stuff for future bad stuff, but in relatively tiny increments.  You really aren’t supposed to do it $14 trillion at a time.

What we had in the 1970s–and since–was half of Keynes.  The easy bit.  The bit that allowed us to spend, spend, spend, with nary a thought of ever applying fiscal austerity in the good times. Austerity is hard and unpopular. It’s easier just to spend money as a way to buy votes.

Since Keynesianism essentially requires the administration of wise philosopher-kings to administer it, democratically-elected polities have failed at implementing it.

Even more than that, Keynesianism essentially requires the ability to rather precisely target both the timing and amount of stimulus needed to ameliorate a recession, and the timing and amount of austerity to apply in an expansion to wring the expansionary and inflationary pressures out of the economy. But, absent a philosopher king who can operate in synch with the state of the economy, things begin to break down.

Timing the changes in fiscal and monetary policy are, at best, difficult in a democratic state.  Messy political deals have to be made and legislation gets held up while waiting for amendments to satisfy some special interest, without which, too few politicians are willing to vote in favor. On the monetary policy side, the effects of policy changes aren’t realized for 8-16 months after a policy change, such as a change in interest rates. And, in either case, no one actually knows what the state of the economy is right now. At best we know what the state of the economy was last month, or three months ago, when the statistics were compiled.

Even at the best of times, with political players of unquestioned integrity, the immense difficulty of knowing the precise timing and amounts of expansionary or contractionary policy that is needed is a daunting task.

Theoretically, Keynes theory is elegant, and explains much about money-based economies.  In practice, it’s so difficult and messy to try and implement, and so filled with negative incentives for the politicians who are asked to administer it, that it has simply proven unworkable.

Like communism, the fact that it’s never been properly implemented, or achieved the claimed result, raises serious questions about whether, in the messy world of real people, it ever can be.

Observations: The QandO Podcast for 31 Jul 11

In this podcast, Bruce, Michael, and Dale discuss concerns about Turkey, and the debt limit.

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.

The Gang of Six is back

Gangs of anything are rarely good things.  And when it comes to the Senate’s Gang of Six, that caution is doubly true.  Today the Gang proposed a bipartisan deficit plan to which the president–eager to kick the deficit can down the road past the 2012 election–gave his qualified approval.  There is only this summary (PDF) available at the moment, and there is much to digest.

The good news is that there is at least some sanity in it.

  • Personal and corporate income taxes would be reduced to a top rate of 29%.
  • The Alternative Minimum Tax–which has turned into a horrific taxation burden–will be eliminated.
  • The CLASS Act provision of Obamacare would be repealed.

The bad news–and there’s always bad news with these guys–is that the budget reduction portion of it is notional.  As usual in Washington, it calls “cuts” what the rest of us would call “reductions in the rate of spending increases”.  In other words, spending isn’t actually reduced at any point, they just promise not to spend as much as they previously said they would. The main problem points include:

  • None of the plan’s “spending caps” apply to entitlement programs, only discretionary spending. So the 800-pound gorilla of the budget remains untouched.
  • Reform tax expenditures for health, charitable giving, homeownership, and retirement. These aren’t expenditures! They are allowing you to keep your money for IRAs, 401(k)s, Mortgage interest, etc.  So, that sounds…ominous. Especially since the plan assumes that these, and similar reforms will net an additional $1 trillion in revenue.
  • No reform at all of Medicare of Medicaid.
  • A politically-imposed requirement to use the Chained-CPI as an inflation measure, presumably to cut down on cost-of-living increases, as the Chained-CPI understates inflation even more than the current CPI does.
  • Requires the tax code to become more “progressive”, so you can expect serious increases in Capital Gains taxes.
  • No Social Security reform at all, unless there’s 60 votes for it in the Senate, i.e., sponsors for such reform prior to its submittal to the Senate for consideration. So, essentially, never.

There’s no information at all on how big or expensive government will be, say 10 years down the road. No information on how strict the spending caps will be, making me expect another Gramm-Rudmann deal: Good on paper, ineffective in practice.

Basically, this plan, so far as I can tell, contains some eye-candy on income taxes to draw in the supply-siders, with the actual deficit reduction portion sounding…sketchy. Or in the case of entitlements, by far the source of most federal spending, non-existent.

~

Dale
Twitter: @DaleFranks

Style Evolves

About once a year, I like to shake things up a bit, visually.  The nice thing about WordPress is that such shake-ups to the template are relatively easy to do. Last year’s version began to strike me as too dark and outdated. So, I decided it was time for a change.

The theme this year is the Constitution, with the Preamble as the blog header photo.  For colors, everything went completely grayscale and much lighter, except for the post titles and the drop caps, which now are a brighter blue and red, respectively.  Site navigation was moved from the header to the top of the sidebar, which has not only switched sides, but has gotten a bit narrower, giving us some extra room in the content column.

Fonts are essentially the same, with Georgia as the header font and Verdana as the body font.  With the wider content pane, I expanded the horizontal spacing of the body font making it a bit easier to read, without actually changing the font size.  If you, as one commenter noted in a previous post, think it’s too akin to reading a children’s book, well, sorry. I think it makes the body text far more readable for a larger number of people.

If you really hate it, then just wait a while.  It’ll change again.

Observations: The QandO Podcast for 17 Jul 11

In this podcast, Bruce, Michael, and Dale discuss the fight over the debt limit.

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.

Taxes won’t help

A commenter to my previous post writes: “Tax increases on the wealthiest would keep rates below Reagan era rates, and add some revenue.”

No, they won’t.  Not even close. Here’s why:

Tax Revenues as a Percentage of GDP by Year, 1933-2010

Now, this chart counts all tax revenues. Income taxes, corporate taxes, excises, tariffs, etc.  All of them. It includes the low income taxes of the 1930s, the 90% top tax brackets of the 40s and 50s, the Kennedy and Reagan rate cuts of the 60s and 80s…it’s all there.

And what do we notice about this model? Well, a couple of things. First, the highest tax receipts as a percentage of GDP was 20.9%.  That was in 1944. In 1945, the percentage was just north of 20%.  I think I have a pretty solid–and obvious–explanation of why tax receipts jumped so high in those two years. Sadly, the Nazis are gone and the Japanese seem rather less interested in the Greater Southeast Asia Co-Prosperity Sphere project than they did back then, so a global conventional war seems out of the picture at the moment. Darn our luck!

But the other thing we notice when we look at this chart is that despite top marginal tax rates varying between 28% and 90% since 1945, tax revenues as a percentage of GDP seem to be locked in at about 18%.  There is, in fact, only one explanation for the variations–minor as they are–in the revenue percentage since 1945, and that is economic expansion.  Irrespective of the statutory tax rates, the single, overriding factor in increases or decreases in the revenue percentage has been economic growth.  The percentage rises when the economy expands, and dips when it contracts.

As a practical matter, this chart shows us a very obvious, but little-understood phenomenon, namely, that 18% or thereabouts is the rate at which the electorate consents to be taxed. Think about that for a minute. Dwight D. Eisenhower presided over a system of steeply graduated tax rates with a top marginal tax rate of 90%.  He got 18% of GDP in revenue.  Ronald Reagan slashed tax rates, simplified the structure into three brackets, indexed for inflation, with a top marginal tax rate of 28%…and got 18% of GDP in revenue.

In the past couple of weeks, three different progrssive policy think tanks have released deficit reduction plans, all of which contained substantial tax increases, and which projected revenues as a percentage of GDP rising to over 23%.

Not. Gonna. Happen.

We know it won’t happen, because the American people have told us repeatedly, over the past 60 years, exactly how much revenue they’re willing to pay in taxes. You can jack around with tax rates all you want and you’ll get 18%.  Unless you grow the economy.  When the jobs are plentiful and the money is rolling in, the American people get a bit more generous. They’ll give you 19%.  Maybe, if things are really going swell, 20%.  But if the economy isn’t rolling hard, you’re gonna get your 18%–or less. Assuming you can lift 23% of GDP in tax revenues is just a fantasy.

Because here’s the thing: You can’t force people to make money. If they can make the same take-home pay working 35 hours per week under the new tax regime as they made in 40 hours per week under the old one, they’ll just work 35 hours per week. The more you penalize income, the less desirable additional income becomes.  It’s almost as if people respond to incentives!

Bonus question 1: If the government collects about 18% in GDP irrespective of the statutory tax rates, what is the electorate telling you the desired statutory tax rate is?

Bonus question 2: If the main factor in increasing tax revenues is economic growth, would economic growth likely be greater or smaller under a regime of lower taxes?

Discuss among yourselves.

~

Dale Franks
Twitter: @DaleFranks

How screwed are we?

I have to admit, I sometimes get tired of being the voice of doom. Sadly, our political class–Republicans and Democrats alike–seems determined to follow the worst policy options available. So, doom slouches closer. The proximate doom they’re fiddling with this time is the approaching debt limit. Now, I yield to no man in my hatred for ever-increasing government spending, but this debt-limit battle is pointless.  We will increase the debt limit. We have no choice.

Here’s the current situation:

OMB estimates federal revenues for 2011 will hit $2.17 trillion. Granny, our servicemen, and other such untouchables — by which I take him to mean Social Security, Medicare, national defense, and debt-service payments — will add up to $2.21 trillion, meaning that even if we cut the rest of the federal budget to $0.00 — no Medicaid, no food stamps, no Air Force One — revenues still would not cover these untouchables, according to OMB estimates…

Our deficit is about 40 percent of spending this year; continued recovery, if the estimates hold, will do some of the work for the 2013 regime, but even under current forecasts that are arguably too rosy, we’ll still be running a 26 percent deficit in 2013.

Even if we eliminate every penny of spending this year except for Social Security, Medicare, and Defense, we still can’t cover this year’s spending.  And next year’s spending projects an economic recovery will save us, and reduce the deficit to 26% of spending. Absent such a recovery, next year we’ll be back to another 40% deficit.

And the politicians of both parties are nowhere near to making the appropriate cuts in the budget in years farther out than that.  The biggest deficit reduction package currently on the table is for $4 trillion over the next 10 years. Which sounds impressive, until you remember that the actual projected budget deficit over the next 10 years is $13 trillion. So, we’re still $9 trillion short of closing the budget deficit for the next 10 years.

But, wait! It gets better!  This $13 trillion figure assumes that interest rates will remain stable where the currently are. If interest rates for treasuries go up by 1%, that wil add 1.3 trillion to the deficit over the same period.  As the moment, the Office of Management and the Budget (OMB) projections are for a stable average interest rate of 2.5%. Of course, the current 20-year average is closer to 5.5%, so a return even to normal interest rates will add up to $3.9 trillion to the deficit.

But the magic doesn’t stop yet! OMB forecasts growth rates of between 4%-4.5% from 2014 to 2014. The average trend rate of growth is between 2.5%-3% however. So, if we don’t get the strong growth the OMB is predicting over the next three years, and the following years, we’ll need to add another $3 trillion or so to the deficit over the next decade.  And, frankly, if you believe Goldman Sachs today, a return to trend rates of growth seems..unlikely, as they’ve lowered 2Q GDP growth to 1.5% from 2.5% and 3Q to 2.5% from 3.25%.  They also forecast unemployment at end of 2012 to be 8.75%.

So, the best case scenario is that we’ll add $9 trillion to the deficit over the next decade. A return to historical growth and interest rates–even if we assume the $4 trillion of budget cuts will actually happen–means a 10-year deficit of $16 trillion. Essentially, we will more than double the National Debt, pushing the debt to GDP ratio to about 160% by 2021.

And that’s the good news.

The bad news is that, in the current debate over the debt ceiling, everyone involved seems determined to play chicken with a default–even if only a selective default–of US treasury obligations.

Tim Pawlenty even suggested that a technical default might be exactly what Washington needs to send a wake-up call to the politicians about how serious the situation is. Others, like Michelle Bachmann, and a not inconsequential number of Tea Party caucus members are steadfastly against raising the debt ceiling for any reason at all.

This is insanity.

Any sort of default, even a selective default that would suspend interest payments only to securities held by the government, while paying all private bondholders in full, will have completely unpredictable results. The least predictable result, however, would be business as usual. A technical default–i.e., delaying interest payments for a few days–or selective default, or any other kind of default is…well…a default. It is a failure to make interest payments.

The most obvious possible result of any sort of default will be to eliminate the US Treasury’s AAA rating, and push interest rates up sharply. If we’re lucky, we’d be talking about a yield of 9%-10%…and an additional $5 trillion added to the deficit (running total in 2021: $21 trillion added to the national debt).

And, again, that’s a best case scenario. Because it assumes that everyone will be willing to hold their T-Notes through all of this.  If any major overseas institution or government–say, China–decides to unload their holdings, it could be the start of a flight from treasuries that will destroy the US Dollar in the FOREX, vastly increase the price of imported goods, like, say, oil, and spark uncontrollable hyperinflation in the US. The life savings of every person and institution would be wiped out.

Naturally, yields on interest-bearing instruments would then pull back on the stick and climb for the skies. Not that it’d matter much at that point, since the currency would merely be ornately engraved pieces of durable paper.  Suitable for burning in the Franklin Stoves with which we will be heating our homes, in the absence of oil.

Flirting with default is extraordinarily reckless. I don’t even have the words to begin to describe how badly any sort of default might go.

The thing is, we don’t know–we can’t know–what the results of a technical or selective default might be.  It might be the judgement of worldwide investors that there are no better alternatives to US-denominated securities, so they’ll just have to ride out a technical default, and accept their interest payments coming a few days late. It might be their judgement that unloading their US-denominated securities and losing a little money is better than the risk of losing everything through a currency collapse. It might be a lot of things, and we have no way of knowing which of those things might come to pass.

As Tim Pawlenty says, a default might be a wake up call.  From an exploding phone filled with napalm and plutonium.

Whatever political points might be at stake, is it worth this level of risk?

The safe path here is a simple $500 billion debt limit increase. That’ll give us 6 months to figure things out, and try to discover some way to get our fiscal picture under control, and avoid a default. Government spending is out of control, but a default is really not the best way to impose fiscal discipline.

~

Dale Franks
Twitter: @DaleFranks

Observations: The QandO Podcast for 10 Jul 11

In this podcast, Bruce, Michael, and Dale discuss the L.A. Counties harrassment of desert dwellers, and the ongoing budget negotiations.

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.

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Observations: The QandO Podcast for 26 Jun 11

In this podcast, Bruce, Michael, and Dale discuss the Libya vote in the House of Represenatatives, the economy, and Gunwalker.

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.

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