Thursday, September 23, 2010

Gov. Default: Not When But How

We peasants have the wrong idea about government default. It doesn't necessarily mean that the government flat out defaults on its debt. Most governments are smarter than that. Nor does default necessarily mean hyperinflation. Most governments aren't Weimar Germany or modern Zimbabwe.

The best way to think about default is this. Governments make promises all the time; politicians make promises to get elected. But once elected politicians must choose which promises to keep. The result is that governments default on their promises all the time. But this time is different. This time it is going to be worse. Here how Arnuad Mares puts the argument:

In other words, some or all of its stakeholders must suffer a loss: either taxpayers (through a higher tax burden), or beneficiaries of public services (through lower expenditure) or bond holders (through some form of default).

When you put the argument like that, you realize that governments are defaulting on promises all the time. Usually, they default on taxpayers. Sometimes they default on the voters that get government benefits. Occasionally they screw the bondholders. And they are doing stuff like that all the time. You think that they never default on the bondholders in advanced countries like the US? Think again.

Examples include: the revocation of gold clauses in bond contracts by the Roosevelt administration in 1934; the experience by then Chancellor of the Exchequer Hugh Dalton of issuing perpetual debt at an artificially low yield of 2.5% in the UK in 1946-47; and post-war inflationary episodes, notably in France (post both world wars), in the UK and in the US (post World War II).

The basic skill of politics is to default in the least damaging way--for the ruling class, of course. Today's situation is interesting because the government is clearly coming up against the limits of taxation. Meanwhile they are trying stealth default on Medicare promises through the reduction in Medicare Advantage benefits. And they are inflating the dollar, which screws the bondholders.

The question is: what's an asset holder to do? Dodge the IRS? Don't get completely dependent on government benefits? Keep out of dollar-denominated assets?

The problem with a defensive strategy like that is that in the long run we are all dead. You could reduce your tax exposure, but that takes money in lawyers and tax accountants. You could stay robustly independent, but why pass up the free money? You could stay out of bonds and bank accounts, but that means getting into riskier equities and "real values."

Most likely, the government will squeeze through with some tax increases, some spending cuts, and some inflation.

But with the highly competent Obama administration, you never know.

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