Recent research by Professors Ken Rogoff and Carmen Reinhart on the long history of external sovereign debt defaults is sobering. In their Eight Hundred Years of Financial Folly they show that sovereign debt default is far from an isolated event. Indeed over the longer sweep of history, there have been fairly regular episodes where all too many sovereign governments have resorted to defaulting or to restructuring their government debt. Over 40% of countries did so in the aftermath of the Great Depression and over 30% did the same in the aftermath of the 1980-82 global economic recession.
Two further regularities found by Rogoff and Reinhart would seem to be particularly pertinent to today's U.S. context. The first is that those countries most at risk of defaulting on their government debts were those that were overly dependent on capital flows from abroad to finance their government deficits. The second was that sovereign debt default or restructuring tended to be highly disruptive to economic performance in general and to inflation performance in particular.
Today's U.S. public finances are on an unsustainable path. This is not simply because the U.S. budget deficit is forecast to widen to 13% of GDP in 2009 and 11% of GDP in 2010 as a result of the combination of a very deep recession and an expansive fiscal stimulus package. Rather, it is because, as estimated by the non-partisan Congressional Budget Office, the U.S. budget deficit will remain at between 4% and 6% of GDP even after the U.S. economy has fully recovered from its present economic recession.
Over the next decade, the U.S. government debt is set to increase at its fastest pace in peacetime history as a result of prospective budget deficits that will be in excess of US$1-trillion a year over this period. On scoring the Obama Administration's 2009 budget, the CBO estimated that in the absence of policy changes, the net U.S. government debt would approximately double from 42% of GDP in 2008 to 83% of GDP by 2019. This would take the level of the U.S. government debt way beyond the 60% of GDP level, considered by the European Maastricht treaty as a prudent level not to be exceeded by an industrialized country.
How might the end game occur? In principle, there are only three possible end games for an unsustainable fiscal position. The first and optimal end game is for the government to adopt bold expenditure reducing and revenue enhancing measures that might in a credible way return the public finances to a sustainable path. The second end game, and the one to which the U.S. itself effectively resorted in 1931 when it devalued the dollar against gold, is for the government to default directly on its debt obligations.
The third end game is for the government by design or by default to resort to the monetary printing press to inflate away its debt obligations. In today's U.S. context, the government would need to credibly commit to bold fiscal measures equivalent to at least five percentage points of GDP in order to convince markets that the budget was being placed on a sustainable medium-term path. After all, the government is presently running a primary budget deficit (namely a deficit that excludes interest payments) of around four percentage points of GDP. Moreover, public expenditures are set to remain at around 25% of GDP over the next decade, while in the absence of policy changes, entitlement program expenditures are set to balloon after 2014.
While in principle the U.S. government could default on its sovereign debt, there are compelling reasons to think that it will choose not to go down that path. Among the more important of these reasons is the very high immediate cost that a default would impose on the U.S. economy. It would do so in large measure by dislocating domestic financial markets as the solvency of U.S. financial institutions holding U.S. government bonds would be called into question. A U.S. government default would also run the risk of causing a breakdown in globalization as foreign governments would likely retaliate against a U.S. government reneging on its obligations.
An equally compelling reason why the U.S. government would choose not to default on its debt is that, unlike the case of many other countries, practically the entirety of the U.S. government debt is in local currency. As such, the U.S. government always has the option of issuing its own currency to service its debt. And one would suppose that it would choose to do so in order to avoid the large and immediate cost of defaulting on its obligations.
One would hope that the government will not underestimate the long-run cost of such a course of action. If there is anything that we should have learnt from our experience with high inflation in the 1980s, it is the damage that it does to the overall long-run economic performance and the particularly heavy burden that it places on the weakest members of our society.
Desmond Lachman is a resident fellow at AEI.