Saturday, December 9, 2023

Actually, the US can default on its debt

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As the country heads towards a debt ceiling showdown later this summer, a dangerous idea is gaining currency. It is that the U.S. Constitution makes debt default impossible. This idea risks breeding complacency among our politicians about the economic and financial market dangers associated with the debt ceiling standoff that lie ahead.

The essence of the idea is that the 14th Amendment to the Constitution unequivocally states that “the validity of the public debt of the United States, authorized by law . . . shall not be questioned.” If the debt ceiling were breached, so the idea goes, the government would be forced to prioritize debt service payment over regular government expenditures to avoid default. It would have no option but to cut back on its other spending to generate the necessary resources to do so.

All is well with this idea except for one thing. Since 1866, when the 14th Amendment was adopted, the U.S. government has defaulted on its debt obligations not once, not twice but at least three times.

The most notable of these defaults occurred in 1933, when President Franklin Roosevelt took the U.S. off the gold standard. During the Great Depression, the White House, Congress and the Supreme Court agreed to wipe out around 40 percent of U.S. private and public debt. The U.S. government did so by simply refusing to redeem its gold bonds into gold coins. Instead, the government repaid its gold bond obligations with depreciated currency.

A more recent example of the U.S. government reneging on its debt commitments occurred in August 1971, when President Nixon “temporarily” closed the U.S. gold window as part of his effort to regain control over inflation. By closing the gold window, the U.S. government abrogated a financial commitment it had made to the rest of the world at the Bretton Woods Conference in 1944 that set up the post-war monetary system.

At Bretton Woods, the United States had promised to redeem all U.S. dollars held for $35 dollars an ounce. When Nixon refused to let foreign central banks turn in their dollars for gold, he effectively “defaulted” on the United States’s long-standing obligations to make the dollar as good as gold.

A more recent, albeit lesser, example of the U.S. government reneging on its debt commitments occurred in 1968, when the government refused to honor its explicit promise to redeem its silver certificate paper dollars for silver dollars. When an embarrassingly large number of bearers of these certificates demanded the promised silver dollars, the U.S. government simply decided not to pay.

With the U.S. government’s far from unblemished credit record, domestic and especially foreign investors can be forgiven for entertaining at least some doubt about the protection afforded to them by the U.S. Constitution. This perhaps explains why in 2011, at the time of the last major U.S. debt ceiling showdown, U.S. and global financial markets crumbled as U.S. politicians played a game of chicken in approving an increase in the debt ceiling. It also might explain why the Standard and Poor’s credit agency chose to strip the U.S. government of its coveted AAA rating, thereby raising the government’s borrowing costs.

This is not to say that the U.S. government will once again default on its debt obligations when the debt ceiling is hit later this summer. Rather, it is to say that there is a material chance that the U.S. government will be late in its debt servicing payments as Washington politicians put their narrow political interests above the country’s interest in finding an expeditious solution to this problem. If that happens, all hell is likely to break loose in U.S. and world financial markets on a scale that will eclipse 2011’s financial market ructions.

Let’s hope our politicians understand the seriousness of this issue rather than taking misplaced comfort in thinking that U.S. bondholders have forgotten the past episodes of the U.S. government reneging on its commitments. Maybe then there is a chance that they will stop playing a game of chicken with this issue and spare us from finding out what will happen to financial markets if no agreement is reached by the time the debt ceiling is breached.

American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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