Unexpected Virtue Means the Government Gets to Have its Cake and Eat it Too

It is a tough week for bloggers. Casey Anthony is in hiding for a while. The Europeans seem to have overcome a big debt impasse. Pro football millionaires and their squabbles seem to have been resolved. Glenn Beck has been replaced by The Five at Fox at 5PM and all five seem to think highly of their own loud and comedic antics.  So what is there to write about? Oh yea, that US budget thing. But what hasn’t been said about that topic?

I got into a discussion with a few friends last week that might be worth tossing out there. It has to do with the difference between a technical default and a real one. There’s a big difference. Let’s suppose you want to take $1,000 out of your bank account so that you can buy a new pond for your prized gold fish. You go to your bank which has a reputation of being a profitable and successful firm and the teller explains that you will have to come back in a few days to withdraw money from your account. The bank lent a bunch of money to Bill Gates and they expect him to replay tomorrow. Since it is very likely that Bill will pay back his loan on time, the bank is in a technical default. You might be angry and feel inconvenienced but you know the situation is temporary. You will get your money and soon your gold fish will be swimming in their new home.

But now let’s suppose a very different situation. In this case you go to your bank because you have heard rumors that it has been making loans to gun runners and other rough characters that have not been good about repaying. The bank has a reputation for corruption and mismanagement. Upon requesting your $1000 from this bank they tell you to come back mañana because they don’t have enough money today and are not sure when they will have it. There is a pretty good chance that they might never have your money. Your gold fish are in major trouble.

Greece is like the second case – a real default. There is a very real probability that private bondholders of Greek banks will not get paid in full. They lent money to the Greek Government but the Greek government is unable to repay despite raising taxes, reducing spending, and making plans to sell the Parthenon and Corfu. The recent EU solution appears to facilitate a Greek default.

The USA is like the first case – a technical default. If government revenues are not large enough for expenditures we borrow from the public. But because of current political issues in the US the government has hit its ceiling for borrowing and the government will not raise the debt ceiling. The revenues coming into the government each month are insufficient for the monthly expenditures but we cannot sell bonds to cover the difference because of temporary political issues. Clearly the US could borrow in credit markets and the US has enough wealth to cover our expenditures. So if the time comes in August when we cannot pay obligations because of the current politics EVERYONE on the planet knows it is a technical default – a temporary situation.

So why does all this matter? In a real default bondholders do not get paid and when they don’t there is a chain reaction of negative impacts that ensue. In the case of a Greek default we know there are many European and other foreign banks that have loaned money to Greek Banks. Thus there will be a global multiplier of lost repayments and negative financial impacts. Along with the impacts on financial institutions will come a wave of declines in bond and stock prices. So Ma and Pa Davidson’s extensive portfolio will be damaged and prevent them from purchasing much needed large bottles of Jack Daniels.   In the case of a technical default none of this has to happen. In a technical default US bond holders whose bonds have matured will be told that they will be paid later. They should believe this even if “later” is not perfectly spelled out. History is not a perfect predictor of the future – but all people need to do is look to the past to see that all US bondholders have been paid. It is true that a technical default could have some important negative financial and real impacts when people who expected to be paid by the government are told to wait for their payments. But it seems to me that this kind of impact, especially if the technical default is short in duration, would be quite small when compared to a true default a la Greece.

So what is the fuss about in the US? Some of it has to do with those so-called bond vigilantes. These are people with chaps and spurs who ride on horses in the Arizona desert and get bored yelling “ye doggie” so they harass profligate countries by selling their bonds and stocks. They sell the bonds and stocks BEFORE the actual default just like you might sell your tired old lawn mower to a perfect stranger who doesn’t know that you haven’t put oil in it since Stage 4 of Nixon’s Wage and Price Controls.  You get out while the getting is good! If too many of these bond vigilantes sell US bonds now, then prices of these bonds will plummet now and this makes a default more likely. It also makes us hate the vigilantes even though they are just following their hunches about assets. Notice people don’t seem to hate the governments that actually created the defaults. But government officials are experts at dodging bullets and pointing the finger of blame elsewhere.

Notice that if the vigilantes are wrong they do not do so well. In the example above they think they are applying the principle of selling at a high price so they can later buy at a low price. But what happens if they are wrong? Suppose the debt ceiling issue was just a matter of timing. Suppose the US government soon solves its political problem and increases the debt ceiling. Suppose they solve it in a way that people believe is real and durable and will lead to smaller future debts and deficits. In that case the price of bonds will go up as people’s faith is restored. In this case notice that the vigilantes will have sold at a low price only to later buy at a higher price. That is a good way to de-spur a vigilante. Notice – when governments do the right thing at times when many people are worried that they won’t – then this is not only good for the country but it robs vigilantes of their ability to profit. It seems to me that our government policymakers ought to keep this in mind. By doing the unexpected virtuous thing they get to have their cake (their own jobs) and eat it too (avert a financial and real crisis).