Bankruptcy and Beyond, Federal Style

The federal government of the United States is bankrupt. Only the irrational willingness of investors to lend money by buying federal bonds and treasury notes is preventing the recognition of bankruptcy.

So, bankruptcy will happen, even if they try to call it by another name. In a bankruptcy creditors do not get paid in full. But even in a normal corporate bankruptcy there is a struggle about who gets shafted the worst. In the federal case there will be many options. Most likely the federal government will muddle on, in a greatly weakened form. Sadly, the negative effects on people will spiral outward far beyond those most at risk, long-term federal bond holders.

While there are many historical precedents for the bankruptcy of nations, including the recent Greek writedown of public debt, the closest historical example was the situation in the British Empire after World War II.

The British Empire was the largest, most brutal empire in the history of the world. Over a half billion people and a quarter of the world's landmass suffered under the British jackboot by the outbreak of World War I in 1914. The British in their home island were filthy rich from centuries of looting. They had a powerfor military and a large industrial establishment. Even the working classes in England enjoyed a high standard of living. But the cost of two World Wars, largely financed by loans from the United States, left the Brits in a fix in 1946.

The Empire was in revolt, and Britain could not afford to keep it in chains. The American Empire, which governed through puppets and business relationships, muscled in on the British colonies. Food and other necessities were rationed in Britain until 1950. While the British economy (in Britain itself, not the Empire as a whole) recovered slowly during the 1950s and 1960s, Britain has never been able to regain its global dominance.

The United States is the only major industrialized nation that did not have its factories maimed by bombing in World War II. This led to the Golden Age of the American economy, which lasted roughly from 1940 until the 1973 oil crisis. Americans of all classes grew lazy and (both literally and figuratively) fat.

During most years since World War II the U.S. national debt has grown. In other words, despite the prosperity up until 1973, the federal government spent more money than it collected in taxes. According to Keynesian economic theory, this was not a problem, as long as the growth in debt did not greatly outpace the growth in economic output.

But the growth in debt has greatly outpaced the growth in economic output. As I write the national debt is approaching $17.0 trillion. A trillion dollars is a thousand billion dollars. A billion dollars is a thousand million dollars.

Nothing to worry about, according to (mostly Democratic Party) politicians. Why that is only $53,500 per citizen. [But it is twice that per person in the work force, and the median wealth of people in the work force is near zero] Why, once we get the economy revved up again (despite the efforts of the Republican Party), we will reduce the annual federal budget deficit to a tolerable level. Anyway, it's just money we owe ourselves, right?

A U.S. bond is a promise to pay interest and principle on a given date. If the government does not pay, it is admitting to bankruptcy. The interest rate on the debt is set in auctions. Since 2008 interest paid on bonds and bills has been very low compared to historic levels. On federal securities issued for under 2 years, the interest paid is near zero. If interest rates go up the interest on the debt will put the U.S. in a death spiral.

U.S. federal spending is running at an annual rate of about $3.5 trillion. Interest on the debt is currently running at only a quarter of a trillion dollars. If the overall interest on the current debt increased to 5% per year, (not a record) the interest would be $0.85 trillion per year. The current run rate of the federal deficit is about $0.8 trillion per year, though that is trending down as the economy improves. A fair guess is that the national debt would continue to expand at about a trillion a year.

Aside from a magically booming economy that somehow did not coincide with high interest rates, the only way to even put a cap on the debt would be to raise taxes substantially or cut spending substantially, or some combination of both. Politicians talk about that, but they always put actually doing it three to five years in the future.

In reality we are not going to see any further major tax increases or spending reductions. The higher interest rates will be financed by issuing even more debt.

The music will continue until enough investors refuse to get stuck holding federal debt.

The other practical solution to the problem is engineering a high rate of inflation. While that would make new debt expensive to issue (high interest rates) it would allow increased tax collections to (perhaps) balance the deficit and even pay off the old debt. It probably would not work, however, because Social Security payments are indexed to inflation.

No one knows when, but the end of debt expansion will cause an economic crash. No one knows how bad of a crash, but probably at least as bad as the one in 2008. Which of course makes it even harder to pay the national debt. The government will have to either repudiate the national debt or dissolve itself. My guess is it will repudiate the debt. It will continue to collect taxes, and it will continue to spend money to keep people (particularly rich people) from rioting too much, but bond holders will be left with paper of dubious value. There will be promises that payments will resume, some day. Some day will never come. The only alternative would be crushing tax hikes. Even crushing the rich with a 90% tax on millionaires would not do the trick.

For the majority of American citizens who have no economic or political power the best thing to do is to get as economically prepared as possible. Pay off your debts and keep them paid off. Be very careful where you keep your savings (I don't believe gold or silver will hold value during a meltdown, but that is another whole essay). Strengthen your private infrastructure, and keep on good terms with your community. People survived the Great Depression, and you can survive what is coming, if you are prepared.

Like Britain without the British Empire, America will somehow muddle through the transition. We may have to sell Alaska to the Chinese to pay our debt to them. We may have to give promissory notes to Yosemite and Yellowstone and some Aircraft Carriers to American bond holders to keep them calm until they realize there is nothing they can do put accept whatever scraps the politicians throw them. But we will still grow food and make things and engage in commerce. Eventually, when enough politicians have been hanged ... out to dry ... things will pick up again, with a smaller, more efficient federal government and a vastly lowered set of economic expectations.

Unless people really freak out and start shooting at each other. Then all bets are off.