More on U.S. Sovereign Default Risk
This set of links contributes to the ongoing discussion of one of the issues my colleagues and I at Moody's wrestled with in the years we spent analyzing government debt default risk. When I retired, the question was still on the back burner, but now it's jumped to top of mind: Could U.S. Treasury bonds, the world's most desired "safe asset," actually default at some point in the not-so-distant future, or, alternatively, could bond holders suffer huge real losses from a burst of inflation engineered by a monetary authority that has lost its independence?
1) To evaluate that risk, we can start by examining possible fiscal futures, as Harvard's Greg Mankiw does in the 2025 Martin Feldstein lecture, delivered at Harvard on July 10. After some brief remarks about his relationship with Feldstein, he identifies the key issue, intergenerational income transfer:
Courses in macroeconomics examine how government debt affects interest rates, capital accumulation, trade deficits, and so on. But the starting point for all that analysis is a transfer of income between generations. In their personal capacity, parents cannot choose to live beyond their means and leave negative bequests to their children. As voters and citizens, however, parents can do exactly that, and Americans are now doing so in a big way.
He then proceeds to evaluate the relative likelihoods of five ways in which the forecasted rise of the debt/GDP ratio could be stopped:
(1) extraordinary economic growth, (2) government default, (3) large-scale money creation, (4) substantial cuts in government spending, and (5) large tax increases.
In my opinion, (1) is highly unlikely and (4) and (5) will be very difficult to implement in our fractured political system with its many veto points. That leaves default and/or heightened inflation as the situation those alive three to four decades from now -- or maybe even sooner -- will face. Mankiw, as readers of this transcript will see, is much more optimistic about the U.S. eventually raising taxes, possibly by means of a VAT. He might be right, but that would only exacerbate the transfer from young to old already built into the system. Far better, as Larry Kotlikoff and others have advised, to completely redesign our entitlement programs for seniors.
https://acrobat.adobe.com/id/urn:aaid:sc:VA6C2:910d107d-4b66-4724-b192-0ab67b228c74
2) Some observers are still in denial about the debt buildup. Jack Salmon references an op-ed in The Hill:
arguing that America’s ballooning national debt is not a problem and asserting that default is impossible, interest rates are policy-driven, and foreign lending is irrelevant. Though superficially reassuring, this perspective dangerously underestimates the real economic costs of fiscal irresponsibility and risks misleading the public into complacency.
He skillfully debunks each reason for believing we don't really have a problem or for hoping it just goes away by itself.
3) James Capretta examines what he calls "The primary cause of fiscal stress:"
The combination of fewer workers, longer lives for retirees, and high inflation in the health sector has placed immense stress on the Social Security and Medicare Hospital Insurance (HI) trust funds, which are financed on a pay-as-you-go basis.
https://www.aei.org/health-care/revisiting-the-primary-cause-of-fiscal-stress/
4) In the first installment of a two-part essay on Social Security, Andrew Biggs explains that the demographic transition is a necessary, but not sufficient, cause of the program's fiscal distress. The 1977 decision to index Social Security benefits to wage growth greatly magnified their growth.
and then, responding to the frequent suggestion that the problem could be solved by raising the income cap on FICA taxes, he shows that,
... the idea that Social Security’s funding has been undermined by letting the rich off the hook for their obligations has a remarkably weak basis in fact. Two factors that have nothing to do with income inequality – a tax law-induced shift in how income is reported and the rising cost of employer healthcare premiums (and their exclusion from the taxable base) – likely account for most of the decline in the share of earnings subject to Social Security taxes.
