I keep getting questions from people, some from RA people about both the U.S. August 2 budget deadline and the European government euro bond crises so I figured I would post a synopsis here.  To do so I am going to coin the phrase "true-lie" to represent something somebody said that is "true" but in fact yields a misleading statement.  Since my guess is interest in the U.S. is what most really want to know about I will start here.  This is a very long post so you might want to read the questions and just read the answers to those you are interested in.

Q.  What is the debt ceiling and what exactly does it limit?

A.  In general governments promise to hand out more units of currency than they take in via taxes.  Not just now and not just the U.S.  This is standard government operating procedure. There are two ways that the government can then make the payment.  The most direct way is to print cash and send that along.  So, if the U.S. government said it would send you $20 it can just print it, mail it to you and call the debt settled.  A less direct way is to issue a bond, sell it for currency it previously printed and then mail you the cash.  Roughly, a bond says the government will send you $25 in five years if you will send in a $20 bill today.  If they owe you $20 they then take the $20 bill they just "bought back" with the bond, send the cash to you and call the debt settled.  Of course, in five years they are then obliged to send off $25 in cash to the bond's owner.  The treasury adds up the value of all the bonds it has issued and if the number exceeds the debt ceiling they are banned from issuing any more.

Q.  On August 2 if there is no agreement to raise the debt ceiling will the U.S. have to default?

A.  No.  In principle we can just print money.  That is instead of issuing new debt we can settle all obligations as they come due via the printing presses.  Federal reserve, which controls this process, is seemingly opposed to printing the cash.  Likely because they, correctly, believe it will lead to hyper-inflation.  Other countries have tried this little trick, and when you flood the market with your country's cash it reacts as you would imagine; the cash quickly becomes worthless as everybody is an instant millionaire but there are no more goods and services to buy than before.  We use money to ration goods and services amongst us.  Too much money in the system and the rationing device fails.  When this happens the economy can collapse back to what essentially a barter economy as people reasonably come to view "money" as nothing more than paper with ugly pictures on it.

Q.  I have heard government officials and pundits say that if an agreement is not reached in time the U.S. will no longer be able to guarantee it will pay off on its bonds.  If printing money is out, then do we have to default? 

A.  The answer you are getting from the government officials and pundits is one of those true-lies.  Once we hit the debt ceiling somebody may come up with a way to avoid paying the bond holders but even that is not clear.  The constitution seems to imply that the federal government is obliged to see to it that bond holders get paid.  I am not a lawyer but as a normal reader I would take it to mean that if all else fails the government has to print the money if necessary.  But, who knows.  In any event, even without turning on the printing presses we take in more tax money than we owe on the bonds.  The government can therefore easily pay the bondholders.  It does not have to default.  But perhaps it could.

Q.  The president said he could not guarantee social security checks would go out if no agreement is reached in time.  Is that true?

A.  Another true-lie.  Assuming the government does not turn on the high speed printing presses it cannot send out all the checks it has promised to send after August 2 or sometime around then.  Indeed that means somebody will not get a check they think they are owed.  It could be a social security check.  But, it does not have to be a social security check.  From my understanding of how the government would have to function, with insufficient funds, the executive branch would pick who does and does not get their money in part or full.  Thus, the president, if he wanted to, could guarantee that social security checks would be safe after August 2.  What he cannot do is guarantee all those expecting checks from the government will get their checks in part or full.  Somebody has to get less than the government promised them.

Q.  How bad is the shortfall?

A.  Pretty bad!  A quick calculation on my part indicates that for every dollar the government is currently promising to send out it gets in about 70 cents in tax payments.  That includes all tax payments from income taxes, to FICA, to tariffs.  If entitlements are inviolate, then you are talking about closing down a very large fraction of the rest of the government.

Q.  Just issuing bonds has worked fine so far why not just keep doing it?

A.  This is good question and will lead us into Europe as well.  In the old days when the U.S. government issued a bond it was typically held by a U.S. citizen.  Basically, that meant future U.S. citizens became committed to send payments to other U.S. citizens when the bonds were cashed.  We essentially owed the money to ourselves.  That is good.  When that is all that is going on, the U.S. government can levy an tax on bond income to pay for the bonds that come due.  Roughly, it turns into nothing but a game of bait and switch.  The government sells you a bond, and then when it comes due taxes the proceeds to pay you off with!  Yes, those were the good old days.  Today things are different.  An ever larger fraction of our debt is held by people in other countries.  That is very different.  Basically, they sent us goods and services and we sent them a bond.  A good trade at the time.  We got a TV they got a piece of paper!  But eventually, they will want something real back for that TV.  When that day comes they will insist that the US send them goods and services in exchange for that bond.  Worse, they sent us $20 worth of goods and services and according to the bond we will send them $25 worth someday.  When people talk about bankrupting future generations this is what they mean.  (Well typically they have no idea what they are talking about but if they did this is what it would mean.)  Today we have promised that future generations will send a large fraction of their output to other countries in exchange for getting back all that paper we have sent out so far.  Think of it this way.  If you owe your spouse $10 or $1,000,000 it really makes no difference.  Your family is no richer or poorer.  But if you buy a car, get a loan from the bank, and sign your kid's name to the note your kid is now poorer.  Your offspring will now need to devote part of his future income to pay off the bank note you had issued in exchange for the car.  Your purchase, in this example, means your child has to reduce his consumption.  Instead of buying steak he buys hamburger and sends the $5 he saved to the bank. This is what we are doing.  We send Japan bonds (loans from the US).  They send us cars.  In the future, US citizens will then have to pay off the notes by sending some of the consumption goods they produce to Japan.

Q.  Greece is a government, it has a lot of debt, they can print money to pay it why not do that.

A.  Actually, they cannot print money.  To join the Euro they gave up that right.  In this way Greece is more like a U.S. state than a sovereign nation.  Illinois may be on the verge of going bankrupt but they cannot print money to fix their problems.

Q.  So what is Greece's problem?  Why is it having so much trouble with its debt?

A.  This is what happens when people outside your tax authority own your debt.  If the Greeks just owed the money to other Greeks there likely would not be a problem, other than perhaps low per capita GPD from the tax rates needed to balance things out.  But, default would not be the issue.  Greece's problem is that they wanted goods and services but did not produce enough of their own to trade at the time.  So they issued bonds, sent them off to Germany and got cars back.  The bond holders are now returning to Greece and demanding real goods and services in exchange for those bonds.  For the government to deliver them it will have to tax Greeks at levels far beyond what they are apparently willing to put up with.  That is, today's Greek workers need to produce things, send them off to foreign countries and accept back pieces of paper their government previously issued.  This will necessarily require a huge cut in Greek per capita consumption levels.  My guess is that this will happen anyway.  Default by Greece seems inevitable.  When it happens they will be cut off from international credit markets.  At that point they will only be able to consume a euro of foreign goods and services in exchange for sending off a euro's worth of Greek production.  Without a credit line, the Greek per capita consumption will be forced to match Greek per capita production, and that will mean a large cut in their standard of living.

Q.  What is this contagion people are worried about if Greece defaults?

A.  They are worried that once Greece defaults interest rates for debt issued by Ireland, Spain, Portugal, and now Italy will go way up.  That will accelerate each country's path towards its own default since each have Greek like debt problems.  Think of it this way, you owe the bank $10,000 and currently pay 6% interest on the loan.  However, the note says that if your neighbor goes bust your interest rate will go up to 10%.  If you were on the verge of financial collapse before this will likely put you over right now.  Of course, you might have gone bust anyway but this is not going to help.

Q.  What about US states how serious are their financial problems?

A.  Very.  Like eurozone countries states cannot print money.  They also have limited taxing authority since people can "run away" by moving to another state.  Many states, a majority, have vastly underfunded pensions and health care liabilities.  The taxes that would be needed to fix this are far higher than we have every seen.  It is not unreasonable to expect many if not most states to break their promises with regard to both pensions and health care and in the process for many to default in some way on their bonds.  The best estimates of the seriousness of all this can be found in a series of papers by Joshua Rauh (Kellogg School of Management at Northwestern) and Robert Novy-Marx (Rochester School of Management).  Just do a search on them and you will find quite a bit of material.  For those that just want the bottom line, the year of reckoning on a state-by-state basis can be found at http://kelloggfinance.wordpress.com/2010/03/22/the-day-of-reckoning-for-state-pension-plans/.  My state of Connecticut is in the second group to go bust:  2018!  Go Nutmeg State! 

Magnificent information! twocat! Thanks for taking the time to enlighten us over such a crucial topic!

Yes to some of us will take a third reading through this to understand the magnitude of the significance of your wisdom shared with us here.

You are a very good writer and eloquent teach! Thank you so very much for taking the time to put this thread together, with your busy schedule and all.

Posie

Hey, WA state's day of reckoning is 2028. Doing good!!! I hope to retire by then!