# Debt Default Is Only A Choice



## Michael Cornips (27 July 2011)

There obviously has been much discussion on whether or not the US will default on their debt. The most important thing to note is that there is no practical constraint to issue debt for any country that issues its own currency. If you personally are in the habit of issuing your own IOUs you will probably realize that you can not run out of your own ability to hand out those IOUs. Certainly people may eventually value your IOU less, but your ability to issue is never restricted. For the Government, it is only a political constraint and any damage done in not increasing the debt limit will be purely self inflicted. The concept of default can only be seen as you refusing to issue your own IOU. 

This brings up the question of how money is managed at a national level. I will attempt an explanation but you will need to appreciate that it is all about accounting and not economic theory. For countries like the US, UK and Australia the process is the same, but it is not for the Euro area since the member countries do not issue their own currencies. 

At the top of the banking pyramid is the Reserve Bank of Australia. In America it is the Federal Reserve. Every financial dollar circulates through the economy eg. from Government to Centrelink recipients to spending with businesses, into business bank accounts, netted back to the Reserve Bank and back to the Government to fund the original spending. A dollar created by Government cannot be destroyed or disappear until it is paid back by a taxation payment. A dollar created by bank lending creates a bank deposit that can't be destroyed until a bank debt is repaid. If you follow the money around it is all quite logical, and that combined with monetary conventions will give you a better understanding how the system really works. 

Australia has the Australian Office of Financial Management (AOFM) to manage its finances, dealing with the RBA and issuing debt into the market. The US has the Financial Management Service (www.fms.treas.gov) that operates with the Federal Reserve and markets on a similar basis. The great thing about the US is that they report Government revenue and expenditure on a daily basis, whereas in Australia reporting can be delayed for months at times. 

Below is a table that tries to highlight the main financial operating accounts in Australia. By convention only, the Government chooses not to simply run an overdraft on its RBA current account (it could and can). Rather than run an overdraft, the monetary convention (which is a throwback to the gold standard) is that the Government issues debt securities to the financial markets. In May 2011 the Government spent $29,542 million and receive taxes of $27,202 million, for a net spend of $2,321 million. The AOFM always runs a positive deposit balance with the RBA, issuing short term Treasury Notes, long term fixed interest bonds and indexed bonds, as needed to maintain a positive balance. Check the website: www.aofm.gov.au - you can see the debt on issue totals $193,242 million as of 22nd July 2011. The AOFM maintains a deposit account with the RBA that has a balance of $8,812 million. The RBA publishes its balance sheet weekly. Check out: www.rba.gov.au - Release A1. 






The Government is not debt constrained. It can spend first and in the process create the dollars required to balance its books. Let us look at an example (below) of the Government paying $10,000 million in Centrelink handouts. The AOFM simply withdraws the funds from its RBA account and electronically pays the funds into beneficiary's accounts. The AOFM, initially, overdraws their RBA account and creates a deposit in peoples' bank account. Whether that money is directly kept as savings with a bank, or it is spent with business, those funds must end up as a deposit in a bank account. At the end of the day when the banks balance their accounts the "banking system" must be in surplus by $10,000 million. If every bank is in surplus, the only borrower must be the RBA, otherwise interest rates would be forced to zero as the banks scramble to find a borrower. The RBA is happy to borrow the $10,000 million, since they must maintain their target interest rate policy and besides, they need to fund the earlier drawdown by the AOFM. Important Rule: Government spending creates its own savings. 

Rather than be hysterical at creating Government debt, why is the media not hysterical at the private savings it creates. We know for a fact that people are saving more (by definition they must) and that bank debt is not growing (another by product of saving) and retailing is suffering. 

How in this world can anyone think that the Government could ever be debt constrained. Government spending creates its own deposit. Monetary convention requires the AOFM's overdraft be turned into fixed term debt (ie going from variable rate to fixed rate debt). Anybody wishing to buy the Treasury Notes or Bonds will use their bank deposit to pay for the Government bond. Overall, net Government spending is captured as a bank deposit with the RBA or a Government bond owned by the private sector. Bank deposits and bonds represent private savings. Government net debt must equal net private savings. It is an accounting identity, not an economic theory. 

Get this - Government debt will soon exceed $200 Billion. That $200 Billion must be private savings. And what is the consequence of excessive savings? Ask the retailers - while the private sector lacks confidence it will continue to save, and the Government, as it doesn't collect tax, will continue to borrow. 

And that describes what Quantitative Easing (QE) was. The US Government wanted to get bond rates lower to encourage investment. QE simply purchased Government bonds and funded that with the bank deposits it created. Logically, if the Government pays you a $1 million cheque to buy your Government bond, you must deposit that into your bank account. And that finishes up as a bank deposit with the Federal Reserve which funds the bond purchase. Important note: QE did not create cash for banks to lend, it only lowered the cost of long term borrowing. 

Geithner and Bernanke get all this, but most politicians and some in the media don't. A debt default will be self-inflicted stupidity which by all logic has a nil chance of occurring. 

Michael Cornips


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## KurwaJegoMac (27 July 2011)

A well written post Michael, thank you for sharing.

As we both know, media has a vested interest in writing sensationalist articles and most of what it writes about the debt ceiling is utter drivel. 

For example, the US government has raised the debt ceiling every year (and sometimes a couple of times a year) for the past 50 years. This is nothing new. The question is not _if_ they will raise it, but _when_ they will raise it.

As you say, debt default is a choice (provided you are a country printing your own currency of course) and I don't think for a second that the US will default. If you have high unemployment, low growth and already fragile consumer sentiment would you scare the plebs by letting your country default?


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## Julia (27 July 2011)

Michael, that's a really useful post.  I'd suggest posting a copy into the Beginners' Forum.


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## wayneL (28 July 2011)

Dumb question:

Why do we need taxation then?


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## Aussiejeff (28 July 2011)

wayneL said:


> Dumb question:
> 
> Why do we need taxation then?




To prevent the hoi-poloi from cavorting in a sea of gummint-created cash?

I suppose those printing presses cost money to run, too.... 

LOL


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## Aussiejeff (28 July 2011)

KurwaJegoMac said:


> The question is not _if_ they will raise it, but _when_ they will raise it.




Maybe the question driving the US political dialogue atm is not _when_ they will raise it but _by how much_??

That BIG BOGEY debt clock the media keeps showing the public has to have some effect on overall sentiment?

aj


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## KurwaJegoMac (28 July 2011)

Aussiejeff said:


> Maybe the question driving the US political dialogue atm is not _when_ they will raise it but _by how much_??
> 
> That BIG BOGEY debt clock the media keeps showing the public has to have some effect on overall sentiment?
> 
> aj




I think they already have an idea as to how much to raise it by, the exact figure isn't important provided it's enough to tide them over for another year (at which point the process will be repeated again). What I believe they're trying to agree on is what route to take to tackle the new debt - i.e. raise taxes or reduce government spending.

The republicans are averse to raising taxes and the democrats are averse to cutting social programs. Until they come to some sort of agreement on how to generate additional funds then we're going to keep seeing this back-and-forth with one party blaming the other for refusing to co-operate.


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## KurwaJegoMac (28 July 2011)

wayneL said:


> Dumb question:
> 
> Why do we need taxation then?




To use money already in circulation for government spending because the alternative would be for the government to print money whenever it intends to spend. Without taxes it's more of a challenge to manage inflation. You're going to have to pump a huge amount of money into the system in order to cover government spending - imagine a bucket under a tap: is it easier to manage the amount of water in the bucket if the tap is on full blast or only 20% of the way open? 

How would you set an appropriate amount of money printing? Print money every time the governement wants to spend it? Rampant inflation would ensue, cash would devalue rapidly. Tax revenue increases with growth and is relatively stable, so the government must spend within their revenue range else they need to either print money and stoke inflation or increase taxes - both are situations that the public doesn't want and will result in that political party not being re-elected.

Although archaic, it does make the system 'relatively' stable.


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## James58209 (28 July 2011)

Gotta love the irony of this:


http://media.theage.com.au/business/businessday/mal-maiden-the-great-us-debt-contradiction-2518765.html

"Wall St is down but the price of US government bonds is up as nervous investors sell shares to buy... debt. Are they crazy? Malcolm Maiden explains."


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## Muschu (28 July 2011)

"Geithner and Bernanke get all this, but most politicians and some in the media don't. A debt default will be self-inflicted stupidity which by all logic has a nil chance of occurring."

Fascinating  post Michael and, like others, I thank you for it.  I am not an economist or  financial analyst and find these issues way beyond my experience.

I guess my question would be whether political obstinacy will throw logic out the window?

With thanks

Rick


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## skc (28 July 2011)

Muschu said:


> "Geithner and Bernanke get all this, but most politicians and some in the media don't. *A debt default will be self-inflicted stupidity which by all logic has a nil chance of occurring.*"
> 
> Fascinating  post Michael and, like others, I thank you for it.  I am not an economist or  financial analyst and find these issues way beyond my experience.
> 
> I guess my question would be whether political obstinacy will throw logic out the window?




Stupidity and politics are found in the same sentence way more often than we would like. The initial voting down of the TARP in 2008 caused a lot fo self-inflicted pain as well to the finaical systems...I think the chance of no deal is way higher than what the market is pricing/expecting.


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## Julia (29 July 2011)

skc said:


> Stupidity and politics are found in the same sentence way more often than we would like. The initial voting down of the TARP in 2008 caused a lot fo self-inflicted pain as well to the finaical systems...I think the chance of no deal is way higher than what the market is pricing/expecting.



I agree.  Or if some last minute deal occurs, it will be a temporary measure only, so hardly reassuring.


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## wayneL (29 July 2011)

So who is stocked up with baked beans and a Kalashnikov? :


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## KurwaJegoMac (29 July 2011)

wayneL said:


> So who is stocked up with baked beans and a Kalashnikov? :




Waaaayyyy ahead of you there:

https://www.aussiestockforums.com/forums/showthread.php?t=22344&p=640286#post640286


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## Julia (29 July 2011)

An extract from an article in Morningstar daily report:



> "At the margins, there will be an increasing trend among investors to diversify away from US government debt," Spooner says.
> 
> But if US debt has its rating cut, it may have little practical impact over the longer term because investors may have nowhere else to go, investors and analysts say.
> 
> That's because the eurozone countries face potential defaults among their own members. Australia's debt market is too small, China's yuan isn't freely traded and Japan government debt has almost no yield.



True enough, isn't it.  So strike out one impetus of urgency for agreement in Washington.


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