A few days ago, the rating agency Standard & Poor’s changed its rating of US government bonds from the usual (highest possible) AAA to a similar one, but with a “negative outlook warning”. This caused havoc around the blogosphere and in policy circles. Some claimed that this was an untimely private, and politically motivated, action serving to undermine public spending programmes in the US. In any case, the market didn’t take much notice, as the interest on government bonds moved little. “Poor Standards” as Paul Krugman called it. He may be right. After all, S&P did funny ratings in the past (remember house-backed securities pre 2007?). And, by the way, it is not the first time, they have raised concerns about the continued AAA quality of US debt. I have no opinion about whether the warning is warranted according to objective criteria, but a government whose debt is around the size of GDP should in most books be worth a check.
What triggered me to write on this is therefore not the rating per se. Instead it is the fact that some has questioned the rating by the argument that the US cannot go bankrupt. For example, James Galbraith is quoted by Dave Lindorff to have said:
“US debt consists of bonds issued in US dollars, which I assume the S&P analysts know. How can the US possibly default on its own currency? The obligation is in nominal dollars, which is to say when the bond retires, the US issues a check in dollars to cover it. Since the US prints its own currency (or actually just issues electronic payments to create new money) whenever it needs it . . . they will have the money to back their own bonds”
This is not necessarily correct. On every market there is a supply and a demand side. What Galbraith is forgetting is that people may not want to hold the money that the US prints. It has been well known since Cagan’s seminal paper “The Monetary Dynamics of Hyperinflation” from 1956 that there may be limits to how many resources a government can extract through the money press. Technically, financing debts and deficits by money creation is called seigniorage or using the “inflation tax”. And any tax revenue consists of a tax rate multiplied by a tax base. With monetary finance, the tax is the inflation rate, and the tax base is the real money stock held by the private sector (a liability of the government that is eroded in value by inflation; hence, it is “taxed”).
Now consider the thought experiment, as Galbraith does, that deficits and debt are so high that the US must rely on monetary finance to prevent default. By increasing the tax rate on currency (through the printing press), it will indeed for low to moderate rates of inflation be able to generate revenue. However, at higher inflation rates, the nominal interest rate will be higher, and people will want to hold less money (why stick on to something that gives you nothing in return when alternative opportunities get better and better?). In effect, the tax base is being deteriorated. The revenue from printing money at a faster pace may then go down as the increased tax rate (inflation) reduces the tax base (real money holdings in the private sector) sufficiently. Such a “Laffer-curve relationship” in monetary economics is well known, and probably much more well documented throughout history than the more conventional Laffer curve. It means in plain words that there may exist an upper bound on how much revenue a government can extract from money creation.
This is just a too important fact to be overlooked: A country can go bankrupt, even if it has monopoly power over money issuance. Inflation is not just an unpleasant side effect of inflationary financing, it is a phenomenon that may make an attempt to pay back public debt by printing money entirely futile. So yes, the US can go bankrupt. I don’t see it right around the corner, and definitely not because S&P decides to poke a bit to the AAA rating. But don’t think, please don’t think, that the printing press is always a certain, albeit bumpy, road out of fiscal trouble.