At the end of July, 2023, the financial rating agency Fitch announced that it was downgrading the sovereign debt of the United States.
 
The stock market tumbled. The bond market tumbled. Talking heads talked.
 
But what does the downgrade really mean?
 
“Sovereign Debt Cannot Default”
In the aftermath of the Fitch announcement, many pundits solemnly intoned their opinion that “the United States will never default on its debt” or something similar.
 
Is this claim true?
 
That depends to some extent on how you interpret the claim. In this email, we will examine three types of default. We will see that it is indeed unlikely that the United States will default in two of the senses. In the third sense, we will see that not only is it likely that that US will default, it’s almost guaranteed. We’ll also see that the United States federal government has, in the past, defaulted on its sovereign debt.
 
Sovereign Debt
Sovereign debt is debt issued by a so-called sovereign entity. Originally, this was a king, and technically in kingdoms like the United Kingdom, government borrowing is borrowing by “the crown,” meaning the king.
 
We don’t have to look deeply into history to find many, and repeated, examples of sovereigns defaulting. For example, Fitch reports 14 separate sovereign defaults since 2020! Among those defaulting have been Ukraine, Argentina and Ecuador. So, the mere fact that the US federal debt is sovereign debt certainly does not tell us that it cannot default.
 
Three Types of Default
What does it mean for a bond to default? In general, the term default means failing to meet a stated obligation. In the context of most non-sovereign bonds, there are two general types of default: money defaults, and non-money defaults.
 
Money Defaults
When most talking heads talk about the US government defaulting on its bonds, they are implicitly referring to a money default. A money default occurs when the obligor (e.g. the US Treasury) fails to make a scheduled payment in full and on time.
 
Money defaults can occur for two basic reasons: inability to pay, or unwillingness to pay.
 
In some contexts, a borrower has the ability to pay, but chooses instead to default. Usually, such a voluntary money default would part of a negotiating strategy, or a strategy to position oneself for bankruptcy.
 
Bankruptcy is the legal process for adjudicating the various conflicting claims on a borrower who cannot pay all the claims in full.
 
For the legal bankruptcy process to work, however, all the parties must submit to the jurisdiction of the court. In the case of private bankruptcies within a single country, this is usually not an issue.
 
However, there is no well established or accepted such process for nations or sovereigns that cannot meet their obligations.
 
As messy, costly and inefficient as the bankruptcy process is, the process, and the associated law, gives at least some idea to the various parties regarding what can be expected if the borrower does default.
 
But an orderly, or semi-orderly, restructuring of the US federal obligations through the bankruptcy process is not a possible outcome.
 
While it might make sense for the US government to voluntarily admit that it has more debt than it can service over the long run, and take appropriate steps, that seems unlikely to happen in the foreseeable future. In other words, voluntary money default seems extremely improbable.
 
Non-Money Default
In most private debt and non-sovereign (e.g. state and local) debt, there is a contract between the borrower and lender. Those contracts, or bond indentures, may contain clauses, called covenants, that require the borrower to meet certain tests from time to time. For example, a corporate borrower may be restricted from allowing total debt to exceed a certain percentage of revenue, or assets, or something like that.
 
When such covenants exist, and a borrower violates a covenant, the borrower can be in default even if the borrower never misses a payment.
 
Such covenants, however, do not apply to US federal debt.
 
Fiat, or Inflation, Default
For borrowers like the US government, and select other governments around the world that borrow mostly in the currency that it can print, including the Japanese, Chinese, and UK governments, there is a third option. We’ll call it Fiat Default.
 
The US government can print dollars. It can, therefore, simply create, out of thin air, essentially any quantity of dollars that it decides to.
 
This ability to print money means that it is unlikely that the US will ever (at least in the foreseeable future) face a situation in which it is unable to meet its obligations to pay interest or principal on the debt.
 
However, that same ability virtually guarantees that such debt will be paid with dollars that are worth less than before. This process of repayment with worth-less dollars is not recognized by most economists as default, though it is hard to classify it as anything else.
 
Inflation Since 2020
Official US government statistics show that cumulative inflation since 2020 has amounted to about 20%. In other words, what cost a dollar in 2020 would now cost about $1.20.
 
So someone who lent the US government $1000 in 2020, and gets that $1000 back now, actually receives money worth only about $833. Yes, they got interest, but that interest was supposed to compensate them for not having the use of the money. And, the interest rate in 2020 was close to zero anyway.
 
If you lend me $1000, and I pay you back only $833, you would be entirely justified in believing that I had defaulted.
 
But that inflation-default is standard operating procedure for the US government. And it has been so ever since 1933. In that year, the government explicitly defaulted by reneging on its commitment to repay loans in gold. Before 1933, the dollar was defined as a certain weight (1/20.67 troy ounces) of gold.
 
The government knowingly and intentionally defaulted on that promise. And since then, the US government has consistently spent more than it takes in from all forms of revenue, making up the difference by borrowing and printing money.
 
That intentional policy of fiat money finance is why we have inflation.
 
Future of Inflation
We believe that in the short to medium term, we have seen the highs for inflation. We believe a recession is likely, and that the government will respond to such a recession with yet more money printing, which, we expect, will cause inflation to revive and return, possibly at even higher levels than were seen in the past two years.
 
We are experts on inflation. To learn more, please call us at 703 437 9720 and ask for Connor or Katherine. Or click here to enter a drawing for a copy of our book on inflation, Politicians Spend, We Pay.