Monday, June 21, 2010

credit risk on treasury securities

I've heard for 20 years that US debt carries no credit risk because the government can just print dollars if it ever gets into trouble. This, on a large scale, would be expected to create massive inflation, reducing the real value of debt denominated in nominal dollars in addition to the direct effect of using printed dollars to pay whatever debt is coming due. The whole set of phenomena goes under the term "monetizing the national debt", and its possibility is part of the reason Treasury securities are considered "risk-free".

Of course, if you're owed $1 and are being repaid with $1 that buys what you expected 10¢ to buy you, you might well object to the notion that you faced no "risk". Indeed, you're in the same practical situation as if the Treasury had defaulted and declared that it would only pay 10¢ on the dollar to holders of its debt. In a technical sense the former is not "default", while the latter is, and the former possibility is not subsumed under the concept of "credit risk", while the latter is. (It's worth noting that, in the former event, dollar-denominated bonds issued by, e.g., GE would be paying 10¢ on the dollar in purchasing value as well, even with no complicity from GE; this is a logical reason to keep the concepts separate.)

Massive inflation would wreak a great deal of havoc on the economy, of course; the textbook purposes of "money" are to serve as a medium of exchange, a unit of account, and a store of value, but once its value becomes unreliable it becomes less useful as a unit of account and even its ability to serve as a medium of exchange is crippled, as people become more and more reluctant to hold it and tend to buy things less because they want them and more because they're available when one finds oneself in possession of cash. Hyperinflationary environments see a move toward barter, with the "double coincidence of wants" problem that money is supposed to solve, and make intermediation between savings and investment much more difficult, screwing up capital allocation.

Technical default, of course, would scare off future lenders, but so would inflationary "default"; indeed, if it affects lenders (and potential lenders' expectations of their subsequent treatment) in exactly the same way, it should scare them off to exactly the same extent, at least to first order. At higher orders, the fact that inflation destroys the tax base in ways that default does not — and this tax base underlies any value that lenders can actually be paid back — suggests that lenders should be more averse to the inflationary scenario than the default scenario.

If I were at the Treasury, and were abruptly confronted with the choice of monetizing a large chunk of debt or defaulting on it, I would prefer to default. If we're locking the government out of the capital markets, we might as well not take the whole economy down, too. If bond markets were rational, they would respond to this news by lowering (slightly) the interest rate the the government pays on its debts. I'm not entirely sure, though, that they are.

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