The Bag

There’s quite a bit of economic turmoil these days. It’s not clear what’s going on. Neil Cavuto says that “the world has no money and right now the emperor has no clothes”. I don’t think things are quite that bad, but I would like to give you my take on The Mysterious Future.

Consumption and Production

Let me begin by pointing out that it’s sort of strange that government deficits are a problem at all. In a macroeconomic sense, everything that’s consumed is produced. This makes talk of “unsustainable deficits” a little hard to puzzle out: the world is producing X, and the world is consuming X, so what’s the problem? Aren’t we really just talking about accounting?

Well, no. What we’re looking at is an unsustainable distribution of consumption.


A government runs a deficit when it pays out more than it takes in. If it pays out P in payments and takes in R in revenues, it will run a deficit D equal to (P – R). Rather than think of P, R, and D as sums of money, I want to suggest that we think of them as quantities of stuff. People and firms work to produce food, software, gauze, Porsches, and cellphones, and then the government takes some of them (roughly speaking: R) and gives them to other people and firms as either transfer payments, or compensation for other goods and services (roughly speaking: P).

Once we start thinking in terms of concrete stuff, we can (I think) ask slightly more concrete questions about how deficits work. How can a government that only takes in R stuff pay out P stuff? It can’t just create it, as it does fiat money, so it must be borrowing the difference D in some way.


Governments borrow by selling bonds, with which they trade a promise of (more) stuff tomorrow in exchange for (actual) stuff today. They use the actual stuff to make up the difference between P and R. This can go on indefinitely; in fact, it’s not even a problem so long as the government can make good on its promises. In a magical, unicorn-filled world in which country A’s output doubled every year, thereby doubling government A’s tax revenue every year, government A could run 20% deficits forever, because its promises of repayment would always be credible.


Deficit regimes collapse when lenders come to believe that a government’s promises are incredible. They might believe that the government will flatly refuse to pay them what it has promised, or they might believe that it will cheat them out of the promised stuff by inflating its currency. In either case, they will refuse to lend. (Note that this belief may or may not be triggered by an actual default.) When people speak of “unsustainable deficits”, what they are really discussing are “soon-to-be incredible promises”.


Once a country’s promises of repayment become non-credible, it can’t borrow any more stuff. At that point, the gap between P and R must slam shut; in practice, P must collapse, since it takes a long time (relatively speaking) to increase R, whereas lenders can turn off their flow of stuff overnight.

Therefore, when a government can no longer run a deficit, the primary effect is that consumption patterns shift; the people who used to get payments from the government now get less stuff, and the people who used to lend to the government now have more stuff. There’s roughly the same amount of stuff being produced and consumed, but it’s distributed quite a bit differently.


All this might seem like not such a big deal, and I would argue that, so far, it isn’t. More serious problem crop up once you start considering default. For the purposes of this discussion, I argue that there are two kinds of default: explicit, and implicit.

Explicit default is associated with explicit borrowing — i.e., bond sales. Default, strictly defined, occurs when a government refuses to pay the face value of its bonds or coupons on time. (I would argue that when a government devalues its currency to avoid making good on the stuff it promised to deliver, a subtler form of default has occurred.) After a default the lenders are worse off than they expected to be when they made the loan; some of their (paper) wealth has been destroyed. This still isn’t such a big deal; investors know that they can lose their money. They’re big boys.

I believe that implicit default is where the real action is. In a democracy (really: in any state) people put up with taxes because they believe the services provided by government justify its costs. High taxes are justified by services provided today, and by the promises of services to be provided tomorrow. In this sense, the taxes in a welfare state are really a kind of government borrowing (except that these “lenders” have no standing to demand repayment) and the collapse in government payments associated with the holdholder-driven end of deficit financing a kind of default. The end of deficit spending leaves the taxpayers worse off than they expected to be.

(Quick note: Even if you close the gap between P and R by increasing R, you’re still in implicit default: You’re providing the stuff you promised, but only by taking more stuff away first. The “lenders” are still much worse off than they expected to be.)


I believe that the consequences of implicit default will be much more severe than those of explicit default, because implicit defaults can be much larger, and because the “lenders” are unprepared for the losses and have not been allowed to diversify away from the “bad debt”.

Governments can run up massive implicit debts because it’s easy to promise people stuff. One would expect that implicit debt would outstrip explicit debt, and, in the U.S., that certainly seems to be the case. Total U.S. debt to the public (i.e., non-intra-governmental debt) is about $12.5 trillion dollars. The unfunded Social Security/Medicare liability is about $107 trillion dollars – let’s call it 10 times larger.

Unlike investors, taxpayers tend to assume that they’ll continue to receive the government services and transfers they’ve been getting, and that they’ve been promised. Even if they don’t believe this, they don’t have much option but to act as if they did; they can’t “opt out” of the welfare state and invest their tax money elsewhere.

Implicit defaults can take a massive toll (relative to expectations) on large populations that are totally unprepared for those losses. Furthermore, these losses cannot be recovered; they do not represent stuff that was taken away, but stuff that was promised but never produced. The trigger for these losses is the moment when explicit lenders find a welfare state’s promises of repayment non-credible.

Holding The Bag

Do you want to know who will be left holding the bag when (and if) the modern welfare state’s deficit regime collapses? If you live in a welfare state: It’s you, baby!

If you don’t want to be left holding the bag, don’t agree to pay taxes based upon incredible promises.

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