In this post, I am going to be as straight-forward as I can. The US won't be able to pay back its national debt only by cutting spending or raising taxes, so something else is likely to be needed. Right now, the US is on the brink of losing its credit rating, and would probably already have done so had it not been for the fact that if it did, major financial havoc would break out (like in september 2008). If a smaller country had acted the way the US has, it would have lost its credit rating long time ago. And why is credit rating important? Because the interest on the national debt is tied to it.
In another post, I explained why tax hikes are better than deficit spending, and in this post, I'll explain what more has to be done.
Here are some options that I have thought of lately - not a complete list obviously, but definitely points for discussion.
1) Debt-for-Equity swap
What it means: The federal government gives away federal assets to creditors as a way to pay back debt. This would certainly mean some kind of "forced privatization". It could be shares (if it's a government-owned company which becomes private), or pure assets. If the government finds some assets it really doesn't need, but which may be useful for someone in the private sector (the IRS skyscraper comes to mind), this could certainly be an option.
Why? The US government will be forced to shrink, which most people here would agree isn't a bad thing. It would pay back some debt for sure, and typically the private sector is more efficient than the government, so growth may go up as well.
Why not? Do we really know which assets the government is going to need in the future? Once privatized, it's very hard to take something back. It's a very permanent decision. Also, since the US owes a lot of money to China, it's hard to imagine not selling anything to them. Do we want more Chinese, or foreign overall, influence on the US market? Can they be trusted?
2) Annuities-for-perpetuities swap
What it means: Most bonds are typically annual bonds, meaning they pay you a certain amount of money each year for a specific set of years, and then at the end of this period you get an amount of money, typically equal to what you bought the bond for. So if you bought a bond for 100 dollars, it may pay you 4 dollars next year, 4 dollars the year after that, and then 104 dollars the next year - that would be a three-year bond. A five year bond would pay you 4 dollars for five years and then the fifth year you'd get the initial 100 dollars invested back.
The numbers of course are made up and the whole thing simplified, but that's pretty much how annual bonds work.
But then there's perpetual bonds, or perpetuities for short. Perpetuities work like this: You give the government 100 dollars today, and they promise to pay you a certain amount of money every year FOREVER.
Does that sound like a bad deal? With an annuity, the government would only have to pay you back four dollars per year for three years, and then give you back your initial 100 dollars after three years. With a perpetuity, the government is indebted forever.
It's not as bad as it sounds. With a perpetuity, government gets smoother payments - instead of having to pay back a lump sum after 3, 5 or 10 years, it simply pays a very small amount every year. Let's say the US sold bonds for 1 trillion dollars this year, and they are all 10-year bonds: That means that in the year 2021, the government will have to find 1 trillion dollars to pay back those who bought bonds 10 years ago. Those 10-year bonds would be, as we say, maturing in the year 2021 and that's when the US would have to pay a lump sum. With a perpetual bond, there is no lump sum, just a relatively small payment every year forever.
And, you would have to pay less per year too. It would be too complicated to dig deep into bond valuation, but let's just say it's tempting to pay a lump sum now and then receive money from the government for the rest of your life. So, to convince someone who right now holds a 10-year bond to swap it for a perpetual bond wouldn't be so hard. Would it?
Why? The US would be able to smooth out the annual payments to its creditors. The US has issued a lot of bonds during the past recession, and while most of those bonds are long-term, meaning the US won't have to pay back any lump sums anytime soon, it would certainly be better to have a smoother payment every year, because taxes could then also be stable (the way things are, the US may have to raise taxes a lot certain years to pay back bondholders whos bonds have matured, or take new loans).
Why not? A standard perpetual bond would break any hope of the US every becoming debt-free, and they are also very hard to sell. While technically a perpetual bond paying 2 dollars per year may be just as much worth as an annual bond paying 3 dollars per year and then a lump sum after ten years or so, investors are used to annual bonds. That is the one issue which my Finance lecturer brought up when I discussed the matter with him today. However, we both agreed that if the alternative was default, then investors would certainly pick perpetuities (since if the US were to default, they would end up with nothing).
A perpetual bond should preferably be callable, which means that the US government has the right to buy it back in the future. This would mean paying a higher interest rate on the bond itself, but the knowledge that you can buy it back at some point and make yourself free of debt is probably worth more.
In addition to that, a perpetual bond which is inflation-indexed - meaning it yields the inflation rate + a certain return (so if inflation is 5 %, the bond would yield 5.5 %, if it's 4 % it would yield 4.5 % etc), would encourage the government to keep inflation low since that would lower the amount they had to pay the bondholders each year. It may also be easier to sell since certain investors are skeptic about the future of the US dollar.
3) Burn (some of) the bondholders.
What it means: That the US refuses to pay back some or all of its debt, and defaults.
The US would tell the bondholders that it's their own fault for investing in a country which already had so much debt, and that they knew there was a risk associated with it (even though the risk of a country defaulting is typically small, every experienced investor knows it exists).
This would cause a major splash in the world economy, with a lot of angry bondholders around the world - but what could they do against a superpower like the US?
An alternative would be to burn some bondholders, and pay back others. For instance, the US could promise to pay back all the money owed to american investors (remember, a lot of regular american citizens own bonds). A lot of the people on the left who claims that the US debt crisis is overblown and that the US has been more indebted (as a % of GDP) before, tend to forget that during WWII (when the US was indeed more indebted than it is today), almost all the money owed was owed to american investors - this was back in the days when the government campaigned for people to buy war bonds as a way to show their patriotism, and a lot of people did. This debt wasn't nearly as dangerous as the national debt is today, because the national debt didn't compromise America's independence. Today, foreign investors can threaten the US simply because the US owes them money. This was not the case during World War II; as a matter of fact, taking on that debt during WWII may in fact have saved America's, and by extension the European countries independence.
If it gets to the point where the US won't be able to pay back all the bondholders, they definitely need to think about the future. If some investors, for example those from America, are spared, then they are much more likely to lend money to the US in the future, if the US would ever need to borrow again.
Why? Because the national debt is unsustainable, and a default would politically speaking probably be easier than an entitlement reform. By paying back some investors, the US ensures that it can still borrow money if need be in the future, but it will never be able to borrow as much as it is doing right now. And why should it? This would ensure that national debt is kept within reasonable limits.
Why not? Some things are costly. Wars, for example. If the US were to default, it would never be able to go to war again, and with the US out of the picture, the middle east is set to deteriorate. Russia's and China's influence in the world would grow exponentially. If, in the future, the US were only able to borrow from domestic investors, the interest rates would certainly be higher since it's a smaller pool of money we are talking about (a smaller supply together with an unchanged demand leads to higher prices, in this case interest rates - that's just Economics 101).
Bond markets are notorious for being unforgiving - Argentina defaulted 10 years ago and still has a tough time borrowing money. If you thought the credit card issuers were tough, just wait until you see the bond holders!
In this post, I have sought to present a couple of solutions or possible solutions to the US debt crisis. You may have noticed I didn't mention anything about tax cuts/hikes or entitlement reform, but that is because 1) I don't think they are realistic and 2) I wanted to focus on the "monetary" side, a side which is often ignored in the debate. Maybe that is because so few people know anything about it, or because these solutions cannot easily be turned into slogans.
I realize none of these solutions are fun. Getting out of debt isn't fun, but being out of debt is, and that makes it worth it.
I believe that the second solution should certainly be tried, and the first as well if it can be arranged properly. The third solution is really the last step, but if the US has to default, it should default in time while it still has time to pay back at least some investors, whom then may trust it again.
Please give me feedback. What do you think about these solutions, do you have any others, which one is the best?