Money, Debt and Default

Question - How can the U.S. have trillions of dollars in debt when the debt (at least to me) appears to be in a currency we control? Inflation notwithstanding, couldn't we just print extra money periodically to pay this debt back? It seems an odd concept to me that a country can be in debt within the currency that it controls.

I know I'm dismissing the complexity of international currency here, but perhaps you could expand upon what it really means when a country is in debt to other nations.

Response - Your question touches on two issues that require clarification and explanation. First, what is debt? Second, what is money? Once debt and money are understood, your question becomes relatively simple to answer.

What is debt? Debt is one of the two perspectives in the relationship between a borrower and a lender (the other being credit). Whenever I deposit money into my bank, my bank becomes a debtor to me in the amount deposited. Whenever a business or a municipal, state or federal government sells a bond to me, that entity becomes a debtor to me in the amount contracted. A bond, after all, is simply a contract to pay a fixed amount of money at some predetermined date in the future. The difference between the amount I pay, and the amount I receive is the 'rate.' So, if I'm indifferent between $100 today and $105 one year from today, my effective rate is 5%. I will not be willing to loan you $100 today unless you promise to pay me at least $105 in one year. Likewise, I will not be willing to spend $100 to purchase a bond that pays any less than $105 in one year.

This is, of course, assuming I believe the borrower will have no problem paying me back. The higher I believe the risk of default, the higher the rate I'll require. For example, even though my effective rate is 5%, I may view the borrower as risky and demand 15%. The 10% premium serves as compensation for the risk I am taking that I may never see my money again. The initial 5% serves as compensation for the inconvenience of not having the money I'm lending at my immediate disposal. If a potential lender is not presented adequate compensation for the inconvenience and risk associated with lending his money to the borrower, then he will have no incentive to lend. The inconvenience and risk simply must be compensated by the rate offered by the borrower.

Ah, but how can the federal government default? Before I can answer this question, I need to explain what money is and how it functions.

Money often gets confused with wealth. Money is not wealth. Wealth is, in a nutshell, stuff. Stuff, and the knowledge and means of making it, inventing it, and innovating with it. As you can see, wealth is versatile. With wealth, one can create more wealth, or sell it for cash, or exchange it for other forms of wealth. Money, however, is only good for one thing: the purchase of wealth.

Money exists because barter is awkward. Money helps economies run smoothly, particularly as they grow in scope and complexity. For example, if I owned an apple orchard and decided I wanted to acquire a new chair for my home office, I might go to a person who makes chairs and offer an exchange of apples for a chair. But, how many apples is a chair worth? How many apples does the chair maker even desire? The chair maker may propose a counteroffer whereby I give him a receipt for 115 pounds of apples. So, whomever presents this receipt to me may expect me to deliver unto him 115 pounds of apples. This way, the chair maker receives something he can use to purchase other things he desires, and I get my office chair without having to cart around 115 pounds of apples. Nor does the chair maker have to worry about getting rid of 115 pounds of apples. He only has to worry about making chairs.

The chair maker may then decide he wants to purchase some bacon, so he goes to the butcher and offers him my apple receipt. Now, the butcher is not going to need all 115 pounds of apples as compensation for 1 pound of bacon. Not only that, but the chair maker won't want to give up rights to all 115 pounds of apples for 1 pound of bacon. Let us suppose, that the chair maker writes a receipt to the butcher signing over his rights to 11 pounds of apples in exchange for 1 pound of bacon.

The receipts for apples have become money in this economy.

What if I decide to start exchanging receipts for my apples above and beyond what my orchard can reliably produce? Well, what are the odds everyone will show up at once and demand their apples? Here's where the art of finance and banking come in. How much wriggle room do I have? If I take too many liberties with my receipts, my neighbors may lose faith in my ability to redeem their claims on my apples. If this happens, there might be a 'run' on my orchard and I'll be ruined. This threat will also create an incentive for receipts for other producers' goods and services to be used as cash as well. There might even arise a sophisticated multi-layered banking system whereby large banks issue widely accepted notes to serve as currency while holding deposits of a wide variety of producers' receipts as claims on actual wealth.

Money will only continue to operate as it is meant to when the production of wealth (upon which the currency is founded) keeps pace with the creation of money. When wealth creation outstrips the creation of money, or when available credit evaporates faster than any decline in the creation of wealth, the result is deflation - where the money circulating in the market may purchase more wealth per unit of currency than before the deflation. When wealth creation is surpassed by the creation of money, or when any decline in the creation of wealth occurs at a faster rate than any decline in available credit, the result is inflation - where the money circulating in the market may purchase less wealth per unit of currency than before the inflation. Naturally, deflation is most harmful to the debtor because the cash he is paying back to his creditor is worth more than the cash he initially borrowed. And, inflation is most harmful to the creditor because the cash he is receiving from his debtor is worth less than the cash he initially lent out. This is a main reason why governments that possess monopoly power over the production of currency would much rather err on the side of inflation than deflation. Inflation would make it easier to pay off debts while deflation would make that much more difficult. The reason governments want to possess a monopoly on coining and printing money is not because the bureaucrats are worried about producers and consumers seeking to con one another. Con men and fraud will exist regardless. Governments want to possess a monopoly on the coining and printing of money because the bureaucrats want power. Diversification and a credible threat of competition are the opposite of power. Legitimate power only exists when there are no other present legal alternatives and no threat of any future legal alternatives.

So, can the federal government default? Technically, no. You are correct in assuming the printing presses can simply be kept running until there is enough cash to pay off all of the bills. However, hyperinflating a currency is catastrophically destructive to a nation's economy. For a potent example, one may simply look at Germany in between the two World Wars. The monetary actions of the German government fleeced the German population of all of their savings and created a massive burden to present innovation and future growth by creating incentives for investors and potential investors to seek foreign opportunities in more stable markets. Money can serve as oil in the gears of the economic machinery. It isn't necessary for an economic machine to run, but it helps it run smoother. Hyperinflation is like pouring sand into those same gears while simultaneously removing the oil. The machine will break down and require extensive repair, if not outright replacement.

In short, you should hope your government does not seek to print its way out of debt. If it tries to do so, very unfortunate things are going to happen.