The ethics of debt default

One of James Buchanan’s most interesting papers is The Ethics of Debt Default (1987), first published in the book Deficits (a collection of public choice articles about public debt and debt financing), edited by James M. Buchanan, Charles Kershaw Rowley, Robert D. Tollison and reprinted in James Buchanan’s Collected Works, Volume 14.

As an individualist contractarian, Buchanan rejects the argument that we have a moral obligation to honor debt obligations that the government has created simply because the modern state is a ‘moral unit’ in the sense of an extended family. He has more sympathy for the conservative argument that government should not default on its debt because we all benefit from a government that honors its commitments. However, Buchanan notes that on a less abstract level of discussion “a collective decision to repudiate the debt need not, in itself, pull down the whole legal-political house of cards, especially if it is accompanied by a change in the rules designed to insure against recurrence of the necessity for repudiation.” As a contractarian, Buchanan can only endorse borrowing  to finance “genuine public capital investments” that also yield benefits to future taxpayers. After all, it would not be fair if the taxpayers that authorized public investments would have to assume the complete burden of the costs when future generations benefit from those investments, too. The situation is different in the case of ordinary public consumption expenses, which mostly accrue to the existing  generation and that push the tax burden to future generations.

In favor of the argument that there is not a persuasive moral argument against debt default in the case of debt-financed ordinary consumption he employs a Rawlsian argument that should persuade modern liberals and progressives as well. Behind a veil of ignorance where people will not know their generational position it would not be rational to endorse debt financing for the sole aim of favoring one generation over another. Or, as Buchanan puts it in welfare economics terms, “there is no multi-period Parato-superior move that can describe a shift to a regime of debt-financed public consumption.” Buchanan even characterizes debt financing for ordinary public consumption “immoral” by such contractarian criteria.

He also discusses the possibility that the risk premium for government bonds (which, in parallel with private borrowing, should be higher for consumption expenditures) attenuates the moral significance of defaulting on the debt. After all, the voluntary payment of the risk premium implies the recognition of the bond holders that such loans may not be paid back.

Buchanan’s contraction framework only allows for a moral obligation to honor debt that was issued for public investment and income-yielding assets. Incidentally, since a significant portion of debt-financing concerns ordinary consumption and special interests, the argument that Buchanan puts forward in this article could also support voting against raising the debt ceiling of the US government.

One could argue that Buchanan’s limited support of honoring debt payments rests on two controversial premisses about public goods and the binding force of hypothetical contracts.

(1) Buchanan’s argument only works if a social contract to produce public goods is necessitated by suboptimal production of public goods in “the state of nature.” But as Anthony de Jasay has so eloquently written, “People who live in states have as a rule never experienced the state of nature and vice versa, and have no practical possibility of moving from the one to the other. It is often a historical anachronism and an anthropological absurdity to suppose such movement. On what grounds, then, do people form hypotheses about the relative merits of state and state of nature?” Furthermore, a Rawlsian contractarian framework cannot apriori assume government production of public goods instead of some variant of ordered anarchy where redistribution is achieved by limiting property rights.

(2) Arguments that derive the legitimacy of  public institutions from hypothetical contracts are intrinsically unfalsifiable. Removing personal, circumstantial and generational elements from the contractarian framework may strengthen “fairness” but at the cost of reducing the possibility to arrive at objective and unambiguous results. As a consequence, hypothetical contractarianism in practice collapses into a situation of a government of experts claiming to know the alleged substance of such agreements, and citizens (understandably) objecting to the contents and terms of these “contracts.”

An alternative approach would be to only honor actual contracts. Such contracts may not be as “impartial” as hypothetical contracts but they have the distinct advantage of permitting objective verification and incorporating evolved conventions concerning person and property. It is doubtful, however, that such a strict contractarian framework can be reconciled with an obligation of all individuals to pay taxes to  “the government” to honor the debt obligations that it made. Moreover, many individuals (or groups of individuals) will have both self-interested and moral reasons to seek default on such debts.

There is therefore no persuasive moral argument why individuals are generally obliged to honor any kind of government debt. Buchanan recognizes that defaulting on the debt may close off prospects for further government financing through borrowing. But to those who believe that government lacks legitimacy, and is a dangerous imposition on the human race, that should be an additional argument in favor of debt default. Defaulting on the debt might also restore the balance of power between generations and provide an incentive to transition to less debt-driven (ans thus more robust) forms of economic interaction.

Arguments that claim that seeking repudiation of the debt will blow up the political and financial system, and produce a net-loss for all, rest on the unrealistic assumption that such views will have absolute instantaneous effects. In reality, it is more likely that as the arguments for debt repudiation will be gradually embraced, financial markets and government operations will gradually adjust as reflected by increased risk premiums and less emphasis on debt-financing of government operations.

Into the Darkness

In 1940 the American author Lothrop Stoddard published an account of wartime Nazi Germany called “Into the Darkness.” Although the book is supposed to be an objective account, it is not difficult to note the restraint the author needs to exercise to not be more critical, if not scathing, about many aspects of the Nazi regime. But with a few exceptions, the style of the book is clinical and dry, which make his descriptions of the effects of the Nazi economy even bleaker.

Because Stoddard devotes a lot of space to describe Germany as it is experienced by the average German family, we learn a lot about the  effects of the socialist war economy on the freedom and wealth of its citizens. Stoddard wrote his account in 1939 and one can only imagine the devastation the socialist war state was about to inflict on its citizens when the accumulated effects of socialism,  repression, war, and international isolation fully materialized. As such, Stoddard’s book makes a good empirical companion to Ludwig von Mises’ “Omnipotent Government: The Rise of the Total State and Total War. (1944),” a classical liberal critique of Nazi Germany.

The title of the book refers both to the perception of Nazi Germany in the US and the war imposed blackouts. The blackouts, the winter cold, and the shortages of even the most basic necessities (let alone luxury goods) do not always produce a content journalist. It is telling that when the author expresses sincere enthusiasm, it is when he leaves Nazi Germany for neutral Hungary:

“Until we reached the border, of course, the windows were kept tightly curtained. Then the train stopped, started, stopped once more. Cautiously I peeked past a corner of the curtain. We were in a brilliantly lighted station bearing the big neon sign Hegyeshalom. On the platform stood policemen and railway officials in strange uniforms. Through the uncurtained windows of the station I could see a restaurant with counters laden with foodstuffs. I was in Hungary–a land of peace and plenty! Standing up in my compartment, I gave three loud Ellyens! Which is Magyar for Hooray!

To enter Hungary from wartime Germany is literally to pass from darkness into light. The sense of this grew upon me with every kilometer the train made toward Budapest, the Hungarian capital….Another wonder was the approach to Budapest–a great city twinkling and sparkling with lights. To one fresh from blacked-out Germany, it seemed like fairyland.”

In the final chapter the author reflects:

There are so many genial aspects of American life which we thoughtlessly take for granted until we are suddenly deprived of them and are plunged into alien surroundings where we have to fuss and plan and almost fight to get the bare necessities of existence.

A positive-sum game against nature

Whenever there is a major economic event (a rapid decline of stock prices, a spike in the price of oil, high unemployment, etc.) the media can be counted on to feature a person who was predicting these events all along. This should not be surprising because there are so many professional economists and commentators who cannot restrain themselves from making economic predictions that a few of them will turn out to be correct. But what is surprising is that so few journalists seem to be able to distinguish between skill and luck. This is one of the major themes of Nassim Nicholas Taleb’s seminal Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life.

If you are an obscure, but aspiring, economist, what are your options? In the June 2009 issue of The Freeman, Anthony de Jasay writes (p.33-34):

What is left for the 250,000 other, less-distinguished economists to do to gain fame and fortune? They too can offer forecasts and might put them on some record. If they place them in the cluster and the actual outcome is in the cluster, they remain unremarked and neither gain nor lose anything. If they go way outside the cluster and the outcome is in the cluster, nobody will remember the wrong forecast made a year earlier. They will again gain nothing and lose nothing. If their forecast is in the cluster and the actual outcome is way outside it, they will be in the good company of their 500 more-distinguished fellows and will again remain unremarked.

The rational choice for such an undistinguished economist is to make extreme predictions, corroborated with pessimistic scenarios that make such forecasts plausible.  If the economist is wrong, nothing (or little) is lost; if he is right, great publicity and riches can be expected. In technical terms, “he has access to a positive-sum game against nature.” On a more serious note, Jasay writes that “such forecasts are the best method of deepening the gloom, frightening the credulous, and making the worst more probable.”

Anti-market bias, unemployment and immigration

Economist Bryan Caplan discusses the important topic of market-clearing wages. Why are wages not falling during the recession in order to establish equilibrium and full employment? Caplan gives an answer that seems common sense but receives little attention from professional economists and politicians.

Is labor market rigidity a market failure?  I’m afraid so.  But strangely enough, this market failure is largely caused by anti-market bias!  The main reason workers hate wage cuts is that they imagine that wage-cutting employers are satanically “unfair.”  If workers saw wage cuts for what they are – a full-employment mechanism – they’d sing a different tune.  While they wouldn’t be happy to see their wages cut, they’d grudgingly accept that a little wage variability is a fair price to pay for near-total employment security.  Once this economically enlightened perspective took hold, employers would eagerly cater to it – and the market failure would largely go away.

Bryan Caplan’s position may have implications that he may be reluctant to acknowledge. If the absence of widespread anti-market bias is a necessary condition for the proper function of the price mechanism, arguments that immigration can alter the cultural prerequisites for sustainable capitalism (let alone laissez faire) can no longer be dismissed as “nationalist” or “collectivist.” The potential for capitalism will become a function of the genetic and cultural traits of a population.

Carl Menger and the exact science of economics

In Significance and Basic Postulates of Economic Theory (1938) Terence W. Hutchison presents a logical-empiricist perspective on economic methodology and takes specific issue with Austrian economists who believe that economic theories cannot and should not be falsified through empirical testing. In the chapter “The Application of Pure Theory” Hutchison criticizes Carl Menger’s view of what constitutes an “exact” science:

Menger contributed a further precision to this concept of economic laws, emphasizing what he and subsequent writers called their exactness, exceptions to them being inconceivable, and that “it involved a misconception of the foundations and postulates of the exact method” to test them empirically…To-day one can hardly help concurring with Schmoller that any worker in a chemical laboratory who proclaimed Menger’s conception of exactness would be ejected forthwith.

He also quotes John Elliott Cairnes on the methodology of economics as saying, “The economist starts with a knowledge of ultimate causes. He is already, at the outset of his enterprise, in the position the physicist only attains after ages of laborious research…”

Hutchison responds to his claim as follows:

It is possibly very encouraging for the economist to hear that compared with the natural scientist the psychological method saves him “ages of laborious research”, but it is curious and a pity that this huge start has not enabled him to formulate any considerable body of reliable prognoses such as the natural sciences have managed to achieve.

Hutchison does not completely dismiss the role of  a-priori reasoning in economics but objects to the idea that such reasoning exhausts the subject of economics. He quotes Ernst Mach on “laws” being “a limitation of what is possible.” If a law does not exclude or forbid any conceivable type of empirical occurrence than it  is not telling us anything about the world and, therefore,  such a science should be considered a pseudo-science. A similar complaint has been raised by Karl Popper about the all-accommodating nature of Marxism. The logical positivist writer Otto Neurath was of the opinion that, historically, metaphysical and anti-positivist thinking go hand in hand with the justification of oppression.

Much ink has been spilled over the question of whether the methods of the natural sciences are suitable for the study of economics. But even after 70 years since the publication of  Hutchison’s classic, economists who  have completely rejected empirical testing have contributed little of substance to the science of economics.