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.