Probability of Default

Conventionally investment advisers hold that there is little chance that the U.S. will default on its debt.  Hence the value of bonds it taken as the risk free rate of nominal interest.  This is justified by the fact that the U.S. government has, as yet, never explicitly defaulted on its debt, although the U.S. did flirt with the idea of not recognizing its debt to France in the wake of the French revolution.

The implicit form of default known as inflation is a different story.  The risk due to this is incorporated in all nominal rates of interest.  The only way out of this would be to state the terms of an agreement to borrow in terms of some real asset, such as gold.  For most contracts, the government has the right to nullify such agreements.  There was actually a court case where gold clauses could be nullified by an act of congress.  This was done during the great depression, so this point is not merely academic.

At the present time the government issues bonds that are held to protect the bearer from inflation.  The amount that the government will pay depends on the consumer price index.  Of course this still leaves open the form of implicit default that the government can simply misstate inflation, thus lowering the amount that they have to pay.  In any case, since this is not the dominant way that the government has of borrowing money, this is academic.

What is clear is that explicit default cannot be completely ruled out.  There is some probability of this occurring that is greater than zero.  While the U.S. government has never explicitly defaulted, other governments have.  This has occurred when political instability has changed the government by one that doesn't recognize the debt of the previous regime, or when a the government comes to believe that the consequences of honoring the debt will be worse than failure to do so.

I regard the latter possibility as being the more likely.  To be sure coups have occurred in other countries from time to time, but most of them happen in countries that are much poorer than our own.  The models that I respect for predicting such events hold that the economic elite stage them when they stand to gain more from repression than the cost.  The benefit to them is a reduction in redistribution.  In a society as rich as our own, the well to do would rather pay their taxes than suffer from the consequences of political repression.  In fact many of them actually support the side that calls for more redistribution in return for other political values that they support.

An explicit default can carry a heavy political cost.  This is seen as a violation of a promise made to the bond holders.  If these people have some control over the political process, then they can punish the leaders who bring about the default.  Under a democratic form of government, such as we have now, this will only have a serious impact on things if the bond holders are citizens of our own country.  Every such person is likely to vote against the people who caused the default.  Thus I would expect that the chance of default would be greater if bonds were held by foreigners, or a small minority of the population.

In addition to the cost imposed by voting bond holders, there is the stigma associated with such a decision.  Defaulting on one's financial obligations is seen as a way of mishandling one's finances.  It is also likely to ruin the government's credit rating thus making it more difficult for the government to borrow money in the future.  This is one reason why would be supporters of default have opted for the implicit form, inflation.  It is much more difficult to understand and harder to attribute blame to particular politicians.

One factor in the choice of the form of default would be whether a government can borrow money denominated in its own currency.  In short, if the U.S. dollar has a history of inflating more than other currencies, then investors will catch on and demand a higher rate of interest.  If the government damages its reputation enough in this regard, investors will only agree to lend money in other currencies, which have a better record of holding their value.  Governments that borrow money in this manner are far more likely to explicitly default.

The alternative to any kind of default is some combination of reduced spending and increased taxation.  This too will carry a political cost, so it is necessary to consider this as well when you are considering the probability of default.