Entertaining The Unthinkable In Tax Policy: Should The U.S. Restructure Its Debt?

Most people take for granted that the federal government will pay its debts in full and on time. After all, the Constitution requires it, and financial markets would certainly punish the nation severely if it failed to meet its obligations.

Federal debt obligations are effectively chiseled in stone: Anything other than full payment under original terms is unthinkable.

But in a 2019 piece for the Michigan State Law Review, Edmund W. Kitch and Julia D. Mahoney urged Americans to consider the unthinkable: a restructuring of the federal government’s huge and fast-growing debt burden.

On close examination, this crazy idea is neither so crazy nor even unprecedented. It’s been done before — twice. Worries about its constitutionality, while not unreasonable, are also on uncertain ground. And while it poses real risks — including adverse reactions in the financial markets — it also promises real benefits.

Perhaps most important, restructuring the federal debt may turn out to be less of a choice than a necessity. Traditional means of addressing the nation’s accumulated debt and chronic fiscal imbalance — tax hikes and spending cuts — are unlikely to get the job done.

When faced with a choice between paying creditors and preserving their cherished social programs, Americans are likely to insist on the latter.

And tax increases? They’re a hard sell under the best of circumstances — even when modest in scope and size. Tax hikes big enough to get the job done? Not likely.

The Problem

Writing in the fall of 2019, Kitch and Mahoney began by taking grim note of the federal government’s large and growing debt: $22.72 trillion at the end of last September.

That number has since grown to $26.63 trillion. It includes not just debt owed to the public but intragovernmental debt as well, including securities held by the trust funds for Social Security and similar programs.

Kitch and Mahoney included such holdings because they “represent important promises of the U.S. government to beneficiaries of key social insurance programs and are not available for other government purposes, including debt service and repayment.”

Those promises figure prominently in the story Kitch and Mahoney set out to tell.

When it comes to fiscal policy, 21st-century Americans face a “harsh reality,” caught between the proverbial rock and a hard place, Kitch and Mahoney insist.

On one hand, they have inherited the existing federal debt, along with its projected rapid growth. On the other, they face the likelihood — it’s a certainty, really — of unforeseen spending needs. (That warning about unforeseen needs seems sadly prescient, having appeared in print just months before the start of the pandemic and its associated economic catastrophe.)

“The United States might not be able to keep all its promises, even if it wants to,” Kitch and Mahoney warn.

Conventional wisdom tells us that when the going gets tough, the lenders will still get paid. But Kitch and Mahoney challenge that assumption.

In a democracy, voters get the last word about first priorities. And voters, it turns out, are not always especially kind to financiers.

“We suspect that if push comes to shove voters will balk if told that holders of United States debt securities enjoy ironclad priority over Social Security claimants and others with well-settled expectations of government benefits,” they write.

If history is any guide, Kitch and Mahoney may be right.

The Precedent

“The claim that the United States of America has always honored all its commitments in full exerts a powerful hold on the public imagination,” Kitch and Mahoney write.

To the extent that the public imagination makes room for any sort of thinking about public debt (a dubious proposition), that assertion is probably true.

What’s probably even more true, however, is that full repayment has a powerful hold on elite versions of the public imagination. That subset can be important for some kinds of policymaking, like routine decisions about taxing, spending, and borrowing.

But elite public imagination may be less politically salient when discussion turns to more radical options on the policy menu — like debt restructuring.

In any case, Kitch and Mahoney are correct when they question America’s supposedly unblemished history of debt repayment. At several points, the nation has played fast and loose with its debt obligations. Sometimes very loose.

The most obvious example came right at the start, when American political leaders took a notably flexible approach to the repayment of national debts.

The Founders were “nothing if not pragmatic” when it came to dealing with the young nation’s debilitating debt burden, both at the federal and state level, observed Kitch and Mahoney.

To illustrate, they offer a deeply pragmatic quotation from everyone’s favorite fiscal founder, Alexander Hamilton:

Every breach of the public engagements, whether from choice or necessity, is, in different degrees, hurtful to public credit. When such a necessity does truly exist, the evils of it are only to be palliated by a scrupulous attention, on the part of the Government, to carry the violation no further than the necessity absolutely requires, and to manifest, if the nature of the case admit of it, a sincere disposition to make reparation whenever circumstances shall permit.

The Founders breached “public engagements” in various ways, most notably when they devalued the wartime currency instruments known as “Continentals.” Congress devalued the bills as part of Hamilton’s famous restructuring plan, allowing holders of these bills to redeem them for alternatives at a “punishing” ratio of 100 to 1.

Holders of interest-bearing debt instruments did better, especially if they happened to be foreigners. But almost all lenders took a significant haircut, forced to accept less than they were owed in exchange for getting more than they expected.

American political leaders sold this early foray into debt restructuring as a one-and-done sort of disappointment. And by and large, the gambit worked, reassuring financial markets but also encouraging financial discipline among federal lawmakers.

“Having pulled off the unusual feat of right sizing its obligations while convincing the credit markets it was unlikely to repeat the behavior, the United States became zealous in its commitment to fiscal probity,” Kitch and Mahoney write.

That probity slipped notably during the War of 1812, and federal officials were forced to delay some debt payments. But the missteps were relatively minor and short-lived.

The next important chapter in the history of federal debt and its ostensibly “inviolable” character came in 1868, when the states ratified the 14th Amendment to the Constitution, including its public debt clause.

The clause reads, in part: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”

Lawmakers included the clause out of concern that “a coalition of southern Democrats and northerners might seek to refuse to pay the Civil War debt,” write Kitch and Mahoney. That clause would feature prominently in future debates over the treatment of federal debt.

Franklin D. Roosevelt’s 1933 abandonment of the gold standard — and the abrogation of gold clauses in U.S. government debt instruments — qualifies as the second great restructuring of American federal debt, Kitch and Mahoney contend.

They are not alone in this view, which is shared by various economic historians; they cite, in particular, a working paper from the National Bureau of Economic Research, which described the gold decision as a restructuring and characterized it as “the first step in what would become one of the largest transfers of wealth (from creditors to debtors) in the history of the world.”

The gold clause abrogation provoked outrage in some quarters — and predictions of financial and economic disaster. All of which largely failed to materialize.

“Although there were likely some adverse consequences for the United States, reneging on its contractual obligations did not cut off its access to capital,” Kitch and Mahoney write. “The U.S. government was able to issue new debt without serious obstacle. Indeed, some of the takers of the new debt were the very bondholders whose earlier debt had been involuntarily restructured.”

In a real sense, then, this second restructuring looked a lot like the first. It was scandalous and outrageous, at least among the lending class.

But ultimately, it proved less harmful than many had feared. And to the extent that it helped resolve dangerous economic conditions (for the 1933 episode, a bout of severe deflation), it may have been downright salubrious for the nation’s economic health.

The Solution

After rehearsing this history of restructuring, Kitch and Mahoney return to the current problems facing U.S. policymakers, including the nation’s accumulated debt, as well as its continuing responsibilities — both to American citizens and the world at large.

They paint a daunting picture, full of mounting problems and limited solutions.

“So far, the precipitous rise in United States government commitments has not led to a concomitant expansion in the set of options under consideration to deal with the situation,” Kitch and Mahoney write. “No matter how high the debt climbs or how massive the growth in entitlements, debates about what to do continue to revolve around tax increases and spending cuts, as well as to assume that all public debt obligations will be met.”

Something will have to give, Kitch and Mahoney suggest. Or more specifically, something will have to be added to the range of options under consideration.

They urge lawmakers to contemplate the possibility — and even necessity — of debt restructuring.

“There is no reason to regard debt restructuring as a sort of third rail, the merest contact with which must prove fatal to the nation,” Kitch and Mahoney write. “On the contrary, debt restructuring is a real possibility, if only because the electorate may favor receiving promised government benefits over repaying creditors. To add debt restructuring to the mix of options, in short, is not to court disaster but to accept reality.”

There are good reasons to believe that Kitch and Mahoney are on to something.

Historically, American voters have never been especially sympathetic to the plight of bondholders, even when their elected representatives have been eager to placate financial markets.

And while lawmakers in some periods have been able to blithely ignore the wishes of the great unwashed, the recent populist turn in American (and world) politics makes that approach increasingly untenable.

The small “d” democratic reforms that have characterized U.S. politics over the last half-century or so — not to mention the advent and influence of social media — make it likely that voters will play a powerful role in setting future policies toward debt repayment.

Of course, the problems of borrowing and repaying are purely notional at this point — financial markets love American debt, right?

But as Kitch and Mahoney point out, “the history of sovereign debt is replete with stories of nations that borrowed freely until suddenly they could not.”

Or as Roosevelt said of the 1920s, “‘Come-easy-go-easy’ was the rule. It was all very merry while it lasted.”

U.S. policymakers might be able to cope with long-term fiscal challenges through traditional means, using a combination of higher taxes and lower spending.

But proposals to do exactly that have won scant support in recent years. Worse, they all take for granted that debt repayment is the first and most inviolable commitment of the federal government, contend Kitch and Mahoney.

“We are deeply skeptical of the notion that debtholders enjoy de facto and de jure absolute priority over all other potential claimants,” they write.

Kitch and Mahoney reject the notion that debt restructuring of any sort is forbidden by the Constitution. While they acknowledge that experts can and do disagree on this score, they insist that the 14th Amendment’s admonition that the “validity of the public debt of the United States . . . shall not be questioned” does not preclude restructuring.

“Failing to pay a debt in full and on time is not at all the same thing as questioning that debt’s validity,” Kitch and Mahoney write. “Adjustment and even full discharge of debt obligations is part and parcel of a sophisticated commercial society, and debtors can (and frequently do) seek adjustments or discharges without claiming the debt at issue is in any way not valid. This occurs with regularity in the area of international sovereign debt restructuring, where nations that seek to renegotiate their obligations generally do not deny that the debt was lawfully incurred.”

Kitch and Mahoney end their paper with a few specific proposals, urging lawmakers to prepare for the possibility of an eventual debt restructuring. They recommend, as a start, that lawmakers extend the duration of outstanding debt, preferably through the use of perpetual instruments. They also call for the establishment of a liquidity fund to provide breathing room during a moment of crisis.

Ultimately, however, they place a lot of faith in the institutions of American constitutional government, including both its flexible and its more sclerotic qualities.

The widely recognized strength of American constitutional governance would help the nation weather the financial storm that would almost certainly surround a debt restructuring, they contend. “To focus only on how bad things are when politics gets bitter is to ignore one of the American system’s great advantages: what emerges from its often messy, cumbersome workings tends to have legitimacy and can generally be relied upon.”

I think that sentiment certainly describes the American past. I hope it also describes the American future.