Jeremy Siegel, Ph.D. The Future for Investors

The headlines are scary. Standard and Poor's warns that UK gilts (British Treasury bonds) may lose their AAA rating and indicates that U.S. government bonds may also be downgraded. Bill Gross, PIMCO's "bond king," says emphatically that the U.S. will eventually lose its AAA rating.

What does all this mean? Is it possible for the U.S. government to default on its own debt?

Technically, the answer is "no." The government can always print the money to pay its obligations. But from an economic standpoint, the answer is "yes," since printing money causes inflation and pays off bondholders with depreciated dollars.

The Debt Mechanism

All U.S. treasury debt is denominated in dollars, and except for the less than 10 percent that are "inflation-protected bonds," all bonds are promises to pay a specified number of dollars on given dates. Dollars are created when our central bank, the Federal Reserve, either buys securities in the open market or lends to banks against their loans and other assets. Although Congress imposes a ceiling on the debt issued by the federal government, the Federal Reserve has no effective constraints on the amount of money it can create.

It was not always this way this way. Before 1933, the Federal Reserve could only print dollars in proportion to how much gold the government held -- the so-called gold standard. During the Great Depression, one country after another, including the U.S., left the gold standard and moved to a fiat money standard. Under this monetary arrangement, the government decrees by law (fiat) that its money (Federal Reserve notes in the U.S.) is legal tender for all transactions. There is no gold, silver, or other commodity backing the money.

In a fiat money standard, money only retains its worth because the government limits its supply. The government can limit its supply if it has other sources of revenue, such as taxes or borrowings, to cover its expenditures. But if those other sources dry up, the government may effectively borrow from the Fed, and this would result in large increases in money and rapid inflation.

There is much debate among conservatives about whether the government's decision to leave the gold standard was correct. I, like the majority of economists, believe that it was a good move. If we were still on a gold standard, it would not have been possible for the Federal Reserve to back up money market funds and other bank deposits last September when the credit crisis hit. The resulting run on banks and flight to liquidity would have likely sparked a far worse financial crisis than we experienced. But the flexibility of a fiat money standard must be weighted against its bias towards inflation.

Default Under a Fiat Standard

Although under a fiat money standard government money must be accepted as a means of payment, there is no law that says what that money is worth when it is paid. If too many dollars are issued relative to demand, inflation must result. In that case the bondholder gets shortchanged not because of a government default on its bonds but because of the loss of purchasing power of the dollars paid. (Some countries impose price controls in a futile attempt to assure their own currency won't depreciate in value. Except for limited periods during wartime, such controls have always failed.)

There is one type of Treasury bond that could theoretically default, and that is Treasury-Inflation Protected Securities, or TIPS. Since TIPS compensate bondholders for inflation by increasing the coupon payments and final principal payment by the cumulative rise in prices, the bondholder suffers no decline in purchasing power during inflation. In contrast to standard nominal bonds, TIPS cannot be inflated away, and this leaves open the theoretical possibility that the government could not marshal enough resources to pay interest and principal on these bonds. TIPs for the U.S. government are similar to issuing foreign currency bonds. Any attempt to pay them off by increasing the money supply will cause inflation, depreciate the dollar, and increase the government's dollar indebtedness.

Of course, just because the government can always technically fulfill its debt obligations does not mean that it always will. Since a large proportion of U.S. government bonds are owned by foreign investors, the government could decide that it will only default on those bonds owned by foreigners. The Russian government defaulted on its foreign-owned bonds in 1998, while still honoring domestic bonds. But such selective default would be met by wholesale dumping of dollar assets, sending the dollar crashing on international markets. Given the huge volume of goods the U.S. imports, a plunging dollar means inflation would skyrocket and render such a policy counterproductive.

Our Current Situation

Since the credit crisis began, the Federal Reserve has more than doubled the supply of its own money, and government deficits are running into the trillions of dollars. Many believe this will inevitably lead to rapid inflation.

But such a conclusion is premature. The Fed has increased the supply of money in response to the tremendous increase in the demand for such money caused by the liquidity crisis. And government borrowing is just offsetting the sharp increase in consumer saving caused by the declining value of assets and tighter credit.

I believe that the government's current economic response is right. But the government must be on guard. Once confidence returns, the Fed must pull back the money it loaned and the government must bring deficits under control. This will inevitably mean raising interest rates, and the latest increase in long-term treasury rates is a clear signal that the bond market sees this happening soon. If, by the second half of this year, the economy turns around, the Fed will have to start raising the Fed Funds rate and restrict liquidity. Otherwise the government will effectively default on its obligations -- not by missing its payments but by making those payments in a depreciating currency.