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Government Default Doesn’t Lower Net Wealth

June 20, 2012

When the government borrows money, they create an asset held by an individual (the government bond), and a liability which falls on all taxpayers (increased taxes). When a government defaults, assets (the bonds) are destroyed, but at the same time, so are liabilities (the future expected taxation) equal to the exact same amount. Government bonds are frequently used as collateral by financial institutions, so their sudden disappearance would throw the financial sector into chaos. Central banks can offset demand shocks, so expansionary policy can help ease shock of default, but there’d likely be relative price shifts as everyone substituted away from purchases requiring long term financing. Not only is net wealth unaffected by default, but society also sees a gain because lower future taxation means less deadweight loss.

It is intensely disputed by economists whether large government debts increase or decrease spending. The average position (with high variance) is that deficits are expansionary, and paying back deficits is contractionary, but that a large total debt load is somewhat harmful. Some possible explanations are that taxes generate deadweight losses, that governments can spend money at a faster rate than the private sector, and that given an interest rate target, the central bank will print more to accommodate the high levels of spending.

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