Federal Government Default? Unlikely but I'm Hopeful.

According to the Wall Street Journal "the [federal] government could default on its debt by July 8." S&P, one the big three of the credit rating oligopoly (along with Moody's and Fitch), has changed its outlook on US Treasuries from "stable" to negative".

Treasuries actually rallied on this news, investors being hopeful that it will force bipartisan compromise on the federal budget and, more importantly, raising the debt ceiling. That ceiling stands at $14.294 trillion and the US debt is $14.219.

I'm hopeful in more of a let the bodies hit the floor sense.

Now, I do not think that default is at all likely, and investors probably rallied with a rational expectation of a Oh Gawd, no! response from Washington politcians. However, I think that default is exactly what the US needs from its federal government right now.

Two economic principles that I have come to believe firmly in are, first, the ratchet effect elaborated most thoroughly by Robert Higgs in Crisis and Leviathan and, second, fiscal illusion, an idea that I most closely associate with James Buchanan and Richard Wagner.

The ratchet effect describes the observation that government powers (and spending) sprawl during a crisis and then recede once the crisis has passed, though not to pre-crisis levels. (Think of using a socket wrench. Your arm motion is forth and then back; forth and then back; etc. However, the bolt is proceding clockwise and deeper throughout.) We're certainly at that point now, in terms of both new regulatory powers and spending following the 2007-2009 financial crisis and recession.

The increased federal spending has not been funded from current revenues and this year's deficit will be about 10 percent of GDP (or about $1.6 trillion). If running a tab rather than paying-as-we-go causes people to underestimate the costs of increased spending, then we have a case of fiscal illusion. Fiscal illusion can be contrasted with the Ricardian equilivalence described by Robert Barro in his classic 1974 Journal of Political Economy article, "Are Government Bonds Net Wealth". In the world described by Barro, homo economicus does not view government bonds (i.e., goods provided by government issuing debt) was wealth because he realizes that the liabilities have the same present value as the taxes he doesn't have to pay today.

However, do you know someone with a credit card who doesn't behave as Barro describes? Someone who treats consumption financed by 20 percent interest rate debt as real increases in living standards? If you do know someone like that, do you think there's a good chance he or she is the median voter? I do, so also think that the median voter does not correctly perceive the costs of the expanding government. Of course, the tab will come do someday, but in the meantime the expanded government becomes institutionalized: new regulations become "just part of life"; the new goods provided by the government become "entitlements". The government has not only expanded but also ratcheted into place so that it will be unlikely to recede.

Whatever the real short-run costs (which uneniably may be large), I say concerning the possibility of federal default: the sooner the better!