Government Debt Isn’t Risk-Free Anymore

It is commonly taught in economics courses that the risk-free asset is a short-term US treasury bond. Since it is believed that a government can always increase taxes, then creditors needn’t worry about the government’s ability to repay. Although this idea has held up so far and America has not defaulted, there are a couple of assumptions here that need to be broken down to understand why this isn’t necessarily the case in today’s environment.

1. The assumption that governments can never default because they can print money. The US economy today is running record breaking federal and trade deficits. Since the US issues the World Reserve Currency, it has granted the US an ability to live beyond its means for longer than what would otherwise be permitted. Generally, a country that is fundamentally weak economically and reliant upon trading partners to sustain its living standards is checked by market forces in the foreign exchange markets. If a government has unsustainable debt levels, the market will reject its currency and the price will fall. Although issuing the WRC has prolonged this process, eventually the dollar will fall and bond holders who are only compenstated in nominal USD terms will lose.
2. The assumption that governments can effectively increase their tax revenue. While there may be political support for increasing taxes on a minority sector of the population like “the rich”, the effectiveness of these policies is often minimal. Other countries have attempted to implement ideas like wealth taxes and higher levels of taxation on the higher incomes, but often get a very small percentage of the tax revenue they budget for. Why? Capital and talent flee to competing nations.
3. The assumption that violence remains as profitable in the future. Government relies on the threat of prison sentences to those who do not comply with tax code in order to make ends meet. With the advent of private cryptocurrencies, it makes it easy for individuals to dodge taxes with much lower risk. The costs of a government attempting to track down crypto tax evaders far outweighs the potential revenue gained. If a government has no ability to repay you because cryptocurrency alters the returns to predatory violence, then the market will eventually start pricing this in, meaning interest rates will explode as nobody is willing to lend to government.

What was once considered a risk-free asset will soon become one of the riskiest assets to hold. Government debt levels are at all-time highs while interest rates remain near all-time lows. This cannot last for much longer. These assumptions have held up most of the world’s power structures but they are going to break, and when they do, the world will be remade.