[shahan]

I was wondering about the exact same thing. Ability and willingness to pay should mean ability and willingness to pay in real terms. Anything else doesn't seem to make sense.

Also: If the US defaults, how does it go down?

Here's why I'm confused:

Given that the US can't default on its nominal obligations, how does it default on its real obligations, so to speak? Printing money, aka inflation, is one way, but there's always inflation. Does that mean that the US is always defaulting to some degree? I'm thinking no, because lenders are compensated for higher inflation with higher interest rates. Would the US ever go "no, Chang, we're not going to give back your $10, sorry"?

Maybe someone can enlighten me.

[shahan]

Oh, I think I answered my own question. The lenders probably factor in inflation when they lend the US money. That would actually mean that the loans are in real money, and that there is no such thing as a nominal obligation.

Anyone know if this is correct?

[fauigerzigerk]

I'm not sure I understand your question correctly. There is definitely such a thing as a nominal obligation.

When the treasury wants to borrow money, it conducts an auction to determine who gets to lend it how much at what interest rate. If, at the end of that auction, a particular lender agrees to lend the treasury USD 1bn for 10 years at a yield (interest rate) of 3%, you can calculate the exact nominal dollar amounts that are to be paid back. These amounts never change from then on come what may.

Every year the treasury has to make a USD 30 million coupon (interest) payment to the lender. After 10 years the treasury has to pay back the principal, that is the original 1bn amount. That's it.

If the average inflation rate in that 10 year time period is 2%, the lender's return on investment is 1% (10 million dollars). If the inflation rate turns out to average at 3%, the lender makes zero. If inflation is 5%, the lender makes a loss of 2% (20 million).

If the inflation rate is somewhat higher than the yield and the lender makes a loss, it is not formally a default. I'm not sure what happens in terms of formal default if a borrower deliberately and aggressively inlfates away its debt faster than lenders can react by demanding higher interest rates at the next auction.

I believe this has never happened in modern times because borrowers who would do that cannot usually borrow in their own currency. What would definitely happen is that this borrower would have to pay much higher interest rates as soon as he comes to the market again, so nobody wants that.

There is another type of treasury bonds called TIPS, which are inflation adjusted. They have a lower yield but are protected against rising inflation.

[shahan]

Thanks for your answer.

> I'm not sure what happens in terms of formal default if a borrower deliberately and aggressively inlfates away its debt faster than lenders can react by demanding higher interest rates at the next auction.

This is the reason why I asked my question(s). Why would the borrower ever aggressively inflate away its debt, as opposed to gradually inflating it away? If there is no definite point of default, the US is either defaulting frequently, or can never default.

I wonder what the definition of default is, and if it's an event or a process.

[fauigerzigerk]

*>Why would the borrower ever aggressively inflate away its debt, as opposed to gradually inflating it away?

Because if it happens gradually it doesn't work as lenders would demand gradually higher interest rates every time a debt tranche is rolled over.

I have looked up the terms of credit default swaps and it turns out that inflating debt away does not constitute formal default in the CDS market. Formal default (a so called credit event) only results from missing a payment or restructuring the terms of payment.