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Can the US go broke?

August 23rd, 2008 · No Comments

It won’t be the first regime in history. We already reported on how Nouriel Roubini, one of the economist who predicted the current crisis, argued that the US would be the next emerging market crisis…

There are several ways to go about it. They could just repudiate the debt, but that wouldn’t go down very well in the rest of the world, to put it mildly. The world economy would come to a grinding halt if this was tried. But there is another way, a stealthily way..

That other way is to just inflate the debt away. This is what Great Brittain did after the second world war, when the war effort had saddled it’s coffers with a debt which stood at 300% of GDP at it’s height.

Here the article:

  • The U.S. government, like so many creaky monarchies and dubious regimes in history, may be conspiring to repudiate its own debt, suggests a former vice president at the Federal Reserve Bank of Dallas.
  • U.S. Treasury debt obligations have long been considered the most secure and most certain of repayment in full, including interest. It’s part of the reason the dollar has stayed strong, and why the United States has been able to borrow so much, so cheaply, for decades.
  • Increasingly, that trust is for the first time becoming questionable. “Congress, with the complicity of the White House and the Fed, has arguably embarked on a stealth repudiation,” warns Gerald P. O. O’Driscoll Jr., writing in The Wall Street Journal.
  • Although not predicting that the government will default on its obligations, O’Driscoll writes that U.S. debt will be met through what famed economist Adam Smith, author of The Wealth of Nations, called “pretend payments.”
  • In other words, debts would be repaid through deliberately uncontrolled inflation, according to O’Driscoll, now a senior fellow at the Cato Institute. That means Uncle Sam will be paying back its borrowed money with debased dollars, the so-called “pretend payments.”
  • In their successful fight against inflation, President Ronald Reagan and then-Fed Chair Paul Volcker were greatly assisted by “bond vigilantes,” who bid up interest rates on bonds to 10 percent and more.
  • The high cost of money and low taxes during that era ignited an economic boom, says O’Driscoll, and beefed up the Fed’s credibility. The message: In its efforts to control inflation, the Fed won’t cave to political pressure. Fed Chairman Alan Greenspan continued to keep a lid on inflation, although inflationary currents were mild during most of his tenure.
  • Now, Fed chief Bernanke pursues an “easy money policy with inflation already picking up,” says O’Driscoll. Even worse, “We have the accumulated effects of seven years of loose fiscal policy.” Long gone are the growth-stimulating effects of the Bush tax cuts, eclipsed by massive government spending, he warns.
  • “Government spending is the ultimate tax on the economy,” writes O’Driscoll, quoting economist Milton Friedman. “It extracts real resources from productive, private use, and puts them to unproductive, public use. And there is the rub.”
  • Even a Democratically controlled Congress cannot raise taxes high enough to pay for all the previous government spending and the accumulated debt. As a result, says O’Driscoll, “We are at a Smithian moment, in which the temptation for the Fed to spend its last dime of credibility may prove irresistible.”
  • Investors, he warns, are already being taxed by inflation and can rationally expect inflation to increase. “Wages are not keeping up. Main Street is being taxed to fund Wall Street excess. Anyone who works, saves and invests is exposed to confiscation of his capital and earnings through inflation.”
  • We wouldn’t be facing this problem, O’Driscoll writes, if the Fed had maintained its independence and had said no to congressional spending. “There has never been a single instance of sovereign debts having been repaid once accumulated to a certain degree,” O’Driscoll writes, quoting Smith again.
  • And, in fact, we may have reached already Smith’s dangerous threshold, he warns.

So, a couple of observations:

  1. Instead of a much more visible repudiation (à la Argentina), the US embarks on inflating the debt away, but the effect is more or less the same, holders of the US debt get a rough deal, they get less money back than what they lent out (in terms of what they can do with it, that is, in real, or purchasing term)
  2. The US, contrary to other countries, cannot really go broke because the debt is denominated in their own currency (we wrote about the advantages of ‘seiniorage’ here), of which they can print unlimited amounts (in principle, but there are countries who actually try that, like Zimbabwe)
  3. The US, although not (yet?) at the dizzying height of Zimbabwean money creation, are nevertheless embarking on a pretty impressive money creation program of their own, much of which is used to bail out dud financial institutions and buy up dud financial instruments
  4. Like the article already alluded on, not only US debt holders get a rough deal, the American worker, insofar his wage doesn’t rise at the same rate as prices, is also short-changed
  5. The way of debt holders to protect themselves is to increase interest rates on debt. Since the outstanding debt is mostly in the form of bonds, that results in these bonds fetching a lower price in secondary markets, which actually helps to reduce the debt further.. (bond have fixed coupon payment, increasing that as a % can only happen through lowering the value of the bond, which increases that fixed coupon payment in % terms)
  6. Higher bond rates will slow the US economy further..

Tags: The Markets