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Treasury Default Not So Unthinkable

By Rick Ackerman Posted on September 1, 2009, 12:49 am EDT Last Updated September 1, 2009, 5:11 pm EDT

Although we can be certain Americans and their government owe far more than they will ever be able to repay, the question of how this debt eventually will be discharged is the economic conundrum of the day. Some think hyperinflation is the only way out, since it would allow debtors to repay all that they owe with worthless bank notes by then in copious supply. However, this is hardly a solution, since those on the receiving end – i.e. the lenders — would be ruined, as would the bond markets, banks and all other institutional conduits and agents of saving.

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We’ve argued here that deflation will prevail, visiting pain on borrowers more or less in proportion to their sins. Lenders would wind up with the collateral, mainly in the form of residential real estate, but the advantage in this would probably be far less than what has been imagined by those who see bankers as conniving thieves out to steal the whole world’s tangible assets. In fact, the bankers would have to rent the homes back to those who had defaulted, saddling themselves with the politically unseemly problem of squeezing blood from a stone. Would they risk stirring up the mob, or would they instead settle up on relatively easy terms?  We don’t think they’ll have much choice.

 Why No Inflation?

Our reasoning about such things has always been intuitive — and so far correct in explaining why the huge fiscal and monetary blowout by the Federal Government during the last two years has produced no significant inflation. This fact is especially telling in the housing sector, which as the inflationists well know was the main target of the government’s historically unprecedented fiscal and monetary blowout.

Anyone interested in the inflation/deflation “debate,” will be abundantly rewarded by reading the superb essay by Jeffrey Rogers Hummel at the Library of Economics and Liberty.  Hummel does not explicitly support the arguments of the deflationists, but he has nonetheless made a compelling case against the possibility of a Zimbabwe-style hyperinflation. Instead, he sees a much greater likelihood that the U.S. will simply default on some of its Treasury debt while acting to prevent the dollar from plummeting to the threshold of worthlessness. He also explains why “seigniorage” – i.e., revenue generated by monetary expansion – can no longer help the U.S. or any other government buy its way out of trouble.

If you read just one more essay on the subject of inflation/deflation, make it this one by clicking here. 

(If you’d like to have Rick’s Picks commentary delivered free each day to your e-mail box, click here.)

  • Rich September 2, 2009, 2:51 pm

    RJ, one of the purposes for completely auditing the Fed, Mint and Treasury gold in NYC, West Point and Ft Knox is to see if it’s really there, or just gold plated lead, and who actually owns it. The Fed is a privately owned 6% dividend for-profit institution with extremely high ROEs claiming to be governmental by returning surplus profits from their usury to the Treasury. According to Alan Greenspan, the Fed is above or beyond the law by design to prevent politics and keep the dollar, economy, free markets and money supply stable. Right. The Fed’s website claims oversight by Congress (and the people). Really. Ron Paul’s bill unlikely to pass the Senate.
    Treasury and Mint are governmental agencies accountable to Congress, Constitution and the people (except when it comes to bank bailouts, gold and silver standard, perks and stims.) How the mighty have fallen.
    In the 1792 Mint Act, adulteration of monetary standards detected by annual audits of specie coin was treason punishable by hanging.
    So far, BB and TG, former NYC Fed President, oppose further audits of the Fed, Mint or Treasury, pointing out they are already audited. They want to make the Fed even more powerful and unaccountable. (When pigs fly.)
    Milton Friedman long ago said the Fed should be replaced by a computer. Then the 25,000 overpaid employees, 47 Fed Lear jets, 59 personal cars, fine art and wood-paneled dining clubs could join the real world and be opened to the little people like the Historic Preservation Trusts in England including Rothschilds, who invented the central banking scientific socialism Jefferson decried.
    Every President who has opposed the Fed has been censured, removed from office or killed. Today Congress subpoenaed the Fed over the BAC affair. Could be interesting or a coverup. Time will tell…

  • Richard J September 2, 2009, 2:27 am

    Rick; I would like to know who has the ultimate claim on US gold. Is it one way or another the Federal Reserve System, or is it the People of the United States of America?
    If the people have ceded the rights to their gold to the Fed, then all this discussion of inflation/deflation is for nought. I really would like an answer to this question.
    We know who will end up with the gold.

  • JR September 1, 2009, 10:46 pm

    I foresee two main events that would trigger a dollar hyper inflation

    1. Collapse of confidence in government.

    The quantity theory of money is weak. If it were true, the dollar should have hyper inflated decades ago. The quantity of dollars vs. gold is only a sideshow at best. The intrinsic value of a lump of 100 dollars or 100 Billion dollars are both the same. Zero. What has value is the stability and power of the United States. Take that stability away and the common share of the United States (the dollar) will collapse like the stock value of Enron.

    2. The black hole of the financial crisis is bigger than anyone thought. Bailouts into the 10’s of trillions would cause an overthrow of power by the people dissolving the dollar.

    The tyranny that the Fed has put on the people could come to a boiling point. When the citizens say enough is enough then the Fed will be a memory and control over the money supply will be returned to the treasury.

    It’s foolish to think the government has power over people in any culture. They only have as much power as people allow. I feel we’re not too far from the boiling point of revolt.

  • Rich I September 1, 2009, 9:55 pm

    If I may add my 1913 2 cents dollar today, since Federal Reserve Notes are backed by Treasury debt, any default of Treasury securities reduces the supply of dollars, thus driving up their value…

  • Richard J September 1, 2009, 7:29 pm

    I would really love to know how Hummel earns his living, because I am willing to bet that in some way he is sponsored by either a University or Banking connected sponsors.
    His essay is very narrow in scope, almost entirely ignoring the main benefit of a well run inflation, which is the devaluation of debt burden while simultaneously increasing tax revenues. Of the two, the devaluation of debt burden is the more important. Hummel chooses to dwell on the revenue aspects and rather poorly in my opinion. In the face of, say 8% real inflation, does anyone really think they can be compensated for the capital loss on their 3% bonds with a higher coupon rate?
    Hummel discusses partial default, citing the American Revolutionary War where debt was repaid and currency repudiated. What is the point of discussing this concept when he has already pointed out how little currency figures in the overall banking world of today? Is he suggesting that bank accounts would be wiped out or devalued while currency repudiated? If so, it would have to happen in concert with devalued Treasuries, and just how do you do that without either entering into a partial gold standard or entering into a beggar thy neighbour currency war? (likely required anyway as we are the beggars)
    What is all this talk of firewalls and Trust Funds? As far as I know, Medicare and Social Security are funded from current revenues. If there actually were funded plans anywhere, they would likely be stuffed with treasuries anyway, so how do you firewall anything with a fire?
    As for paying banks for their deposits being a disincentive for inflating; this can be undone in a heartbeat.
    In my opinion, deflation, if that is truly what we are in, will only continue so long as the banking establishment has something to gain and when that is no longer the case we will see the inflationary component of this grand liquidation cycle.

  • Arnold September 1, 2009, 4:53 pm

    Rick:

    If the Federal Government defaults on its debt, what happens to the persons / trusts / corporations holding that debt as their asset? How can the dollar have any value (and any financial asset denominated in dollars) if the government defaults on its debts?

    &&&&&

    If the U.S. were to, say, simply lengthen the maturities of Tresurys, that would give foreign creditors a reason to hope they might someday get paid. As the Hummel essay notes, Russia effected a “soft” default that gave the ruble a prayer of coming back. In fact, Russia eventually made good on its external debts. RA

  • Rich I September 1, 2009, 3:10 pm

    When conundrums present themselves, enigmas inside puzzles shrouded in mystery, sometimes ancient wisdom has the answer.
    Old Testament scriptures are clear from the times before Arjuna, Buddha, Confucius, Hammurabi, Mohammad, Moses and Pharaoh: the Borrower is servant to the lender. That’s why it’s called debt service, indenture or even slavery.
    The OT scriptures are also clear about the penalties of tampering with monetary weight and measure standards. And the OT outlawed usury to our own people because it knew interest ultimately compounds faster than the economy can grow, leading to default and Depression, as many are finding out today with 16+% defacto deflation adjusted interest rates more than offsetting government fiscal and monetary stimulus as so much wishful thinking like inflating our way out of debt.
    The Old Testament debt solution to profligacy was the Sabbatical and Jubilee, where the debts of properties, servants and slaves were forgiven, freed, repaid or returned every 7 years, or 7 times 7 years.
    Certainly that is what IMF and World Bank did with countries that could not pay their debts, initiating painful austerity programs augmented by collateral foreclosure.
    Why should the USA be any different after using up its credit line?
    The collapse and breakup of the Soviet Union from 1990 to 1998 provided an instructive example for US as we posted on JubileeProsperity.com.
    US Governments own enormous properties, including armament surplus and military bases around the world, buildings, food, parks, petroleum, ports, resource, timber; even helium reserve and retirement centers in Florida from Dearborn, MI. We have already seen some of this with the uproar about China COSCO or Hutchinson Whampoa operating Caribbean and US ports, Panama Canal and other strategic gateways.
    It is quite possible privatization repos of government property may be the ultimate (deflationary) solution. In the meantime there may be select debt defaults like extension of Treasury maturities, repudiation of agency obligations like FDIC, Medicare, Mortgages, OPIC, PBGC, SBA plus deflationary defaults on the $600 T of derivatives around the world including the ones that just defaulted in China with PRC government consent.
    Unlike Continentals and Greenbacks, the surprise may be that holders of the dollar around the world realize they have little to gain by trashing the dollar, driving the price of commodities, energy or gold up 100 or 1000 times, despite Chinese student laughing at TG and wishful proposing of SDR dollar substitutes. The currently unpopular reserve dollar, inflated and devalued -98% against gold since 1913, may be the best of a bad lot of fiat currencies today. As the late Milton Friedman and Alan Greenspan wrote in private correspondence, returning to the Constitutional gold and silver standard is unlikely. (At least until deflation has its way repudiating leverage as high as 125% DiTech loans.)
    The China wondereconomy may prove as fragile as the Japan and German economic miracles.
    The US still has the world’s largest Air Force and Navy by a factor of many times, despite China, Cuba, Iran, N Korea, Russia, Saudi Arabia, Syria and Venezuela trying to change that…

  • Ben September 1, 2009, 1:59 pm

    Hello Mr. Ackerman, and forum.

    Well… I’m rather surprised that I mostly understood that linked article! I’m actually in the process of writing an essay of my own that touches on that very subject. At least, I THINK I am. So maybe somone can answer me a question or two…

    If understand one point correctly in the essay written by Mr. Hummel, what he’s saying is that the reason more… seignorage?… won’t work is because interest has been drive too low. Yes? No?

    Second, I’m writing about taxes and inflation and I’ve come to conclude (rightly or wrongly) that the government has been taxing money velocity rather than money supply. Whatever the source of revenue these days, it’s all subjective value and the money never did (and still doesn’t) exist to pay for it in it’s entirety. ie, there never was enough money, per se, that paid all the incomes in the nation. So in taxing them, government had to create the money to make money velocity it’s source of revenue. In turn, this has driven interest too low for more devaluation to matter. Thus, tax will rise. This is of course unconstitutional as taxing money velocity, or subjective values, forces a policy of (at first) compulsory inflation, then taxation, which is exactly what we’re seeing today. They could have started off doing the latter, but that would have been obvious and people would have revolted right off the bat, like our colonial founders did.

    I do hope I’ve hit the nail on the head, and grasped what Mr. Hummel was saying because, I admit, I dread re-reading that one!

  • Bill September 1, 2009, 11:52 am

    — Yesterday Reuters broke this story about China. “Chinese state-owned companies will be allowed to default on commodity derivative contracts”. The reason or basis for defaulting was not given but this could open a door to “return” these “assets” to the originator.
    Could be an application of ODIOUS DEBT, something we all should take a long hard look at.

  • Rich September 1, 2009, 6:11 am

    If the U.S. government defaults on its debt any last semblance of confidence in this Country will be gone. America will be a deadbeat with a credit score in the 400 range. How would the dollar remain strong when that default will most certainly destroy any exchange value the dollar has. Who would take the dollar as payment ? It is a government guarantee of value or a share of stock in the United States if you will.

    Bernanke’s re-appointment reeks of him becoming an administration team player , meaning quantitative easing to infinity if necessary. For the next 3.5 years he will be printing money in the trillions for lost tax revenues, the FDIC black hole, 1000 bank failures, 100 trillion dollar commitments to Medicare and Social Security, continued Wall Street Bailouts, MANY more stimulus packages, California and other state bailouts, Health care, Pensions and on and on.

    I do not believe the liberal government will go for the massive social unrest that the elimination of even some of the obligations above would bring. Bernanke has said he did not want to preside over the Great Depression # 2 and it’s obvious he believes in electronically printing money as necessary.

    Hyperinflation isn’t a way out of anything. It’s a path that our government (Goldman Sachs and their Washington minions ) has chosen over the last 12-15 years.

    If the U.S. defaults on its debt it will become a laughingstock with no confidence in leadership. And a definitive no-confidence vote for the government will bleed right into the dollar. Price inflation due to currency failure…NOT an uptick in the economy.

    Rich

  • Paul September 1, 2009, 3:17 am

    Rick,
    Thanks for bringing Hummell’s ideas to our attention. Very thought provoking article by him and you in your introduction.

    Hummell writes about “nominal” firewalls which could forestall (my verb) a debt default:
    1. The viability of the Trust funds (SS, Medicare, etc.)
    2. “…between U.S. currency and government debt…. But my [Hummell’s] guess is that, faced with the alternatives of seeing both the dollar and the debt become worthless or defaulting on the debt while saving the dollar, the U.S. government will choose the latter.”

    I believe that the USGov’t will not be able to save the current dollar or repay its debts. The USGov’t can’t impose faith in its fiat currency holders. Most Treasury debtholder’s faith is in the ability of the USGov’t to rollover its debt. The Treasury officials’ faith is that it can rollover the debt at an extremely low rate.

    As Hummell writes: “If investors respond by requiring a risk premium on Treasuries, the unwinding could move very fast, much like the sudden collapse of the Soviet Union. Politicians will be unable to react.”

    Best of luck to all.


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