The definitive Inflate-away vs. Default [on the Federal debt] thread

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Erik T.'s picture
Erik T.
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The definitive Inflate-away vs. Default [on the Federal debt] thread

It occurs to me that a key in developing one's understanding of economic trends is to figure out what the real key issues are, then focus on them. To wit, the question of Inflation vs. Deflation has been critical for a few years, but only recently have people come to really focus their attention on understanding the factors that play into determining whether we'll see an Inflationary or Deflationary outcome.

I contend that the next big question after Inflation vs. Deflation is that of "Inflate or Default" with respect to the national debt, and I propose this thread as a place to discuss whether in the long run the enormous U.S. Federal debt will be defaulted outright, or if the necessary "virtual default" will be accomplished by inflating the currency to the point that the debt can be serviced in nominal terms with watered-down dollars. I expect that most CM.com regulars will agree with me that paying back the national debt in real terms is simply not a realistic outcome at this point. The U.S. is in too deep already, and there is no political will to "do the right thing" and implement the necessary austerity measures to effect a full repayment in real terms.

Most experts I've read including CM seem to be assuming that the unservicable debt will be inflated away. At first glance that makes perfect sense; if your debt is denominated in your own currency and you have the keys to the printing press, why in the world would you (meaning the U.S. gov't) default when you can just monetize the debt? At first glance it seems that simple.

But I wonder what other scenarios could develop to change that outcome. The monetization solution (print, dilute, and repay the nominal principal with watered down dollars) will obviously have consequences. At some point foreign lenders will stop taking the sucker bet known as a U.S. Treasury Bond, and will insist on bonds denominated in another currency or in gold. At some point the U.S. Gov't will realize that if they let that happen, they loose a whole lot of options down the road. Furthermore, just allowing the USD to slowly devalue indefintely won't be politically viable for much longer. Governments have gotten away with that in the past in nations where the economy was largely self-contained. But America is extraordinarily dependent on imports for just about everything. So far the effects of the current reckless monetary policy have yet to really be felt by the American consumer, much less understood by the American voter. But eventually as prices of imported goods go through the roof and there are no domestic substitutes available, the mainstream will become irate about dollar devaluation, and demand reform.

So what other options does the U.S. Gov't have, and what curveballs might be coming our way? Far too many investors (myself included) have jumped on the short long-bond trade as an apparent ace in the hole. The investment rationale is simply that sooner or later, probably sooner, foreign lenders will wise up and demand higher interest rates or stop lending. The more the Fed prints money, the more scared the foreign lenders should become and the sooner they should demand higher yields. At that point the fed looses contrtol of the long end of the yield curve, and long-dated treasury values collapse. It really does seem like a no-brainer that this trade just has to pay off. And that's what scares me.

So what's the curveball scenario that could catch everyone by surprise? Seems like if it's not inflating away the debt (what everyone is expecting), it must be some form of the other obvious solution, Default. Is there a selective default scenario that could realistically play out? Is there a single group (say, Arab SWFs) that could be conveniently labeled as "enemy combatants" or "terrorists", giving the U.S. gov't an excuse to selectively default on their holdings and their holdings alone? If the U.S. could find a way to identify such a group and stick it to them without scaring off all other foreign lenders, I think they'd do it in a heartbeat.

Or is there an outright default scenario that could make sense following a change of political sentiment? Right now, inflating away the debt seems to be the Gov't's best choice, and it's clearly what they seem to be doing with all the monetization that's already happened and is certain to continue. But at some point I could see the popular revolt growing to the point where Americans take to the streets and demand that the dollar be protected. One way that could be accomplished would be to label the debt holders as "evil rich people", and just default as a matter of "justice". That seems completely absurd and implausible. But it basically happened to the G.M. bondholders already. Is there a "revaluation scenario" where the government conveniently declares that in the "name of justice for the people" a cramdown should occur on treasury bonds? I would think that would have the effect of instantly cutting the USA off from further international borrowing, but that doesn't mean it can't happen.

I continue to feel that the strong perponderance of evidence favors the inflate-away scenario, but I think it's worth exploring all other possibilities in as much detail as possible. What do others think?

Erik

 

guardia's picture
guardia
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Re: The definitive Inflate-away vs. Default [on the Federal ...

Err, one might ponder about what happens to gold (or PMs in general)? If in any scenario, they shoot up, the final outcome might well be the same..

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Re: The definitive Inflate-away vs. Default [on the Federal ...

Erik,

your idea about a selective default is thought-provoking.  I have heard of scenarios where there would be a brand new currency issued.  A name for the new currency that has been mentioned is the "Amero" instead of  the Dollar.  The old dollars would be exchanged for new dollars at different rates depending on who held the dollars.

American citizens or just American residents might get 1 Amero for each 10 dollars.

Foreign creditors might get 1 Amero for each 5 dollars.

Investment banks etc could get 1 Amero for each dollar.

These ratios could be ajusted to satisfy the political sentiments you mention.  I am sure that whatever happens the ordinary guy is going to lose big time.

Similarly the debt could be defaulted on selectively.

Another scenario would be to provoke some kind of war with a creditor nation and then unilaterally cancel all of your debts to that nation as part of hostilities.  There would not even have to be any fighting, just declare war and then default as your first belligerent act.  Then just sit around and have a "Phony War" for a while like Britain and France did for the first 6 months when they declared war on Germany in 1939. 

Under either circumstance, it sounds like shorting bonds would be profitable.

Does anyone know how currency devaluations, currency replacements or debt repudiation played out in other countries like Brazil, Argentina or the Soviet Union?  How did it affect the day to day lives and investments of ordinary citizens?  Are there any readers who lived through those times in one of those countries?  In retrospect, what could citizens have done in advance to mitigate the effects or even to prosper?

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Re: The definitive Inflate-away vs. Default [on the Federal ...

Prediction is always a challenge ...

- China/Japan demand all future bond purchases to be repaid in rem/yen.
- interest rates go up
- foreign exchange controls in the US are introduced
- gov't fans great rise in US nationalism
- US consumer commences an unofficial 'buy American' philosophy, which will be very successful
- gov't pegs US dollar to the Euro
- gov't inflates at 7%/yr
- US military stops acting as police officer in Asia, lets 2000 year old Japan/Korean/China tensions rise
- conflict breaks out in Asia, probably with China as aggressor
- NAFTA style trade is expanded to all of the Americas

Conclusion: Don't ever underestimate the Yankee trader

 

 

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Re: The definitive Inflate-away vs. Default [on the Federal ...

A lot of food for the mind.. thanks guys. Still, IMO because it will be VERY hard to make the economy grow from now on (ugh peak oil ugh) I see this eventually ending in one of two ways:

1. some sort of gold standard because, well, inflation would be driven by excess liquidity under a non-growing economy. It would happen either naturally (gold coins, hey it'll be even easier with ultrasound scanners and what not) or endorsed by the state. (If entities start to default instead, the rate would accelerate under these conditions and destroy the currency as well I believe...)

2. nanny state that outlaws trading using PMs (brr, in that case, it would be time to move to another country)

Given how much time it took governments to accept climate change (a couple decades..) I don't expect them to accept peak oil, overpopulation, water and food shortages, etc. any sooner. It'll just be rounds and rounds of "oh we need to make the economy grow, we need to make more babies" and other crap like that.

Anyone sees other possibilities? And the rationale?

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Re: The definitive Inflate-away vs. Default [on the Federal ...

"My fellow Americans, and members of the world community, I stand before you today to announce the results of the audit of the Federal Reserve. Those of us who have reviewed the actions of this establishment have been shaken to our core with the criminal and immoral actions taken by this agency. The Fed has been instructed to settle all US debt with their Federal Reserve Notes and then cease all operations from that point forward.

The United States of America will immediately, for the first time since the early 20th century, begin issueing it's own currency through the National Treasury, backed fully by the wealth of this great country. The United States no longer recognizes the validity of the Federal Reserve Dollar (FRD), and from this point forwad the Treasury Dollar (TD) will be our legal tender.

All US citiizens will be allowed to exchange FRD's for TD's, at an exchange rate of 100:1 up to a maximum number of 100,000 TD's. There will of course be no limit to the amount that US owned banks and businesses can exchange. This offer will end in 30 days.

In order to aid US citizens through this time of hardship, that was inflicted upon them by the Federal Reserve, and others, I am instructing all banking institutions currently covered by the FDIC to adjust all personal loans... credit card, auto, mortgage, etc.. to reflect a 10 to 1 ratio.

The US would like to extend our deepest apologies to those who have been hurt by the inept behaviour of the Federal Reserve. It is my hope that other countries will take similiar steps to restore finacial solvency for their citizens and that together we can all move forward to a brighter tomorrow. Thank you."

The Prez

 

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Re: The definitive Inflate-away vs. Default [on the Federal ...

Erik...

Isn't your post stipulating they recognize and/or understand at least to a certain point the problem/issue?

CM is correct on a vital point.  Our elected officials operate on the premise of maintaining the status quo (growing).

Two sub points...

1.)  We must evaluate how much skill there is in the arena of problem solving by elected officials and apply to your post.

Example:   Involved in a project to get more tax payer money based on a bureaucratic derived need (i.e. not a certified, proven, real request from the ground up...the public).   

2.)  One must fully grasp, understand...the government "operates" to one purpose.    Think building and developing empires.

What your proposing is a paradigm shift that they are still not operating within as the horizon of certainty (i.e. ignorance).

Based on the above...what actually unravels may be driven more by the above points...than a planned selective default.   It would not be consistent how our governmental system operates.   Look how they have handled things so far?

Essentially, are you giving our officials too much credit?

2 cents,

 

Nichoman

(Government Employee) 

 

Ken C's picture
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Re: The definitive Inflate-away vs. Default [on the Federal ...
guardia wrote:

1. some sort of gold standard because, well, inflation would be driven by excess liquidity under a non-growing economy. It would happen either naturally (gold coins, hey it'll be even easier with ultrasound scanners and what not) or endorsed by the state. (If entities start to default instead, the rate would accelerate under these conditions and destroy the currency as well I believe...)

As was pointed out by Erik it appears that the FED/Gov would like to inflate away the debt in a controlled inflation over an extended period
of time. This may not be as controllable as they would like.

a.   There is a movement afoot by several states to make gold coin legal for payment of state debts.

The support and rationale for this is U. S. Constitution Article I, Section 10, “No State shall… make any Thing but gold and silver Coin a Tender in Payment of Debts.”At this point a few states (Colorado, Indiana, Missouri, Montana, et al) have introduced such legislation but to date none have passed.

b.    Many states are considering a more forceful application of the 10th Amendment.

c    Ron Paul has introduced H.R. 4248 to allow choice of the type of money a citizen wishes to use.

       Imagine how long it would take for people to voluntarily replace FRNs with gold/silver if HR 4248 were to pass.

If one or more of these movements gains enough traction it may force the issue. People at many different levels are becoming very upset
and intolerant of what is happening. It is my guess that some "event" like this will force the government to act. I am sure that whatever "act" they decide upon will not be in the best interest of average American.

If a devaluation of 10:1 or 100:1 were to take place I suspect we would have rioting in the streets.

Just my humble opinion.

Ken

 

 

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Re: The definitive Inflate-away vs. Default [on the Federal ...

Erik,

I think there is one possibility on the table that hasn't been mentioned, even though it has a historical precedence, and is occurring right now in the American economy: Inflation in the public sector AND default in the private sector. 

The ability of the government/Fed to inflate is dependent on a functioning FRB system. Without the private sector taking on more debt, the Fed is powerless to create more money (inflation). 

More money = More debt.

But the private sector is defaulting on their debt, so the money created by the Fed does not increase the velocity of the money in circulation, it just sits in the banks.

So this economic stalemate creates a market that moves sideways from peak fear of inflation to peak fear of deflation and back again, and again, and again. The end result is that significant capital from both sides of the trade flows into the bookie's hands (the market makers).

In this economic environment, its foolish to believe in hyperinflation or a deflationary spiral, because a belief in either extreme, paralyzes you at market turning points, and there will be many market turns in our future.

Steve Keen elaborates on some of the above points in this interview, which starts at the 12:30 minute mark of the video.

(Edit: Sorry I didn't see the specifier [on Federal Debt], so my post is a little off-topic)

Nate's picture
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Re: The definitive Inflate-away vs. Default [on the Federal ...

Erik,

I've spent far too much time educating myself on these issues and far too little time preparing.  Never in the history of this planet has the nation holding the world's reserve currency gone bankrupt. Since I am lousy at predicting this nations future, preparing for different outcomes seems more fruitful.  They collapse down to the same preparation themes that CM has been sharing for the past few years.

Paid for land and independence is at the top of the list.  PM's are close behind.  Getting off the grid (not the electrical grid, but the $ grid) is tough but necessary.

My general feeling is that ownership in corporations ("stock") is not the best bet.  Kunstler is more right than wrong.

 

guardia's picture
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Re: The definitive Inflate-away vs. Default [on the Federal ...
kenc wrote:

If one or more of these movements gains enough traction it may force the issue. People at many different levels are becoming very upset
and intolerant of what is happening. It is my guess that some "event" like this will force the government to act. I am sure that whatever "act" they decide upon will not be in the best interest of average American.

If a devaluation of 10:1 or 100:1 were to take place I suspect we would have rioting in the streets.

Great, thanks for some of the details behind how this scenario might unroll in the US.. When you mean it would not be in the best interest of the average American, are you thinking about games with the dollar? Or more serious actions targeting silver, gold... ?

This makes me think about what's going on in China right now.. It's been known for a while that the government is encouraging its citizens to buy precious metals, in particular silver, since most Chinese can afford that, and it's as good a deal as gold, and maybe even better. Anyway, the other interesting thing is their Yuan right now is pegged to the US dollar, and they don't seem to want to change that.

It looks to me like China might just let the dollar AND the yuan die and is positioning itself for a possible switch to a gold/silver standard at the right opportunity... and making sure their citizens are ready for this moment.. ?

 

In any case, I am still confused as to what major differences would occur whether the government defaults or inflates.. Maybe we should start with that, and see how this would profit or hinder various parties and their interests.

guardia's picture
guardia
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Re: The definitive Inflate-away vs. Default [on the Federal ...

Oh oh, I remember what I wanted to say originally that pertains directly to this thread.. phew, got lost in the bigger picture there :)

Erik, IMO, at some point it will become obvious to all of the population that the goverment is insolvent, and I believe that will make them the first target of a default (bye bye social programs). The average guy will just "take the bullet" as they always do, for the "good cause" or whatever they can induce by propaganda.. or anyway that's what everyone assumes, right? "whatever they do can't be good for the guy on the street", not sure if anyone here would disagree with that? (I'd love to hear about a contrarian view on that one.) Once that's done with, well... who knows... They might just start a war to distract people :) We all know what happened at the end of the Great Depression... At that point, we'll have more present and clear dangers to worry about I think

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