Debts and US Fiscal Policy: Is There a Case for Default?

Discussion in 'Archive: The Senate Floor' started by Vaderize03, Sep 23, 2013.

  1. Vaderize03 Manager Emeritus

    Member Since:
    Oct 25, 1999
    star 5
    With the passage of the House's CR on Friday, the threat of a government shutdown has now become much more immediate and real. While much of this is obviously partisan posturing, there are major structural issues in the US economy that are getting lost in the soundbites. I would like to discuss some of them here.

    I read a very interesting article in Forbes late last week that talked about the specter of default. Its tone was one of almost casual indifference which stemmed from a single fact: the US dollar's reserve currency status. The author asserted that technically, the United States can't default because we can simply print whatever we need to cover our debts.

    Obviously, this is a very oversimplified view of the situation, as printing money to pay our bondholders and obligations will likely destroy confidence in an already-shaky US dollar. If America breaches the debt ceiling, there are several potential outcomes:

    1) The government prioritizes payments on a daily basis so that interest to bondholders goes out first, followed by Social Security, Medicare, and military pay.

    2) The President orders the Treasury department to print as much money as it needs to fulfill all US obligations on a daily basis.

    3) The President tries the "trillion-dollar platinum coin" option from 2011.

    4) The government cuts all spending necessary to halt the need to borrow 40 cents of each dollar.

    Out of the above options, I think #2 is the most likely, with the Constitutional clause of "...the validity of the debts of the United States shall not be questioned...." cited as his authority to do so. Certainly, there will be a massive fight between the President and Republicans in Congress over whether or not this is even legal, and impeachment could come up.

    Outside the politics, the consequences of such a historic event would likely have a profound psychological impact on the markets. My personal opinion is that US stock markets lose at least half their value over the 4 weeks following a breach of the debt ceiling, followed by a similar crash in bond markets as interest rates spike and large investors dump US Treasuries. Instead of being view as the global vehicle of safety, capital would flee the dollar, likely for the Euro and perhaps the yuan, both of which would now be viewed as "safe" in relation to America. As a result, the dollar will plunge in value, leading to a spike in the price of basic commodities such as food and gas. Worst case, major economies abandon the dollar completely, choosing instead to conduct commerce in an alternative currency and no longer accept dollars as a way to denominate their debts. Gold, silver, and real estate would likely become safe havens as well, given that they are "real", as opposed to "fiat" assets.

    This is of course the 'doomsday' scenario, but it is possible. What I find concerning is that amidst the unreality of Tea Party Republicans who insist that if they stand firm, the President will come around to their way of thinking, there is also a firm belief that a default will not cause harm. Indeed, many in the House GOP feel that default is the only way to get our house in order. It's very disturbing, because even if a default leads to a grand bargain, markets will have lost confidence in the US for potentially decades to come. If the worst case is realized and the dollar is dropped as the global reserve currency, Americans' standard of living would drop dramatically. At best, there would be a depression; more likely, the savings of millions will be wiped out.

    It sounds pretty bad, but I would like to hear opposing viewpoints on the subject. Would a US default be a nation-ending earthquake, or, like defibrillator pads, the shock which gets America back on track? It's likely to go down to the wire either way, but will it happen? And if it does, who will get the blame? Obama? The GOP? Both?

    Discuss.

    Peace,

    V-03
    Last edited by Vaderize03, Sep 23, 2013
  2. Saintheart Chosen One

    Member Since:
    Dec 16, 2000
    star 6
    Remember that if the US defaults on its debts outright, it won't be the first time it's happened. I think the event would look a lot like the 1971 Nixon Shock, complete with the public being fed a pack of bull about the causes of the problem and about how the government is "protecting" people by defaulting.

    I think, too, that there'd be a rude shock awaiting anyone who thought they could ride out the crisis buying gold. Executive Order 6102 proves quite clearly that the US government can and will enact seriously heavy capital controls to force people to use its worthless currency if they feel it politically expedient to do so. That goes for both sides of politics, because both of them are responsible for the appalling mess that is the US's debt levels.

    I don't think there will actually be a debt default at the initiative of the US government. The Republicans, even with the Tea Party, strike me as still too gutless to pull the trigger on raising the debt ceiling and be blamed for what follows.

    A US debt default, if it happens, will come from outside the US. I think it will come as a "last straw that breaks the camel's back" scenario. At some point, someone like George Soros will put real money on the proposition that the US will not pay its debts, or that it will pay its debts back with worthless coinage. Via shorting, it's perfectly possible to bet on a loser and still come out ahead. Because of a set of circumstances particular to that moment -- so-called "perfect storms" which are in fact detectable and need not have been perfect at all -- a few major institutions will decide the Soros of that moment has it right, and a collapse in the US's economic credibility will begin.

    But not before. People have been sounding the alarm on the US's debt levels for literally a decade or more, but markets only pay attention when there's considerable money to be made or lost on the proposition.
  3. Jabbadabbado Manager Emeritus

    Member Since:
    Mar 19, 1999
    star 7
  4. Vaderize03 Manager Emeritus

    Member Since:
    Oct 25, 1999
    star 5
    Thanks for the replies, guys.

    Capital controls are not uniquely American, although I think the government would more than happily institute them if it meant seizure of "rich people's" assetts would be made easier by such a move. Of course, there are many ways to remove wealth from the country outside the US dollar system.

    Saintheart, I think your comments are spot-on. One caveat: the main reason America's economic credibility has not reached the point of collapse is that there is as-of-yet no other viable alternative. China, despite its insistence to the world that it is ready and able to step into America's shoes, really isn't. A country with a quasi-free market and manipulated currency that in reality does a great deal of book-cooking will never stand up to (or tolerate) the scrunity that large investors will demand of its books should China try and unseat the dollar as the global reserve currency.

    A more likely scenario is China attempting to back its currency with gold. Such a move would radically strengthen the yuan, although it would also greatly harm its export capacity (not to mention vastly deflate the value of its US Treasury holdings). But if China really wished to cause America economic pain, doing just that is the way to go. The US would likely be forced into a similar maneuver to keep the dollar from plunging, and in doing so would cause a sudden, rapid deflation (especially since a gold standard is the opposite of printing money). Either way, it will be interesting to see how it plays out.

    I think Ted Cruz and the like are in the process of destroying the Tea Party's credibility. Establishment Republican senators have already said they won't go along with any of this; all that remains to be seen is how much damage they will cause on the way down.

    Peace,

    V-03
    Last edited by Vaderize03, Sep 24, 2013
  5. Jabbadabbado Manager Emeritus

    Member Since:
    Mar 19, 1999
    star 7
    Speaking of quantitative easing, I've made more money on my investments in 2013 than in any other year of my life. More than a 16% return in the first three quarters alone, and I know plenty of people who've done a whole lot better, as I've lost some return to hedging and risk management. This is happening at a time when putting money in a bank account actually makes it worth less at the end of the year.

    The extent to which this bizarre economic environment is all being propped up by QE3, and the Fed's understandable fear of "tapering", makes me more than a little bit anxious. TIME magazine calls the connection between QE3 and stock market highs "a myth" which I take as a clear counter-indicator.
  6. Vaderize03 Manager Emeritus

    Member Since:
    Oct 25, 1999
    star 5
    TIME is absolutely wrong.

    Of course there is a connection; if a savings account loses money after inflation due to artificially-depressed interest rates and "safe" bonds and CDs have negative real returns after inflation, where is there left to go?

    Stocks.

    i've also done amazingly well so far, thought not as much as last year. My investments are set up in such a way that they capture less of the upside when the bulls run, and less of the downside with the bears. Regardless, I was close to 20% last year, not completely counting the reinvestment of dividends.

    The top will come when mom-and-pop America move into stocks en masse. We'll know this when risky assets begin trading at insane valuations, like just before the dot.com and real-estate bubbles burst. We've probably got a couple of years, at least until the short-term Fed funds rate begins to rise. There will be corrections along the way (perhaps big ones once tapering starts), but the overall trajectory will iikely be up.

    But I agree with you 100%: the prices of stocks have very little to do with actual growth. Valuations are not as cheap as they were just after the crisis, but they're not insanely expensive, either. The fall, though, will be rocky.

    Time to sell some options :).

    Peace,

    V-03
  7. shinjo_jedi Force Ghost

    Member Since:
    May 21, 2002
    star 5
    This - I've never really understood some concerns over investors abandoning the dollar as the world's reserve currency. Even with all of our problems and debt, it's one of the safest financial assets in the world. What else would they go to? The euro and renminbi both have their own problems, which leaves the pound and the yen - which also have problems.
    Jedi Merkurian likes this.
  8. Vaderize03 Manager Emeritus

    Member Since:
    Oct 25, 1999
    star 5
    Exactly.

    Who here thinks America avoids a default, but not a downgrade?
    Last edited by Vaderize03, Sep 24, 2013
  9. Saintheart Chosen One

    Member Since:
    Dec 16, 2000
    star 6
    The shortest response to that is: if, at any stage, a perception is created that the US government intends on overinflating its currency to pay for its ballooning debt, that will be the point where you would rationally expect people start looking for the exits. All it requres is that the euro and/or renminbi appear less risky than an investment in a US bond all other things being equal -- not that the euro or renminbi are intrinsically better. As a very crude example, if forced to a choice between the Argentinian currency and the Zimbabwe currency around the time of Zimbabwe's hyperinflation, investors don't really care that Argentina is almost as bad a monetary basket case as Zimbabwe is with an inflation rate of 20% or so estimated; all they care about is getting somewhere that the inflation rate is lower than Zimbabwe. Or indeed to any country which leaves the perception it will not inflate its currency as much as Zimbabwe does. It also must be noted that those decisions are invariably made in a "rush for the exits" situation, because people invariably don't move quietly towards the doors ahead of a crisis.

    The US dollar being "one of the safest financial assets in the world" is predicated on one foundation: the promise that the US will not try and pay back its debts with worthless dollars in order to keep its politicians safe. Given the level of the US's debt and the lack of attempts to rein it in, and the very existence of QE 1, 2, and 3 the implications of which seem to have gone completely over the head of Joe Q. Public, I don't personally think that promise will be kept. Albeit it may take a few years before the US's politicians realise just how much theft by inflation can be committed. The economic history of the world, if not the US in recent years, is quite compelling if depressing on that: there is not a government throughout history that at one time or another has not manipulated its fiat currency to the benefit of itself and to the detriment of its citizens. The methods differ -- Constantine started with debasing the currency -- but the net effect, again and again, is the same: you cannot trust a government with a fiat currency. Not forever.
    Last edited by Saintheart, Sep 24, 2013
  10. Vaderize03 Manager Emeritus

    Member Since:
    Oct 25, 1999
    star 5
    Yep. The question then becomes: how does America get out of the mess?

    There has been talk of return to a gold standard, but as I stated in my opening post, that's a recipe for deflation that will cause political shockwaves of unparalleled magnitude. As David Frohm (?sp) once famously said: "A fiat currency is the worst possible system, except for the alternatives."

    I think, when all is said and done, "hard assets" such as real estate will end up being the storehouses of real value. Also frightening, given how much foreign ownership there is of US property.

    Peace,

    V-03
  11. shinjo_jedi Force Ghost

    Member Since:
    May 21, 2002
    star 5
    I was about to write the same quote as V-03 until I saw it. For all of the flaws and problems in a fiat currency, the gold standard is much, much worse.

    And, to save myself some technical jargon and reasoning, while the threat of overinflation/QE is a problem in the U.S., I sincerely doubt that it will ever manifest and cause a global crisis or ruin the dollar. Inflation hawks have been warning against it for decades to no avail...
  12. Saintheart Chosen One

    Member Since:
    Dec 16, 2000
    star 6
    I'm conscious of not sidetracking the debate, but that statement generally leaves out the various Free Banking Eras that have been in vogue from time to time and which compete as favourably if not better than trusting a pack of politicians with the value of your money. Particularly in the 21st century when national borders are under pressure and digital currency is not only possible but viable, I'd suspect we may well see a return to that in some form as the decades wear on. The only thing a government's currency has going for it is coercion: it can force people to accept its worthless currency in return for debts owed, and it can impose capital controls to try and prevent people from using other modes of currency. The Internet is possibly one of the greatest tools of economic freedom the world has ever known in that regard.

    Anyway, getting back to the question, a gold standard would be heavily deflationary. There is no question about that. Not to mention that nobody on the planet uses it anymore, let alone America, and a gold standard would only be viable if the US still had anything more than a pittance of gold at Fort Knox or if it revived Executive Order 6102 to thieve sufficient gold stocks off the American people to make it happen. But at the same time, if America does continue on its current course of spending without regard to ever paying back its debts, you're going to deflate eventually anyway, and it's going to be even more painful when you hit that wall than it would be to adopt a gold standard. Even so I don't think a gold standard is the solution, because ultimately it's not the problem. It's simply casting about for a form of currency that people trust sufficiently to use. Gold has good (if self-interested and overly optimistic) press going for it, and not a lot else. As it is, you don't necessarily need a gold standard. All that you need is a currency the people will trust. Austria/Germany finally created one after their misery of hyperinflation that was backed by real estate, IIRC; it came down to the fact it was a currency able to be backed such that politicians could not easily devalue it, which therefore meant business could trust it, which therefore meant it was used.

    How America solves the crisis is straightforward to my thinking. The libertarian point of view, which I have a lot of sympathy for, is that you have to cut government spending. When you get past all the bullcrap about "reform" and "sustainability", that's what it has to be in real terms. I think the popular libertarian estimate is by about 50% or so to avert the crisis, to stop the debt growing and start paying it down. (cf. Souderwan's interesting points over in the "Income Inequality" thread - the present sheer immaturity of the US people is a big reason why nobody has the guts to talk about the debt level.) Some people advocate "reforms" of the system coupled with some cutting spending to make the descent a bit less painful - the problem being that "making the descent less painful" translated into political terms is always "what will buy us more votes" or at worst "what will cause us to lose the least votes." Overall the problem is that people are addicted to entitlements from government, that their financial affairs are built on money being given to them by government. Addictions are always hard to break, and this form of addiction harder than most.

    Other places I've seen do point out that cutting spending by even a fraction would cause an unemployment spike and a recession, that the government should wait until the economy is on the upswing and then look at cutting spending and taxing higher. To an extent my reply to that is: tough. You don't keep feeding more dwindling fuel into a rocket in the hope of staving off, or because you really think, you can ignore the fact of gravity. Cutting spending invariably causes a recession. Reagan caused a recession when he ended the Carter government's inflation, for example. It's an unescapable consequence of trying to cut your debts down. But two things to that: first, if you don't start making some inroads into the debt, you're going to have to make an even harsher cut later on when you have to cut the debt, i.e. by outright default or hyperinflation; and second, monetary policy is never a single balance of unemployment vs. debt size. It is a multifaceted problem, crossing about 12 different variables. I believe all people's economic differences come down to how much we prioritise one of those variables over the others (again cf. Souderwan's "saw" about military spending: you can build something fast, cheap, or good, but at a maximum you can only have two out of three, so make your choice and live with it.)

    But never trust a politician to make the right choice or prioritise the right variable for the situation, because politicians, no matter the stripe, no matter the party, no matter what they say, are concerned about (a) what will get them past the next election and (b) what will give them more power.
  13. Vaderize03 Manager Emeritus

    Member Since:
    Oct 25, 1999
    star 5
    Sainty that's a great post. You basically laid out the two choices: cut spending and deflate, or monetize the debt (or at least try to), which will hyperinflate the currency followed by a deflation. A good analogy would be the Medicare SGR, or Sustained Growth Rate formula, which determines how to pay physicians. Every year for more than a decade it has prescribed a larger and larger cut for physicians, and every year, Congress has passed a patch. This year, there is a push for real repeal, as the CBO cut the estimate for its cost down to $130 billion or so, when in the past it has been as high as more than twice that. The longer we wait, the higher the cost, and the higher the cut.

    The cuts could be allowed to go through, but it will drive many doctors out of business. Oh, poor rich doctors, many in the public might say, until they realize that their access to health care will be gone. People just don't understand what's coming until it directly affects them. Not being able to see their physician (or get dialysis, for example; most centers will close with a 24% pay cut), will wake them up, but it will be too late.

    Peace,

    V-03
    Last edited by Vaderize03, Sep 26, 2013
  14. Vaderize03 Manager Emeritus

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    Oct 25, 1999
    star 5
  15. shinjo_jedi Force Ghost

    Member Since:
    May 21, 2002
    star 5
    Great post, although I agree with most of what you're saying I'm less skeptical of a fiat currency.

    Cutting spending in our current economic condition would only exacerbate our problems and the spending we've been forced to cut at the demand of the GOP has only hurt us. Austerity doesn't work; just look at Europe.

    And, also, the early 1980s recession was caused by Volcker raising interest rates to end inflation - not Reagan cutting spending (he raised it).
    Arawn_Fenn likes this.