Blog Post: Can a country default on its debts? Can the US?

[Higgenbotham]

Gold Standards can be inflated as well. It's happened many times. The government simply recalls the coins and dilutes the gold or silver with copper or something else.

I believe the British used tally sticks prior to the gold standard. I can't remember the sources, but it lasted 6 centuries (longer than any other currency in the history of civilization). Which goes to show that anything can be used as currency.

I can't find any evidence to indicate that happened during the period leading up to the South Sea Bubble.

http://en.wikipedia.org/wiki/Guinea_(British_coin)

However, besides debasement, all that's needed to create a rip roaring inflation on a gold standard is to find more gold. I don't know enough about this to say, but it's possible that some of the bubbles that were blown in the 1700s and 1800s were fed by gold discoveries and then collapsed of their own dead weight while the gold was still rolling out of the mines. The 1850s US could be one example.

[Higgenbotham]

That's why I find iTulip.com's "kapoom" theory convincing: first a period of disinflation because of the credit collapse ("ka") then huge inflation ("poom") as the newly printed money takes effect.

Ka-Poom Theory says that the ultimate outcome of this political conundrum problem is built into the structure of the foreign debt itself: if only the US can get its foreign creditors to start selling US debt, the dollar will weaken on global currency markets as dollars are exchanged for domestic creditors’ currencies. The weaker dollar deflates the foreign debt. The more the dollar deflates, the more the debt deflates. Of course, US interest rates and inflation rise to compensate new borrowers, but that increases domestic saving while the domestic inflation deflates the domestic debt, both private (household and business) and public (local and state government). The political question is, in this scenario, which savers are losing? Remember, savers lose when debt is written off, either explicitly or via inflation. The answer is that in inflation, all savers lose. Politically, inflation is a tax on all savers to pay all creditors, but the creditors pay, too, by loss of purchasing power of debts collected. The political advantages of inflation in a debt deflation crisis are obvious: savers and creditors share the pain, and to accomplish it all the government has to do is continue to do what it is already doing, without changing course. That is the basis of Ka-Poom Theory, the first theory of inflation, but not hyperinflation, as an outcome of the credit bubble.

http://www.itulip.com/forums/showthread ... #post72798

There are a couple recent articles about some of this. One is in a blog by Brad Setser where he estimates Chinese holdings of agencies and treasuries. Even though the US government guaranteed the agencies, the ChInese still dumped off $200 billion of them at the end of last year and bought treasuries. They have another $400 billion left. He points to another article in the online Wall Street Journal that discusses China's shock and dismay last year upon learning that they could lose money in US assets. Apparently, the Chinese leadership didn't believe they could. They even had a few billion in the Reserve money market fund that broke the buck and got it out in the nick of time. The article describes the process by which the Chinese leaders have become very risk averse in the past few months. Apparently, they received a lot of criticism from within their country on what was perceived to be unnecessary risk taking. The same thing happened in Russia.

From what I can gather, the US would like to up the ante and get the Chinese to strengthen their currency by selling dollars as outlined above. That's what I think Geithner was talking about that created all the flap recently. The US would like to see this happen, but it doesn't appear the Chinese are going to go along with it. I can't see why the Chinese would want to strengthen their currency and kill of their export market at this juncture.

In a sense, that's what makes all of this politically impossible. I believe that's what John has been referring to, but everyone correct me if I am wrong here or about any of this other stuff. What I see is that the Chinese leadership is perceived by their citizens to have been reckless by buying up some less than secure US debt in the form of agency debt, Lehman bonds, Reserve money market funds, etc., and they want that money in safe and secure treasuries.

That big chart he shows further down in the article is swaps and guarantees. Mostly, it's holes that they are trying to fill in the banks, money market funds, etc., because the debt has been purged out or become illiquid. Really, all he needs to do is look at the increase in government debt and then offset that by what the banking system has written off, written down, or should have written down but hasn't yet.

If anyone sees anything different I'd sure like to hear it.

[tobyguy]

WinMark
I entirely agree that on the gold standard, the sort of crisis we are undergoing would result in deflation.
Mark

We have experienced credit inflation rather than money inflation. Deflation occurs because of too much credit (exactly what we have seen in the last 20+ years, and at alarming rates over the last 8 years or so). Monetary policy has allowed this to happen by allowing banks to have virtually no reserves (lending out all of it's money) and setting interest rates at historically low levels to encourage that borrowing. Also, credit has grown well beyond the actual supply of money.

With all these bailouts, the government is just printing more IOU's, not money. And it's your tax money that will end up paying those IOU's. Once (if) the Bond market figures out/looses faith with the treasury (or the ability of the US tax payer to pay back those loans), that's when the house of cards will/may fall. A collapsing bond market is deflation as it is a contraction of the outstanding credit supply. Printing money will have the same effect regardless - more on that below.

But if the choice is between inflation, which reduces the value of their holdings, and default... I wager they would prefer inflation to a default every time.
Mark

You give people to much credit arguing they'd behave rational. Haven't we all learned about fear/panic the last year or so and how "fundamentals" or rational thinking goes out the window in such times?

Holders of dollar denominated debt (eg. treasuries or anything else), when fear/panic sets in, will get rid of those dollar denomianted assets in a flash - leading to a contraction of the outstanding credit supply - which is deflation. Arguably, this would aggravate deflation, not relieve it. Fear/panic can sets in because borrowers may fear hyperinflation lay ahead and/or the eventual depreciation of their dollar denominated assets. Who's going to stick around in those assets to find out? The net result of attempting to inflate the system would be a reduction of total credit extended - which again is deflation.

The current situation is a perfect illustration of that. Rather than let these bankrupt financial institutions collapse, the Fed has stepped in with unprecedented levels of newly-created money to support them. Obama and the Democrats plan to spend like mad, on a trillion-dollar scale.
Mark

The fed hasn't stepped in with newly-created money. Money is not the same thing as credit. They are just printing more IOU's

Also, you argue that Treasury bondholders do not want inflation. I agree they don't. But if the choice is between inflation, which reduces the value of their holdings, and default, which completely ELIMINATES their holdings, I wager they would prefer inflation to a default every time.
Mark

Whichever it is, when the market decides either is about to happen, these people will get out in a hurry (since they are all in dollar denominations), leading to even more deflation.

That being said, eventually currency inflation will kick in, but it'll be long after deflation has run it's course.

Tobyguy

[John]

> You argue that the U.S. couldn't inflate the dollar supply because
> all those people holding dollars would be angered. What about all
> the people holding the Treasuries that would be defaulted on? You
> don't think there'd be some focused anger there?

Devaluing the currency would also devalue the Treasuries anyway.
Devaluing long-term Treasuries could be done by international
agreement. Devaluing the currency would force all other countries to
devalue their currency equally, since the dollar is the international
reserve currency.

> I cannot foresee a situation where the Fed would sit by as new
> Treasuries were offered, and not bought up, and do nothing so that
> the debt has to be defaulted upon.

A similar thing happened to Germany in 1931.

> And printing is a much more politically pallatable option than
> default. Printing can be done gradually, relatively quietly. No
> single great printing event need alert people to trouble.

I assume you're joking.

> A year or two ago we exchanged some emails where I predicted that
> because there is no real sense of fiscal restraint or respect for
> real capitalism and the free market's price signals left in our
> government, the government's response to the approaching fiscal
> crisis would be to bail out and nationalize companies and
> industries left and right. You ridiculed that idea, saying the
> government would never nationalize. Well that's just what's
> happened on a trillion dollar scale. And they're not done yet.

You're using "nationalize" in some ideological sense. The federal
government has not nationalized anything, and will not do so. Neither
Democrats nor Republicans believe that politicians can run a car
company or a bank. Also, the UK nationalization of Northern Rock has
taught everyone that nationalization does not good.

> But let me offer one more thought: a default would be the RIGHT
> thing to do. It would preserve the purchasing power of the dollars
> in the accounts of the savers and retirees. A bankrupt entity,
> whether government or business SHOULD have to default. But that's
> not what will happen. The easy way out is to quantitative easing,
> and the easy way is virtually always the way that is chosen by
> government.

You miss the point. Quantitative easing will not prevent deflation,
and it will not prevent default. The bubble is too huge.

Sincerely,

John

[John]

Hey guys, this stuff about the gold standard and "fiat currency" is
totally irrelevant. It literally has absolutely nothing to do with
the situation.

First, if a country wants to inflate its currency, it just does so.
If it's on a gold standard, it just raises the price of gold, or it
refuses to convert currency to gold. FDR did both. Inflating the
currency is a political decision, and a "gold standard" is no more
relevant than whether or not it's raining.

Second, the gold standard hasn't had much meaning for centuries,
when it controlled the amount of paper currency.

Today, paper currency is a small amount of the money available.
Money is created through credit. Money can be created by any
financial institution, public or private, and the government has no
control over that.

Third, when we're talking about generational bubbles and panics, the
amount of currency is not the issue.

The issue is SECURITIZATION OF DEBT. This is a process that's
completely unrelated to the amount of currency. I wrote about this
in

** The bubble that broke the world
** http://www.generationaldynamics.com/cgi ... rett071009

• The 1637 Tulipomania bubble was based on a market in tulip
  futures, securitized with personal credit notes.
• The 1721 South Sea Bubble was securitized by shares of the South
  Sea company, a company operating in South America.
• The 1789-1795 bankruptcy of the French monarchy was securitized
  by "assignats," bills of credit based on lands confiscated from the
  clergy.
• The Panic of 1857 was securitized by railway shares.
• The 1929 Wall Street crash was securitized by stock shares. But
  Garrett's book gives us another dimension: it was also securitized by
  bonds from well over 100 foreign countries.
• Today, the bubble was securitized by mortgage-backed securities,
  credit default swaps, and dozens of other structured finance
  vehicles. The notional value is estimated to be $1 quadrillion.

You have to focus on these securities, since their notional value is
always many orders of magnitude greater than the amount of currency.
When the bubble bursts, these securities become worthless, but debts
remain, resulting in a deflationary spiral. The printing presses
cannot turn fast enough to make up for the worthless securities.

In today's world, the above argument applies to only ONE currency -
the US dollar - because all of those structured finance vehicles were
written in dollars.

You have to focus on these securities to make sense of what's going
on. The other stuff is just details.

Sincerely,

John

[JLak]

The issue is SECURITIZATION OF DEBT.

Okay, so the unraveling occurs over the term of the debt, right? Do you know what expiration curve looks like; how far it goes out for instance? You've stated that we are just at the beginning. I don't doubt that, but is there a quantitative way to show that?
Also, just a comment: The federal budget will increase to $4.5T with this new 'stimulus' bill. If the GDP deflates to 1999 levels, that's half of our economy. This amounts to a totalitarianism because the GDP is increased by the federal budget times the monetary velocity and a velocity of two is a 50% expenditure rate - basic subsistence only.

[tobyguy]

The issue is SECURITIZATION OF DEBT.

Okay, so the unraveling occurs over the term of the debt, right? Do you know what expiration curve looks like; how far it goes out for instance? You've stated that we are just at the beginning. I don't doubt that, but is there a quantitative way to show that?
Also, just a comment: The federal budget will increase to $4.5T with this new 'stimulus' bill. If the GDP deflates to 1999 levels, that's half of our economy. This amounts to a totalitarianism because the GDP is increased by the federal budget times the monetary velocity and a velocity of two is a 50% expenditure rate - basic subsistence only.

Unraveling occurs when they can no longer service (pay) the debt.

That time is now and possibly extended to over the next few years. It will get worse and worse as people continue to loose their jobs, corporations fail, banks fail to lend out of fear and the public stop wanting to borrow (our of fear as well).

PS. The tipping point will likely not be some date when a whole bunch of debt is due, but rather a panic at some point well ahead of that time due to fear of default (or something like that).

Tobyguy

[Higgenbotham]

First, if a country wants to inflate its currency, it just does so.
If it's on a gold standard, it just raises the price of gold, or it
refuses to convert currency to gold. FDR did both. Inflating the
currency is a political decision, and a "gold standard" is no more
relevant than whether or not it's raining.

Some writings indicate that the US inflated its currency in the late 1920s, as there were more gold redeemable currency notes outstanding than gold in storage to cover them. When the Europeans withdrew the gold in the early 1930s that would have exacerbated the situation. I believe the currency had already been inflated and FDR was acknowledging the reality that had existed for some time.

All credit is built off of the money base and the more the money base is inflated, the greater the bubble that can be generated. The distinction in my mind is one of speed and scale. By speed, I mean the speed of response to any systemic crisis to feed liquidity in and continue to grow the bubble. By scale, I mean the fact that speed of response allows a bubble to grow larger. A fiat money system allows for greater speed and scale, meaning the Central Bank can extend the bubble longer and grow the bubble larger than can be done on a gold standard. There are a number of factors besides whether the money base is gold or fiat that are greater determining factors. The most important in my mind is the leverage employed. The leverage employed by hedge funds, for example, was more than 100 to 1 in some instances. Banks employ leverage of about 10 to 1; therefore, it can be seen that the introduction of hedge funds and the failure to regulate them was a bigger contributor to the bubble than whether the base money was gold or fiat.

A relevant note on this--a headline from yesterday said something to the effect that Geithner is saying speed of response is critical at this juncture. There are limits and the bigger the bubble gets, the faster it leaks when it does start leaking, and the faster the authorities have to move to grow it bigger until finally there comes a time when they cannot move fast enough.

[tobyguy]

A relevant note on this--a headline from yesterday said something to the effect that Geithner is saying speed of response is critical at this juncture. There are limits and the bigger the bubble gets, the faster it leaks when it does start leaking, and the faster the authorities have to move to grow it bigger until finally there comes a time when they cannot move fast enough.

To bad he doesn't realize that such a window has long past.

Also, how can they move fast enough when they never even saw it coming, and only saw it long after it was too late.

Tobyguy

[Higgenbotham]

To bad he doesn't realize that such a window has long past.

Also, how can they move fast enough when they never even saw it coming, and only saw it long after it was too late.

Tobyguy

Off topic but, you know, Geithner was criticized because he didn't pay some Federal taxes. And I thought to myself, what a dummy, I can file my own taxes and do them right. About that time, here comes a letter from a state I've never lived in saying I didn't file a required tax return in that state and some income taxes are owed on a property I sold in 2004 (in that state). Turns out they were right and Geithner and I have something in common--neither one of us knows how to file our own tax returns. This anecdote also shows how the states are beating the bushes for revenue--the guy from the tax office even volunteered to do my return and I gladly took him up on his offer.