What bankruptcy of the U.S. might look like
by John T. Reed

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Since the subprime crisis hit, I have been reading books about the Great Depression, the subprime crisis, Long Term Capital Management’s failure, the 2008 crash, Bear Stearns, J.P. Morgan, bailouts, stimulus, earmarks, and all that. I have also sought out local speeches about those things in San Francisco at the Commonwealth Club and TV expert discussions on Charlie Rose and similar shows.

Singapore leader Lee Kuan Yew was on Charlie Rose the last week in October, 2009. Very impressive, seemingly extremely knowledgeable guy.

Bond and forex traders

Based on everything I’ve read and heard and seen, I think Yew’s prediction is the correct one. He said or seemed to say that the bankruptcy of America will start with bond and forex (foreign exchange or foreign currencies) traders making a run on the dollar. Bond traders and forex traders are like the canary in the mine. They watch the U.S. fiscal and monetary policy with microscopes and telescopes 24/7. They will be the first to herald the arrival of the financial apocalypse.

What will bring us to the tipping point? Either an accumulation of straws on the camels back in the form of one media story after another, one new law after another, one new entitlement after another

or

some major shocking event, like a downgrade of U.S. credit by some international authority; hyperinflation, something like that.

When will it happen? I’m not sure. Maybe tomorrow. Maybe next year. Maybe five years from now.

Can we escape this fate? In theory, yes. But as a practical matter, no. There is not the slightest indication that the Congress or the president will behave prudently. Obama is worse than his predecessors, but his predecessors going back to Roosevelt the second were all disasters to one degree or another.

Panic

Normally, the phrase “run on the” ends with the word “bank.” Yew spoke of a run on the dollar.

In both cases, it means the public wants their money out of there. In a run on the bank, they lose faith in the bank and want to get their money out before the bank fails and they lose money.

That used to happen in the U.S. before the FDIC was created on 1/1/1934. Since then, deposits are covered up to $250,000 per account per bank with many rules about how many accounts one can be covered for.

A run on the dollar

A run on the dollar would be caused by people in the U.S. and other countries losing faith in the U.S. government’s willingness to get their national debt and unfunded liabilities under control.

If the debt and unfunded liabilities continue to explode, informed people expect that the Federal Reserve will be forced to print huge amounts of money. That causes inflation and hyperinflation.

Yew said if the U.S. government does not convince the world bond and forex markets that the U.S. government debt and unfunded liabilities intends to control it's fiscal policy, there will be a run on the dollar. He seemed to shudder or wince at the thought of a run on the dollar and said it would be very bad or words to that effect.

What that would mean

A run on the dollar would mean that all the people of the world including U.S. citizens would decide the dollar was going to inflate big time. That means the purchasing power of the dollar would fall significantly, maybe to zero, as it has in the past in

Angola 1991-1995
Argentina 1975-1991
Austria 1921-1922
Belarus 1994-2002
Bolivia 1984-1986
Bosnia-Herzegovina 1993
Brazil 1986-1994
Bulgaria 1996
Chile 1971-1973
China 1948-1949
Danzig 1923
Georgia 1994
Germany 1920-1923
Greece 1944
Hungary 1945-1946
Israel 1971-1986
Japan 1943-1951
Krajina 1993
Madagascar 2004-2005
Mozambique 1977-1992
Nicaragua 1987-1990
Peru 1988-1990
Philippines 1942-1945
Poland 1989-1991
Romania 2000-2004
Russia 1921-1922
Turkey 1990-2005
Ukraine 1993-1995
United States 1861-1865
1916-1920
1969-1982
Yugoslavia 1989-1994
Zaire 1989-1996

This is research I did for my forthcoming book on protecting yourself from inflation, hyperinflation, and deflation.

As you can see, there were three bouts of inflation in the U.S.: during the Civil War (both sides); just before, during and after World War I; and in the 1970s after the Vietnam War. There was also severe inflation technically before the U.S. existed during our Revolutionary War (“not worth a Continental”). There was also on-again-off-again inflation (and federal price controls) during and after World War II.

So don’t say it can’t happen here. It already has and it can again.

When hyperinflation occurs, as with the Revolutionary War “Continental” and Confederate dollars and the German mark in the early 1920s, the currency in question simply ceases to exist. That is, it becomes worthless. Obviously, no one wants to still be holding that currency when that happens. They want to get out before it goes that far. Hyperinflation is a form of Ponzi Scheme. If a Ponzi Scheme “victim” manages to withdraws their money before it collapses, they typically make a lot of money. But if they are still there when the music stops, they lose everything.

That’s how hyperinflation works.

If and when the people of the world conclude there is a danger that the U.S. will inflate the dollar significantly, they will get rid of dollars.

Currency and bonds

You get rid of dollars by trading them for other currencies or goods and/or services. Dollars take the form of actual currency, bank accounts, certificates of deposits, U.S. bonds, and contracts payable in dollars.

You’ve heard of the deficit—deficit spending. But do you know what it means? It means the government is spending more than it takes in in tax revenues. So where do the get the extra money?

They sell U.S. bonds. Who buys them? U.S. citizens and organizations and foreign governments and organizations and individuals.

A run on the dollar would mean among other things that:

A. No one bids at the next U.S. bond auction
B. Owners of U.S. bonds sell the ones they already own so they can put the money in something other than dollar-denominated bonds or accounts

As a practical matter, what would actually happen is that the U.S. Federal Reserve bank would buy all the bonds offered at the auction. This is what goes by the phrase “printing money.” When the Federal Reserve buys U.S. bonds, they are doing one of the things that is technically the equivalent of printing money. The Federal Reserve buying the bonds puts that much into the bank accounts of the federal government. That increases the money supply by that much. That causes inflation.

Indeed, there is a vicious spiral. Fear of dollar inflation causes people to refuse to buy U.S. bonds that they fear will lose purchasing power because of inflation. The government reacts by printing even more money which causes inflation to get even worse which cause more people to try to sell the U.S. bonds they already own which causes the Federal Reserve to buy those bonds because no one else will and so on.

To keep on deficit spending, the U.S. would either have to “print” money (Federal Reserve buying U.S. bonds) or the U.S. would have to pay higher interest rates on the new bonds to attract enough bond buyers. That would be awful because it would mean they would have to raise taxes or cut benefits even more to pay the new higher interest rates on U.S. bonds. Also, higher interest rates on U.S. bonds, would mean even higher interest rates on all other types of bonds or loans including mortgages, car loans, education loans, business loans, and so on. That, in turn, would drive down the values of all capital assets like cars, houses, factories, nd so on.

U.S. imports

We got lots of stuff cheap. Probably most of the clothes you are now wearing were made outside the U.S. Ditto your TV, car, and so on.

What happens if people in other countries no longer trust the dollar? They will tell you to pay for your flat screen TV or underwear or imported car in yen or euros or yuan or whatever currency they trust. So you have to exchange your dollars for other currencies to get the money to buy your imports. But the forex dealers aren’t much more interested in your dollars than anyone else. So you will have to pay a lot more dollars than in the past to buy, say, yen.

My youngest son and I went to London, Paris, and Rome in May, 2008. The dollar amount for purchases that were cheap in the U.S. were brutal. What Yew fears would be a lot worse.

U.S. exports

In theory, U.S. exports would be greatly helped by the value of the dollar falling in relation to other currencies. It would make our stuff cheaper overseas. But as a practical matter, those countries are used to exporting to the U.S. not importing from it. Losing those exports would lose many jobs and cause very unhappy people in those countries. Their politicians might react the way they often do when we pass tariffs that hurt their exports to us. That is, they might slap retaliatory tariffs on our exports to them to placate their unemployed workers and force their citizens to buy from manufacturers within their own countries.

Inflation not enough

The U.S. government has five choices for fixing the excess debt:

• monetize the debt (use inflation to make it easier to collect more taxes and easier to make payments on debt not indexed to inflation)
• cut spending, mainly social security, Medicare, and Medicaid
• raise taxes (not really much of a possibility because the amounts needed are about three times current total tax revenues)
• economic growth that increases tax revenues
• default on the debt

Economic growth, is of course, the most pleasant choice, although the rate of growth needed would have to be almost unprecedented and for an unprecedented period. But the bigger problem is Democrats are now in charge and they hate all pro-growth measures, namely:

• reduction of top tax rates
• elimination of dubious environmental restrictions
• free trade (elimination of tariffs like the “Buy American” part of the Stimulus or the tariffs on Chinese Tires)
• increase in the percentage of the economy that is controlled by entrepreneurs
• strongest possible rewards for innovation
• drill for oil and dig for other minerals in U.S.
• end detrimental restrictions on business like zoning, rent control, permits
• tort reform

and so on. See my longer article on a miracle growth program that would cost the American taxpayers almost nothing.

Default is arguably the best alternative

Crazy as it sounds, default may be the best choice. It eliminates the need to raise taxes. It does not monetize all debts. So private debts would still be payable and the lenders not cheated by inflation. Default would hurt all owners of U.S. bonds, but generally, they can afford it better than the wider group that would be hurt by inflation. Many people own U.S. bonds without knowing it via pensions and mutual funds.

What would be the consequences of default?

Probably all the other countries would promptly do the same. Why be a chump? Why not retaliate against the country(ies) that did that to them?

What about future deficit spending? There would not be any.

Why not? Because governments have to sell bonds to engage in deficit spending and no one would buy government bonds after a default.

Essentially, the previously no-limit credit cards of the President and Congress would be terminated and cut up into little pieces. They would have to pay all cash—that is, tax revenues—for all government spending.

Our children and grandchildren would not be stuck with an impossible debt. Neither would they live in a country with good credit.

Government spending, mainly Medicare, Medicaid, and Social Security would have to be cut drastically—probably means tested, that is, affluent and middle class people get no money from the government. What about the fact that you paid into it?

Tough.

They would also have to cut things like government employees, government employee pensions, government employee health care benefits, earmarks, boondoggles, government buildings, etc..

The budget would look like it did in, say, 1927—percentage and deficit-wise, not counting the effects of 82 years of inflation since then. We had a budget surplus that year. Our government spending was a bit less than total tax revenues.

Would the government not being able to deficit spend be the end of the world? Actually, that’s more or less the way all 50 states have always had to operate. They could issue bonds, but not too many. They recently did issue too many such bonds in CA and other states. The bond rating agencies downgraded them and that was, roughly speaking, the end of their deficit spending.

Let me repeat one part of this. If we defaulted on the national debt, our Congress and President would be henceforth prohibited from spending more than they collect in tax revenues.

As Martha Stewart likes to say,

That would be a good thing.

Actually, compared to what’s been going on since 1930 (Hoover Administration), it would be a fantastic, unbelievable improvement.

Most of all, it would keep the barefaced-lie promise that we are not going to “kick the can down the road” or “put a bunch of debt on the backs of our children and grandchildren.” In fact, “kicking the can down the road” and mortgaging the futures of our children and grandchildren is exactly what we have been doing since 1930. The authors of The Coming Generational Storm rightly call it fiscal child abuse.

Defaulting is not the right thing to do. The right thing to do is to broaden the tax base, adopt pro-growth policies, and drastically cut entitlements. However, there is absolutely no hope that Congress or the president will do the right thing. Nowadays, Represenative democracy attracts to Congress and the White House a collection of sociopaths. Normal people like you and I would never run for Congress or president in a million years. The people who will in the 21st century are psychiatrically defective. We need to default to stop those sickos from making things even worse.

Defaulting would force the voters and politicians responsible for that misbehavior, us and our parents who are still alive, to pay for it right now.

Rough justice.

Disaster only way to get ‘change we can believe in’

On page 246 of their 2005 book The Coming Generatonal Storm, authors Kotlikoff and Burns put it this way:

Truth be told, our politicians care more about their next fix—the next election—than they do about the next generation. And they’re not going to clean up their act unless and until they are confronted with a major crisis. Hence, as crazy as it sounds, our only real hope is that the economy will go critical sooner rather than later.

I would add, if that’s where we’re going, and there seems no doubt of that, let’s get it over with—save the nine stitches.

The best way to push the economy off the cliff ASAP is probably Obama’s current quartet of health care, cap and trade, protectionism, and increasing taxes on “the rich.” They are likely to be the anvil on the camel’s back.