Default Our Way Out of the Mess?

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Published : October 23rd, 2008
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Category : Market Analysis





Some commentors have referenced a guy named Karl Denninger who thinks he has a solution for the present credit mess. At the website, he says we should simply deflate housing values and have everybody with an underwater mortgage default and walk away. At the same time, those with unsecured debts that cannot repay them in the short term should declare bankruptcy. Furthermore, all the Federal Reserve and U.S. Treasury bailout and financial rescue programs should be rolled back and eliminated. Although this might have some very painful economic consequences, Mr. Denninger believes it will preserve the borrowing capacity of the U.S. Treasury, which is key to maintaining American economic might. He views the choice as pretty simple: either we let the private sector default on all debts it cannot repay or the government will eventually be dragged down and defult on all the debts it cannot repay.


While his solution is intriguing, Mr. Denninger ignores the fact that the U.S. government is the largest debtor of them all even without the bailout packages. What is the point of having the private sector default on most of its debts when the total debt of the U.S. is $60 trillion including unfunded liabilities? With a U.S. GDP of $14 trillion, the U.S. government debt is more than four times the total economic output of the nation! At an overall savings rate of 10% (including personal savings rate, corporate retained profits and government budget surpluses), it would take 40 years to fully fund the U.S. debt assuming all private savings are taxed 100%, we ignore interest payments, and there is zero new debt in the private sector. In other words, even if the U.S. government allowed a deflationary collapse of private sector debt until it effectively reached zero, and then somehow managed to maintain GDP at current levels while generating a 10% budget surplus, it would still never be able to pay off its debts in dollars at their present value. And that means its own creditworthiness will evaporate.


Indeed, my back-of-the-napkin estimate is that U.S. government debt will have to be deflated by a factor of 8-12 times over the next few years and decades in order to retain any semblance of creditworthiness. Conversely, the government debt will have to remain static in nominal terms (that means no more deficit spending) while the supply of dollars is inflated by a factor of 8-12. Either method would make debt repayment at least plausible but not necessarily probable. In particular, deflating the government debt would put tremendous pressure on the tax base and would create massive new deficits and/or a complete destruction of the U.S. as an economic, political and military power on the world stage.


The fact is that we are way beyond the point for a constructive plan or structural solution to deal with the debt problems. Perhaps 15 or 20 years ago the plan proposed by Mr. Denninger would have had a chance to succeed. At this point, however, the only option is to either (1) systematically wipe out all debts and start over, or (2) hyperinflate the money supply to the point where debt service becomes manageable in both the public and private sectors. It’s understandable that nobody wants to face this reality. Both choices are ugly.


This type of denial is similar to what I imagine is a common experience of people trapped in a burning high-rise building. Until the very last second before becoming engulfed in flames, there is always some small hope that a rescue will succeed. But once the flames are close enough, jumping out of a window becomes a preferred alternative. There is at least some exhilaration in the free fall that precedes the inevitable splat on the sidewalk below. In most cases, death comes quickly and is relatively painless. On the other hand, being burned alive is recognized universally as one of the most painful, if not the most painful, ways to perish.


Thus we should not expect that the irreversible decision to hyperinflate will come at any moment before it is absolutely necessary. There is always some hope up to the last second, no matter how remote or misplaced, that a rescue will succeed. Yet as the flames of deflation engulf the financial system and all hope fades, there will undoubtedly be that last attempt to seize destiny as the global monetary regime jumps out the nearest window.


As I mentioned a couple of days ago, Rick Ackerman has recently wondered out loud how a hyperinflationary tsunami wave would hit the markets today. In If Gold Hits $5K, Would You Sell?, he says the following:


Indeed, the coming economic collapse may not be the slow, black-hole implosion that we have long imagined, but more like a tsunami. As such, it could make the 1920s German hyperinflation, which took nearly two years to play out, seem almost leisurely in comparison. Back then, the financial world wasn’t wired like the ganglions of a central nervous system. It is now, though, and that is why the banking system, along with the global economy, could conceivably short out instantaneously in a shower of sparks.


. . .


So, what of this idea that the financial system could collapse so swiftly that even those who have been preparing for it would not have time to react appropriately? Realize that many stocks have experienced bear markets in mere days, collapsing 50% to 90% before investors knew what hit them. Some of the largest financial institutions in the world have gone belly-up just hours after “problems” surfaced in the news. Even a whole country, Iceland, has gone from being a picture of financial normalcy to bankruptcy in less than a week. It happened in Argentina as well. Could the dollar collapse with equal swiftness, laying waste to the U.S. economy in a  matter of days? You better believe it could.  After all, the dollar is already fundamentally worthless, backed by nothing more than IOUs that have swelled far beyond our ability to repay them.


You say the dollar has been soaring recently? Well, yes, it has. But that doesn’t mean it is worth anything. In fact, the dollar is valueless, and the $1 bills in your wallet are worth no more intrinscially than the $100 bills. Those who do not understand why this is so or who would argue otherwise are simply ignorant or delusional. As we explained here a couple of weeks ago, the dollar is rallying because it is caught in a short squeeze. Short-term borrowers, unable to keep rolling their loans, have been forced to settle up in cash. This has created a made scramble for cash dollars, as opposed to credit dollars. And although the Fed has attempted to keep the system liquid with unprecedented infusions of new cash, the amounts pale in comparison to a global financial deflation that has already caused tens of trillions of dollars worth of financial and real estate assets to vanish from the economy.


For more than a decade, we have argued here that a ruinous deflation was the only possible outcome when the credit system finally collapsed. Although we still think that’s where we’re headed ultimately, we now see the possibility of a hyperinflationary spike along the way that would wipe out savers but also challenge the assumptions and investment strategies of gold bugs who have been preparing for the worst.  What would you do with your ingots, krugerrands, Maple Leafs and Pandas if the price of an ounce of gold were to soar in mere days into the thousands of dollars?  Would you continue to hold them?  We think this is a very risky strategy, since the world in which you will emerge from your bullion-lined safe haven will be too broke to pay a king’s ransom for a nugget, an ingot or a coin.


I don’t necessarily believe a deflationary wipeout is imminent but I do consider it a possibility that “a hyperinflationary spike” could come along and wipe out fiat savers over the course of a few weeks or perhaps even a weekend. What would you do with your gold if that were to happen? Sell it for dollars? Buy a cave in the remote wilderness and as many guns, ammo, beans and rice as your horse-drawn buggy can carry?


Tom Szabo

24hGold - Default Our Way Out ...




Tom Szabo introduces The Metal Augmentor, which will be the detailed coverage of mining equities from junior explorers to major mining companies.


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