What Happens When the US Defaults on Its Debt?

Cat recently asked:

Now I’m curious… what happens when a country defaults on its debts? Somebody else absorbs the loss, I presume, but then what? What happens to the country?

I agree that economics must be a collision of mathematics and psychology. There are too many human players in the economy for human psychology to be ignored.

This is one area where I would you think you could tell me a thing or two. Haven’t you been in touch with a survivor of Argentina’s debt default? 

Here’s what I see happening. The US Government has, by law, declared the US Dollar to be legal tender for all debts public and private. Where the US to default on its debt, this doesn’t actually change the legal tender status of the US Dollar. Theoretically, the dollar would still be worth something, but I’m sure that a debt default would bring down the entire currency. The reason being that the other nations of the world have been piling into US Dollar denominated debt in order to seek a safe haven during this crisis. US Treasuries are deemed the safest form of this debt for no other reason than the US owns a printing press and can just print all the money it needs to pay off its bonds. 

Were the US Government to default on its Treasury bonds, then the other nations of the world would no longer view the dollar as a safe haven and would instead take their remaining assets out of dollar denominated bonds and instead put them into some other safe-haven: perhaps bonds denominated in Euros or, perhaps, into gold. Who knows where they will put their assets, but an exodus out of the dollar is all but guaranteed. Given that there are trillions of dollars of US Dollar denominated debt that aren’t US Treasuries, you’d see the value of the dollar plunge as these bonds were sold off as investors began fleeing. That would make imports very expensive for Americans; everything from television sets to cars to the oil to run them would surge in value. 

In essence, a default on US Treasuries would spell the end of the value of the dollar. The US Government would probably just try again with a new currency, but suddenly we would no longer be able to expect the rest of the world to loan our government money. That would mean that the government would have to be present itself to investors as a good credit risk and the investors would need to be fairly compensated for the risk they would assume with higher interest rates. Gone would be the days where the Federal Reserve can lower interest rates just because it feels that US economy needs an extra jolt. Interest rates would now be determined by foreign investors. It would spell the end of America as a super power and, for the vast majority of Americans, be the end of acting like a wealthy nation. 

Of course, why would the US ever default on its Treasuries? After all, it owns a printing press. It could theoretically print up some trillion dollar bills and pay off all of its bonds tomorrow. Of course, the US monetary system doesn’t work like that. As I explained in an earlier blog, the US Government has been content to hand the keys to its printing press over to its central bank. So in reality, the Federal Reserve would “monetize” however many US Treasuries it needed to by creating the money to buy them. Either way, the result is the same; money was created out of nothing and given to the US Government. The only difference is that one would appear as a loan from the Federal Reserve whereas the other would be the government printing money outright. 

It won’t take investors long to figure out that there’s really no difference between those two realities. In fact, Japanese economist Akio Mikuni recently told the nation of Japan that they should just write off the value of their US Treasuries because there was no conceivable way that the Americans would ever make them good. So people are starting to wake up to what’s going on. More and more people will awaken to what’s going on the longer Obama and Bernanke continue their campaign of trillion dollar deficits at zero percent interest. As the printing presses run day and night to bail out everyone from Wall Street banks, to automotive companies, to US mortgage holders, people will realize where the money’s coming from.

We will witness the collapse of the US Dollar in our lifetime, and probably within the next decade. It will spell the end of American life as we know it. We will no longer be an empire dictating world events going on halfway around the world, but instead a broke nation hoping to present a good credit risk to foreign investors who might want to  build a factory here. If we’re smart, we will rebuild this nation the same way previous generations did: by making much, spending little, and trying to avoid getting involved in any wars. We will have completed F.A. Hayek’s Road to Serfdom, and we will have to begin the hard work of rebuilding what we once took for granted.