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.

An American Christmas Carol; Part III; A Ghost of America’s Future

So where will all of this lead? Should we believe the Chairman of the Federal Reserve when he says that his policy of lowering interest rates should ease us through this crisis? Or, perhaps we should believe our new President who’s promising to make the economy his top priority and, through a combination of stimulus and bailouts, guide America back to the path of prosperity? And even if they are right in the short-term, and we do make it out of this recession — what is the ultimate path that our nation is on? Where is it heading?

The thing is, no one really needs to ask. You already know. It’s uncommon that I meet someone who doesn’t seem to know that:

  • Our country is broke and only the kindness of strangers keeps it from being bankrupt
  • We are losing our competitive edge to overseas competition
  • That we are an empire in decline

And so you don’t have to ask me where our country is going to end up. It’s obvious to any who dare ask the question and ponder the answer with any amount of objectivity. We are going to witness a collapse of our currency and, possibly with it, the corrupt body that serves as our government. We may not revolt and overthrow the government; perhaps we will only revolt against the taxes it levies as it tries to keep itself afloat for just a little while longer. But right now, the whole apparatus of the US Government is made to spend other people’s money in large quantities: the lobbyists are there to ask for it; the politicians usually got there to begin with on the backs of campaign promises to spend money; the Federal Reserve is there to create it; and the Congress is there to spend it.

Once the magic fountain of being able to print unlimited quantities of the world’s reserve currency has ended, we are left with a very different picture. If the government is to spend money, it must borrow, raise or print it. Given that we will have all but exhausted the printing and borrowing option, we will be left with a situation where money spent must come from current revenue. In other words, every dollar spent by the government must first come from someone else.

In that scenario, I doubt that politicians will get elected on platforms of how much money they’re going to spent to try and improve the economy. People will inherently understand the absurdity of that statement; money spent by the government to benefit the economy must first be removed from the economy. Thus, I think it highly possible that the government will be forced to suddenly discover frugality not soon after the voters pay more attention to their representatives actions and start holding them accountable. The entire scenario would reflect a far different kind of government functioning than we see today, and a better one.

Henry Hazlitt wrote a novel entitled Time Will Run Back that featured characters in a fully Socialist society “rediscovering the wheel” of capitalism and implementing it to improve their society, and I would love to think that this would happen. Perhaps after completing The Road to Serfdom as outlined by Hayek, we will once again heed the words of Jefferson who wrote:

I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.

It would indeed be a shame that Jefferson had the answers to all of these questions back when our nation was founded, but that we chose not to listen.

At any rate, our near term future is very dark for those of us who are not prepared for it. For the majority of America’s citizens this will serve as a rude awakening. They will discover that borrowing for the purposes of consuming is second only to war in terms of its economic destruction. I am sure that by that time we will have had our fill of both war and borrowing to consume, but this newfound austerity will be a forced one. Like many empires before us, we will stop attempting to conquer because we can no longer afford to support an army capable of the attempt. Like many peoples before, we will discover that we were not really entitled to the wealth of the world as we had deluded ourselves into believing.

The specifics of the future are impossible to predict, but I am sure that It will prove a very harsh awakening.

An American Christmas Carol: Part II; A Ghost of America’s Present

Today, we are a people that would best be characterized as sheep. Having taken control of our money as well as the most important functions of our Government, the banking sector is fulfilling its traditional role in support of it by creating all the money it wants to spend. The two major political parties of our nation have lost any meaningful distinction, and both favor a strong central government that oversees most areas of American life underneath layers of bureaucracy. They only differ in terms of how that power should be used: Republicans favoring the traditional fascist agenda of allowing government to work closely with large corporations to enhance their profits, while leveraging the military to open up and further expand the influence of both. Democrats favor using the power of government to reallocate wealth and correct for the errors of a free market. Both seek to expand government powers that were never granted by the US Constitution to begin with.

Instead of being outraged at the continual depredation of the American Government and way of life by moneyed powers and power-hungry politicians, Americans look to television to tell them what they should care about and how they should feel. Television serves to do little but distract them from what’s going on around them; even the news channels do little outside of featuring infotainment designed to titillate our infuriate its viewers regarding some contrived controversy epitomized by Fox News’ “War on Christmas.” And so Americans have come to look at politics much as they do sporting events: they have the team they’re rooting for and sympathize with, and the opposition they love to hate. They don’t seem to care whether the party sticks to its principles or not. Sometimes they don’t even know what those principles are.

In the midst of these sheep, the banking industry is content to make itself the power behind the curtain. Let Americans look to their government for guidance; they’re happy to just keep creating the money and lending it at interest for all of our ridiculous wants.

And why shouldn’t they? It’s not their money, after all. It’s ours.

The US Dollar is our obligation, and the bonds we take out to finance the whole circus are our childrens’. Why should the banking industry care if we spend it frivolously? It didn’t cost them anything — and they’re happy to make the interest.

At every turn in American political life, the banking industry is there to guide us. And, when it turns out that they’ve loaned Americans money they can’t afford to pay, they’re ever quick to exert their influence with Washington politicians to receive a bailout — courtesy of the tax payers, of course.

The game bankers play reminds me a bit of how parents pacify children; they know that children have short attention spans and a primitive understanding of the world, and so are happy to play on both in order to mold their behavior towards the parent’s own ends. And so it is with bankers and the American people: bankers know that Americans’ eyes roll into the back of their heads when they mention interest rates or the mathematical models of Keynes and his almighty multiplier effect, so they make what they’re doing artificially complicated as to purposefully misdirect everyone away from the obvious scam being perpetrated against us. And when they need to translate it out of economistspeak and into ordinary terms, they always do so with the most dire of warnings: Ben Bernanke himself told Congress that if they did not act to save the economy this week, that there might not be one to save come Monday. Of course, there was, but people were still scared enough to grant the Treasury and the Federal Reserve additional powers.

This can only go on for so long before we lose our prosperity and complete, in the words of FA Hayek’s book, The Road to Serfdom. And here we are, at the end of the road. Looking to our shepherds for guidance as we face a crisis that they previously promised us would never happen. Today our shepherd is Barack Obama and the Democratic party, and they are convinced that they can spend enough money to stimulate us out of the hole that naturally resulted from all the previous efforts at stimulus. As if to somehow show solidarity with Socialism, Dick Cheney recently scolded Congress for not bailing out the auto industry.

And so, we again are ready to rally around the leader and follow whatever plan he outlines to get us out of these dark times. We march forth, not really understanding the problem we are facing, but determined to do our best to fix it anyhow. Ben Bernanke has said that we have to lower the value of our money in order for us to beat this recession, and he has offered to do that for us by creating money out of nothing and loaning it out until interest rates fall to absolutely nothing. I’m sure that the average American feels somewhat suspicious of that course of action, just as they were somewhat suspicious of the Wall Street bailout, but they figure that the middle of a crisis is no time to question the orders being handed down. If the plan is to devalue the dollar, then here we go:

Printing presses: maximum warp!

This can only lead to one inevitable destination. We’ll look at that in the final installment of this series, when visited by the Ghost of America’s Future. Until next time.