Saturday, July 23, 2011

Default now or suffer a more expensive crisis later

In an oped piece posted in Bloomberg, Congressman Ron Paul once again outlines the common sense argument over US debt that is so poignant.

In strict terms, the US will default if America fails to meet its debt obligations, through failure to pay either interest or principal due a bondholder.

To avoid this, there is a giant push to raise the debt ceiling.  The other way of avoiding it is to make massive spending cuts.  America is bringing in roughly $1 Trillion in tax revenue and needs to borrow an additional $1.9 Trillion to cover all expenses.  To avoid raising the debt ceiling, America would have to institute massive spending cuts.

In his OpEd piece, Ron Paul notes that there are numerous claims that a default on Aug. 2 is unprecedented and will result in calamity (never mind that this is simply an arbitrary date, easily changed, marking a congressional recess). 

Paul notes that the U.S. government defaulted at least three times on its obligations during the 20th century;
  • In 1934, the government banned ownership of gold and eliminated the right to exchange gold certificates for gold coins. It then immediately revalued gold from $20.67 per troy ounce to $35, thus devaluing the dollar holdings of all Americans by 40%
  • From 1934 to 1968, the federal government continued to issue and redeem silver certificates, notes that circulated as legal tender that could be redeemed for silver coins or silver bars. In 1968, Congress unilaterally reneged on this obligation, too.
  • From 1934 to 1971, foreign governments were permitted by the U.S. government to exchange their dollars for gold through the gold window. In 1971, President Richard Nixon severed this final link between the dollar and gold by closing the gold window, thus in effect defaulting once again on a debt obligation of the U.S. government.
Paul goes on to describe how these moves freed the US government to now spend unlimited amounts of money because they were no longer constrained by any sort of commodity backing; the only check on its spending being the market’s appetite for Treasury debt.
  • "Despite the defaults in 1934, 1968 and 1971, world markets have been only too willing to purchase Treasury debt and thereby fund the government’s deficit spending. If these major defaults didn’t result in decreased investor appetite for U.S. obligations, I see no reason why defaulting on a small amount of debt this August would cause any major changes.  The national debt now stands at just over $14 trillion, while net total liabilities are estimated at over $200 trillion. The government is insolvent, as there is no way that this massive sum of liabilities can ever be paid off. Successive Congresses and administrations have shown absolutely no restraint when it comes to the budget process, and the idea that either of the two parties is serious about getting our fiscal house in order is laughable."
Paul quotes the Austrian School’s theory of the business cycle that describes how loose central bank monetary policy causes booms and busts:

Loose monetary policy drives down interest rates below the market rate, lowering the cost of borrowing; encourages malinvestment; and causes economic miscalculation as resources are diverted from the highest value use as reflected in true consumer preferences.

Loose monetary policy caused the dot-com bubble and the housing bubble, and now is causing the government debt bubble.

Paul zero's in on how, for far too long, the Federal Reserve’s monetary policy and quantitative easing have kept interest rates artificially low, enabling the government to drastically increase its spending by funding its profligacy through new debt whose service costs were lower than they otherwise would have been.
  • "Neither Republicans nor Democrats sought to end this gravy train, with one party prioritizing war spending and the other prioritizing welfare spending, and with both supporting both types of spending. But now, with the end of the second round of quantitative easing, the federal funds rate at the zero bound, and the debt limit maxed out, Congress finds itself in a real quandary."
And it's that quandary which has America at it's most important crossroads since the Civil War.
  • "Unless major changes are made today, the U.S. will default on its debt sooner or later, and it is certainly preferable that it be sooner rather than later. If the government defaults on its debt now, the consequences undoubtedly will be painful in the short term. The loss of its AAA rating will raise the cost of issuing new debt, but this is not altogether a bad thing. Higher borrowing costs will ensure that the government cannot continue the same old spending policies. Budgets will have to be brought into balance (as the cost of servicing debt will be so expensive as to preclude future debt financing of government operations), so hopefully, in the long term, the government will return to sound financial footing."
By raising the debt ceiling all America does is postpone the inevitable. Increasing the debt ceiling allows the US to keep spending.  Since there is no way the money can be paid back, it means default is simply kicked down the road.

More spending will mean more money printing. A future default won’t take the form of a missed payment, but rather will come through hyperinflation.
  • "The already incestuous relationship between the Federal Reserve and the Treasury will grow even closer as the Fed begins to purchase debt directly from the Treasury and monetizes debt on a scale that makes QE2 look like a drop in the bucket. Imagine the societal breakdown of Weimar Germany, but in a country five times as large. That is what we face if we do not come to terms with our debt problem immediately."
Paul notes that default will be painful, but it is all but inevitable for a country as heavily indebted as the U.S.

The past 40 years have clearly shown that pumping money into the system to combat a recession only ensures an unsustainable economic boom and a future recession worse than the first.
  • "And continuously raising the debt ceiling only forestall the day of reckoning and ensure that, when it comes, it will be cataclysmic. We have a choice: default now and take our medicine, or put it off as long as possible, when the effects will be much worse."
Wise words.

But the path of action has already been chosen. And without titanic resolve, there won't be a deviation from that path.

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  1. +1
    debt ceiling

    "I’ve described the typical American as follows (exaggerating for effect,of course): He has $1,000 in the bank, owes $10,000 on his credit card, makes $20,000 ayear after tax, and spends $22,000. And what do lenders do about this? They mail himadditional credit cards"

    if you think growth is in the cards your insane. This is going to get very ugly and the budget cuts coming are a wakeup call.

    gold and silver is the way to go

  2. The attached link is to an interview with Dr Michael Hudson a university economist. He describes how since Sept 2008 $13T has been created out of thin air for bailouts of various entities, yet the government now can't find a trillion, over 50 years, to support medicare and social security. He says the current budget drama is nothing more than a charade and that Obama supports an end to medicare and social security.

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  4. that is correct. they are using Medicare and Social security right now to keep things running. they might have one more kick but they will be forced very soon to cut spending drastically and that is when things unfortunately are going to get ugly.

    Sorry if I'm pushing this on you whisperer but this stuff is just flying in my inbox and people are really getting worried. Just heard a rumour that one large bank across the pond defaulted on a bond issue so things are fluid.

    Steve Keen's

    This is the basis of a Ponzi Scheme, and it is also why the Scheme must eventually fail. Because it relies not merely on growing debt, but accelerating debt, ultimately that acceleration must end—because otherwise debt would become infinite. When the acceleration of debt ceases, asset prices collapse.

    if you have had enough just give me a shout and I will stop the relay. I thing gold long term is a very good hedge unless they outlaw it.

  5. I lost a lot of respect for Garth Turner when he called Ron Paul a "whack job". I think Ron Paul is one of the few that really get it.