"Full Faith And Credit"

By Paul Nathan    May 26 2010 2:45PM

Let's talk default.  There are three ways to finance a deficit. When you spend more than you have as a government and refuse to cut government spending to bring receipts in line with expenditures, you need to go where the money is to pay your bills.  The money is in individuals hands. So, you have to tax the money needed, print the money needed, or borrow it. 

Taxation is an act of legal plunder where the government confiscates your money or sends you to prison if you refuse to pay.  Inflation is a way of stealing your money through printing up new money, which makes all existing money worth less.  However, borrowing is a voluntary act between two parties that amounts to a contract.  One party agrees to lend another party a sum certain for a specific period of time and for specific remuneration.  Of the three, borrowing is the least offensive way for governments to raise money.  It is the only non-coercive way of doing so.

Implicit in borrowing and lending money is risk.  The lenders are not assured they will get their money back.  Even with the strongest credit rating and the firmest of promises and an ironclad guarantee, creditors at times lose money.  They are defaulted on.
One reason lenders like to lend to governments is they rarely if ever default.  Or do they?

The practice of defaulting is, in fact, commonplace.  The US defaulted when it devalued the dollar against gold during the depression.  First, Franklin Roosevelt confiscated the gold of US citizens;  then he raised the price of gold, thereby devaluing the dollar.  With a stroke of the pen he wiped out the purchasing power Americans had abroad.  It then cost consumers more to import goods.  At the same time, he wiped out debt held by foreigners, leaving them with dollars and debts owed to them, worth less in dollar devalued terms
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Then there were the devaluations against the dollar after WWII.  Under the Bretton Woods system, nations agreed to keep their currencies at parity against the dollar and gold.   Competitive devaluations mounted into the hundreds during 1944 and 1971.  All were forms of default.

After WWII Russia defaulted on its debts and Europe never repaid the loans under the Marshall plan.  Most debts owed to America were written off at zero to ten cents on the dollar. And Latin America inflated their currencies into oblivion never repaying their loans in real terms, in effect, defaulting on all creditors.

So, the practice of government default is not new; in factthey have a long tradition.  What has been unthinkable -- until recently -- is that the US might default. China, our biggest creditor, I assure you, has been losing sleep thinking about this option.  The US's recent stimulative package has led to a structural deficit which is unsustainable.  Greece only serves as a reminder to all nations and creditors around the world that default is on the table for ALL debtors.

The rating agencies, which are a joke, should be downgrading US debt as we speak.  But just as they were the last to officially recognize the Greek debt problem by downgrading their debt, they will be the last to downgrade American debt.

The market is the ultimate rating agency and upgrades anddowngrades debt on a minute to minute basis.  It has recently been safer to lend to private corporations than to the US government according to market interest rates.  Although government bonds have rallied recently on a flight to safety away from Europe, it remains to be seen whether the rally will stick.  As we look into the future no one really has confidence that the government will take the measures necessary to get its financial house in order -- any government.

Raising taxes will be met with strong resistance as it becomes clear that everyone will have to pay.  As will cutting government entitlements as everyone, again, will be targeted.  Borrowing will only be a viable option, however, to the degree we employ the other two options. If you don't tax or cut, your borrowing ability is reduced.

Many are saying inflation will be the way we will default and that the fed will print money to pay off government liabilities, which will cause progressive inflation for years to come. I doubt that.  Not that Government might not have a go at it…it's just that everyone knows about it.  At the first signs of real inflation the bond market vigilantes will flee the bond market forcing interest rates to soar, as we have seen in Europe. An open inflation is very difficult to pull off. As interest rates rise suddenly and punitively, the dollar will cave, and the stock market will likely go into free fall.  An open inflation invites chaos, and a hidden inflation is virtually impossible to get away with today.

Further, the big entitlement programs are indexed to inflation.  It is Medicare and Social Security that are the largest entitlement programs and you won't be able to get rid of those unfunded liabilities through inflation since all prices and all services are tied to the cost of living.  So, Government is on the hook for all price increases and will not be able to gain much through inflating.  No, the most likely resolutions of debt will be either cuts in government spending with a little "politically acceptable" inflation and tax increases, or default.  And probably all of the above.

A calculated default may or may not be launched against foreign governments.  However, domestic defaults are a certainty.  It could come via defaults on promises to pay unfunded liabilities under present contractual agreements. Raising the retirement age under the Social Security program is a form of default. Or freezing the cost of living adjustments on Medicare and Social Security.  All arebreaches of contract.

The term "claw back" describes a process by which promises are broken, a process that’s becoming commonplace in today's world.  So, pension plans and wages may be reduced. Or, it might come in the form of not paying all pensions or even wages in a timely manner as California has done with its recent issuance of IOU's.  Or cutting days worked. Or it could come from restructuring and amortizing debt whereby creditors will not be paid as promised over time.

 For example, governments have been known to pay out the interest promised on bonds but suspend convertibility of the principal. TheEuropeans are contemplating some form of restructuring of debt but no details have been provided.  Or it could be by outright repudiation of all debt as was the case with most of the world toward the US over the last 60 years. 

As I write this, it is being reported that the Treasury is "forgiving" 1.6 billion dollars in debt owed by Chrysler to the government -- which is us folks, the American taxpayer.  Debt "forgiveness" is just a fancy word for a "back door default".  Whether private default or government default all lead to a wiping out of wealth, which adds to the forces of deflation and is anti-growth.

Yet, Congress will be voting next week to increase government spending, once again, another 190 billion dollars!  Money that we can not afford.  And remember, there is no formal budget.  They've done away with that and are spending as much as they can via the national debt extension past last year. With this kind of fiscal suicide being employed, I believe we will be hearing a lot about debt "forgiveness" in the future by all governments around the world that claim they will not default on their debts. 

And let us not forget the potential increase of Special Drawing Rights (“SDR's”) that would attempt to create reserves out of thin air and "solve debt" with more debt by amortizing old debt over a longer period of time. "Restructuring" will be the word used for this bag of tricks.

Whatever the case, calculated default is an option that will be exercised.  However uncalculated debt default is the Pandora's Box no one wants to look into.  It amounts to a breakdown of the international monetary system.  This is a possibility.  In this scenario money loses confidence and ceases to function as a medium of exchange.  Paper currencies become worthless.  This is not inflation.  This is not rising prices over time.  This is not the 1970's where inflation rose from 2% to 12% over a decade. This is a situation where all credit and debt priced in paper currencies are defaulted on; where moneyis no longer accepted for the payment of anything.  A new currency would have to be established, one that would gain the confidence of all people everywhere.  A government currency would not be viewed favorably in a world of collapsing government paper promises.  Something more tangible would be needed.  Something like gold and silver coins, perhaps?

To avoid all of these very unpleasant options will not be possible.  We as a nation will be forced to endure one or more of them over the next few years.  One thing we can do other than replace the politicians that are in power today -- in both parties -- is to get our own finances in order.  That is what this weekly commentary intends to help you do.

Paul Nathan
May 26, 2010

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Paul Nathan has specialized in gold and gold stocks and has written extensively on monetary and economic matters since 1968. He also writes a weekly blog and can be contacted at paulnathan2000@aol.com

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