“Bankruptcy 1995” Revisited

In 1992 a book entitled “Bankruptcy 1995: The Coming Collapse of America and How to Stop It” hit the nation by storm. Written by Harry Figgie, a prominent businessman who had built a Fortune 500 company, and Gerald Swanson, an economics professor with expertise in public finance, it forecast that the US federal government would go bankrupt in 1995 and default.

The default would arise from a currency[i] collapse. Each lender to the federal government might receive back the same number of dollars they had loaned, but those dollars would have considerably less purchasing power[ii], and possibly none at all, making them worthless. So US Treasury debt instruments would have little or no value because they are denominated in dollars, the purchasing power of which would be decimated by hyperinflation.

Obviously it hasn’t happened. Even though the dollar subsequently experienced some horrific swoons and its purchasing power continues to erode, it has endured, but we should not ignore this book’s conclusions.

Two Key Assumptions Underlying “Bankruptcy 1995”

The logic of the authors’ analysis was faultless, but it was built on two assumptions, one of which turned out to be wrong. The first correctly inferred that the federal government’s debt would continue to increase, which at the time they wrote it had done every year since 1969. This ignominious annual streak of new indebtedness remains unbroken to this day.

The incorrect assumption was that interest rates would remain high and even increase. This interest rate outcome would occur because of the federal government’s growing debt load. The authors naturally expected that lenders would require higher interest rates to compensate them as the risk of default grew as a direct result of the growing debt burden.

The authors did not, however, anticipate that the Federal Reserve would force interest rates to unnaturally low levels. They did not – nor did anyone else – expect to endure what we now call “financial repression”, but forcing interest rates lower was only part of the repression.

The federal government also had to convince the purchasers who bought its debt that everyone was getting a fair deal. In other words, not only did the federal government need to lower interest rates, it needed to make the inflation rate look low too.[iii] In this way, real interest rates – the nominal interest rate less the purported inflation rate – would show a positive return to the lender. After all, lenders expect as a matter of course to gain purchasing power when lending their dollars to compensate them for putting them at risk while foregoing until the future the purchasing power it represents.

Clearly, it was going to be a Herculean task to convince lenders – and indeed, the ‘market’ – that inflation was not as bad as people were experiencing from their everyday purchases. But it was a task that had to be undertaken to postpone the projected 1995 bankruptcy and currency collapse.

So the federal government formed the “Advisory Commission to Study the Consumer Price Index”. It of course concluded that inflation was not as bad as everyone believed. Even though the federal government in the early 1980s had already changed the calculation of the CPI to report an inflation rate that was lower than the true rate at which the purchasing power of the dollar was being eroded, it did so again[iv].

This pernicious sleight of hand by the government significantly distorted the means to perform accurate economic calculation with the result that for decades, precious accumulated capital earned from hard work has been misallocated and wasted on countless follies. What’s more, currency debasement has taken purchasing power out of the hands of savers and diminished the value of one’s wages. Even if the amount of the wage increased, “keeping up with inflation” requires cost of living adjustments above the CPI. [v]

The federal government’s fiddling with its calculation of the dollar’s inflation rate is without a doubt the biggest swindle of all-time. The result has been increasing friction across the US and throughout all levels of society. As Lenin correctly observed, to destroy society you simply debauch the currency.[vi]

I have presented this background information purposefully in order to ask the following question. What if “Bankruptcy 1995” was written twenty-five years too early?

Looking at “Bankruptcy 1995” in the Current Environment

Financial repression has enabled the federal government to avoid a total collapse of the dollar even while adding more debt year after year. It has managed to attract purchasers to its debt instruments notwithstanding the stealth annual erosion of the lenders’ purchasing power.

Nevertheless, while the federal government’s powers to influence may be vast, it has not changed the laws of finance. Debt must be serviced with a fair rate of interest.

If not, lenders will eventually move their wealth – which in the case of currency is properly expressed as “purchasing power” – out of dollars into tangible assets like gold, silver and commodities, or perhaps even into Bitcoin or other currencies perceived to offer an acceptable level of safety.

Recognising that a currency’s purchasing power is a function of both the supply of and demand for the currency, the ensuing fallout arising from a collapse in demand for the dollar could lead to the dollar’s collapse and the federal government’s bankruptcy. Let’s look at the numbers and draw some conclusions.

The columns in the following table contain:

A – Total debt of the federal government[vii]; 2018 is from its February 2018 budget forecast for the 2018 fiscal year ending September 2018

B – Average debt: calculated as (2018 debt + 2017 debt)/2; used for the interest rate calculation in column D

C – Total interest expense paid; year 2018 is calculated (see D)

D – Column C/column B; 2018 is 7.14% higher than 2017 (2.30% * 1.0714) based on actual results for the first four months of this current fiscal year

E – Total revenue of the federal government; 2018 is from its February 2018 budget

F – Column C/column F; the Solvency Ratio, which is the federal government’s interest expense expressed as percent of its revenue

In September 2018 the federal debt by the government’s own projection will be 27.7 times greater than 1977. Yet federal revenue for fiscal year 2018 will be only 10.5 times greater than 1977, the implication of which is obvious. When debt grows faster than income, the risk of becoming over-leveraged from too much debt increases.[viii]

The key piece of data in the above table is column F. It is the federal government’s Solvency Ratio, which is a measure of its ability to meet its debt obligations.

The Solvency Ratio reached a peak just before “Bankruptcy 1995” appeared, when interest expense paid by the government on its debt was more than 25%, which likely was the proximate cause for the authors to write and publish their book.

They were correct to focus on the relationship of interest expense to revenue. Historical experience in various countries has shown that when this ratio reaches 30%, hyperinflation follows and often as quickly as six to twelve months. Thus, 30% can be seen as a critical “Tipping Point”, which when exceeded leads to hyperinflation.

The Importance of the Tipping Point

Every useful good or service is subject to supply and demand, the interaction of which determines an item’s price. Any nation’s currency is no different, except the result of its supply/demand interaction is called purchasing power, not price.

So for example, if the supply of currency (i.e., the quantity of units in circulation) remains unchanged and demand for that currency falls, its purchasing power will also fall. Similarly, if the supply of currency increases while demand remains unchanged, its purchasing power will again fall. We today generally label this decline in purchasing power as “inflation”, which clearly can result from changes in the currency’s supply, demand or both.

If the currency’s purchasing power falls far enough and does so quickly, hyperinflation results. Two well-known examples are Germany in 1923 and Argentina in 2001. In the former, hyperinflation occurred because of a rapid increase in the quantity of marks, which then led to a collapse in demand for the currency.

In contrast, in Argentina the quantity of pesos declined because of bank failures and government imposed restrictions, which caused demand for the peso to decline even more rapidly than its supply. Hyperinflation again was the result.

From these examples we can see the overriding role that demand plays. In effect, hyperinflation is a “flight from currency”. Hyperinflation results when the demand for the currency collapses. Fearful for the loss of their purchasing power, fewer and fewer people want to hold the currency, so they spend it or exchange it increasingly quickly for other currencies, which brings us to the importance of the Tipping Point.

As the Tipping Point rises above 20% and approaches 30%, demand for the currency declines. This decline occurs because historical experience shows that the currency is on the road to hyperinflation. So to be cautious, watchful observers start selling the currency and thereby move their purchasing power into other currencies or other forms of wealth to seek safety. Some, like the authors of “Bankruptcy 1995”, sound the alarm, further contributing to the decline in demand for the currency.

When the Tipping Point exceeds 30%, recognition of the government’s financial stress begins to spread with the result that the decline in demand for the currency begins to accelerate. That acceleration creates the inevitable flight from currency and ultimately leads to the collapse of the currency and hyperinflation.

The Vicious Cycle That Creates Hyperinflation

As the government’s debt grows, its interest expense burden grows too, unless interest rates decline enough to keep the amount of gross interest relatively stable, like occurred in the above table since the mid-1990s. But growth in debt without declining interest rates perforce must result in a rising interest expense burden. This outcome puts the currency on the road to hyperinflation.

The hyperinflation results from the same insidious process seen time and again. The government does not generate enough revenue to meet its spending aspirations, including the obligation to service its debt. Rather than cut back on spending, it issues more debt.

In normal circumstances, investors purchase the debt, but at some point, demand from investors is satiated. The government then relies upon the banking system to act as a backstop and purchase the debt not taken up by investors.[ix]

As one would expect, different outcomes result from these two different purchasers. Investors do not turn government debt into currency; only banks can do that. Central banks turn government debt into cash-currency, i.e., the paper banknotes that circulate hand-to-hand, which was manifested in the German hyperinflation.

Commercial banks create deposit-currency, which circulates by check, plastic cards, wire transfers and the like through the banking system. As the saying goes, banks create “dollars out of thin air”. Through the magic of bank accounting, a bank purchasing government debt credits the government’s checking account with newly created amounts of currency that the government then spends, which is the process that created the Argentine hyperinflation.

Regardless which of the two types of hyperinflation occurs, they both start when investors are unable or unwilling to purchase more government debt, which results in growing government reliance upon the banking system to give the government the newly created currency that it then spends. Whether cash-currency or deposit-currency, the banks turn government debt into currency the government needs to meet its expenses and keep its head above water, i.e., to maintain the appearance that the government is solvent.

In this way, the government, with the assistance of banks, creates a never-ending vicious cycle of currency debasement when it is borrowing just to meet its ongoing expenses, including paying interest on its ever-growing debt. As the debt grows, interest rates rise, resulting in a greater annual interest expense payment to lenders and an even larger annual deficit, which in turn requires more debt and higher interest rates, thereby repeating the cycle until it invariably spirals out of control in a hyperinflationary currency collapse.

Borrowing to meet operating expenses is never a good idea. A worse idea is borrowing to meet interest payments on existing debt. These bad ideas when applied to government finance are the worst result because government’s today control the process of creating currency. Consequently, they use banks to turn government debt into circulating currency, and when done without end, the government inevitably creates a vicious cycle during which everyone suffers because it leads to hyperinflation and the collapse of the currency.

Watch the Solvency Ratio

The Solvency Ratio highlights the risk of this currency creating process, and the Tipping Point flashes a warning signal when the process is about to result in the vicious cycle leading to hyperinflation.

Ominously, the Solvency Ratio has been rising since reaching a low of 12.4% in 2015. I project that it will be at least 15.3% this fiscal year, but could be higher if interest rates rise further this year[x], as most people now expect.

A Solvency Ratio of 15% or even 20% may not seem worrying, but it can change rapidly. Because the federal government is over-leveraged, its Solvency Ratio is extremely sensitive to rising interest rates and/or a drop in revenue.

For example, if the interest rate paid by the federal government were to double to 4.92%, which is still low by historical standards, the Solvency Ratio would be 30.7%. The Tipping Point would be reached even when assuming that the federal government does not borrow more than it is forecasting, which maybe unlikely because knowledgeable observers are forecasting the return of trillion dollar annual increases in the federal government’s debt.[xi]

As the talk of trillion dollar deficits becomes increasingly widespread, new assessments are also being made to analyse the impact on government revenue from the recent tax cut. Further, its revenue may also fall short of projections if there is a reduction of economic activity from rising interest rates.

Federal government bankruptcy could be swift. To paraphrase Ernest Hemingway, bankruptcy is first gradual and then sudden. The gradual part has been happening for decades, which leads one to ponder whether the sudden part is about to begin.

Conclusion

The Federal Reserve recognises that market forces have finally begun to overpower the financial repression that has forced interest rates lower. To keep these powerful market forces at bay, it has reacted with gradual interest rate increases and a lot of jawboning, hoping that federal revenue grows rapidly enough to keep the Solvency Ratio from reaching the Tipping Point.  But the Federal Reserve is “behind the curve”.

I remember this phrase very well from the 1970s. Interest rates kept rising, but the Federal Reserve never caught up with the worsening inflation until Paul Volcker became Federal Reserve chairman. He raised interest rates high enough so that the real interest rate reached a record level to re-establish demand for the dollar, which slowed the rate at which its purchasing power was being eroded. That’s not going to happen this time around.

When Mr Volcker raised interest rates to those extremely high levels back in the late 1970s and early 1980s, the US was the world’s largest creditor nation. Now it is the world’s largest debtor nation, so the current Federal Reserve chairman, Jerome Powell, does not have the same options that were available to Mr Volcker. The federal government today is over-leveraged with a huge debt load. The Tipping Point would be reached in any Volcker-like attempt to foster demand for the dollar by raising interest rates to even normal levels, let alone record real interest rates. So what is the federal government going to do?

It is unlikely that the federal government will give up willingly its power to create currency and return to a Constitutional dollar, which is defined as 13.714 grains of fine gold. It will not cut back on government spending nor learn from the lessons of history. As a direct result of the federal government’s boundless propensity to spend the currency the banks create for it out of thin air, the dollar is on the same path taken many times by many countries that incurred economic collapse as a result of the currency’s collapse.

Forcing interest rates to artificially low levels and underreporting the true rate of inflation for decades together have kept the federal government’s Solvency Ratio under control. But abuse of financial principles and irresponsible self-indulgent behaviour does not last forever. There always are consequences.

The dollar will hyperinflate. Like every other fiat currency before it, the dollar will end in the fiat currency graveyard.

[i] I do not use the word “money” in this report. Money today is widely misunderstood. There are goods. There are services. Then there is money, which JP Morgan defined in 1912: “Money is gold, and nothing else.” See:

https://www.goldmoney.com/research/goldmoney-insights/what-did-jp-morgan-mean

There are also money-substitutes that purportedly have ‘value’. I purposefully use the apostrophes to indicate that the value of money-substitutes may be temporary or fleeting because their usefulness arises from impermanent circumstances, e.g., cigarettes as currency in post-war Germany, government edicts regarding fiat currencies, etc. The US dollar, British pound, euro and other national currencies are money-substitutes, as are Bitcoin and the other cryptocurrencies, which are called that for a reason; they are not cryptomoney. Money is often confused with “currency”. This arises when money is mistakenly defined as “a medium of exchange, unit of account and store of value”. These are features of currency, and either money or money-substitutes can circulate as currency.

[ii] Purchasing power expresses the value of a currency, and is measured by the amount of goods, services or other currencies that it can buy. Consequently, when it comes to measuring wealth or undertaking other tasks requiring economic calculation, it is important to think in terms of purchasing power rather than using the unit of any national currency, all of which lose purchasing power over time because of their debasement from central bank policies.

[iii] It is worthwhile noting that to attain these two objectives – lower US dollar interest rates and to mislead people about the true inflation rate – the federal government needed to also suppress gold interest rates, which results in its suppressing of the gold price. This result occurs because gold is removed from central bank vaults (without being publicly reported) and loaned at artificially low rates to borrowers, who in turn sell the metal for dollars or other currencies. If gold interest rates were allowed to rise above US dollar interest rates, gold would be in backwardation with the future price of gold less than its current price, which is impossible in unfettered markets. When gold is backwardated against the dollar, it implies that gold is more risky than dollars, which of course is not a natural result because the purchasing power of dollars can be inflated away until it disappears altogether. That outcome is an impossibility for gold, which over 5,000 years has proven useful in preserving purchasing power, notwithstanding the relatively small cyclical swings up and down in gold’s purchasing power.

[iv] For more discussion on this point, see the following article by ShadowStats: http://www.shadowstats.com/article/no-438-public-comment-on-inflation-measurement

[v] Inflation adjustments to wages are typically made in arrears. Thus, a wage earner may suffer from inflation for one or even more years before receiving an adjustment, which itself is based on the inaccurate Consumer Price Index. It is only over time that workers sense that they have become less well off from the erosion of the dollar’s purchasing power.

[vi] In “The Economic Consequences of the Peace”, John Maynard Keynes wrote: “Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth.”

https://www.maynardkeynes.org/keynes-quotes.html

[vii] Total debt is Gross Debt and not Net Debt, which the federal government defines as Total Debt less the amount of federal government debt held by the federal government in trust accounts for Social Security and other purposes. Given that debt is a real obligation and not an abstract concept, by using these two different labels for its debt obligations the federal government obfuscates the amount of debt it owes. It also downplays its true debt load by repeatedly referring to Net Debt in its reports to the public, which are then dutifully picked up and unquestioningly relayed by the mainstream media.

[viii] Keep in mind that this debt total does not include the federal government’s contingent liabilities, which are those potential liabilities that may arise from the outcome of future events. Its contingent liabilities have been reasonably estimated to exceed $100 trillion, which is more than 5-times the size of the reported federal government debt.

[ix] The exception to this rule is Germany. Having learned well the lessons of hyperinflation and having suffered the consequences of a currency collapse, the Bundesbank is not obligated to purchase any German government debt.

[x] See: “Powell hints that the Fed will raise interest rates 4 times in 2018”

https://finance.yahoo.com/news/powell-hints-fed-will-raise-interest-rates-4-times-2018-160936735.html

[xi] See for example: “The US’s national debt spiked $1 trillion in less than 6 months”

http://www.businessinsider.com/us-national-debt-spiked-1-trillion-in-less-than-6-months-2018-2?IR=T