Debt Repudiation

August 25, 2008 – In the last letter I questioned whether the US government is solvent. All the available financial evidence as well as some simple logic says that it is not.

The inevitable result of insolvency is debt repudiation, so an article in The Wall Street Journal on August 22^nd entitled “Washington Is Quietly Repudiating Its Debts” caught my attention. The article is particularly noteworthy given that it was written by Gerald O’Driscoll, a former Federal Reserve Bank vice president. The article was dispatched the same day by GATA, and can be read on GATA’s website at the following link: www.gata.org

It is an important article, and I recommend reading it for two main reasons. First, as is clear from its title, the article explains that “Congress, with the complicity of the White House and the Fed, has arguably embarked on a stealth repudiation” of the federal government’s debt. Quoting Adam Smith, the article notes that repudiation is inevitable once debt is “accumulated to a certain degree” and warns us that “monarchs have been repudiating debt explicitly and implicitly throughout recorded history.”

The article wonders aloud whether the US government has now reached the repudiation “threshold” and implies that it has. O’Driscoll puts it thusly: “The bond markets are certainly not protecting creditors from the risk of what Smith called ‘pretended payment’ through inflation.” In other words, anyone who owns T-bills and T-bonds is losing wealth because the rate of interest one can earn on those government debt instruments is less than the inflation rate.

The second reason for reading the article is less obvious, but just as important. The article explains something I have not been able to understand about Federal Reserve thinking. Namely, Bernanke talks about “inflationary expectations” as the means to controlling inflation. His contention seems like nonsense to me because Bernanke’s comments ignore money supply and its rate of growth. Given that inflation is always a monetary phenomenon, it is money supply and not people’s expectations that determine the rate inflation.

I’ve written before about the Fed’s focus on “inflationary expectations”. In Letter No. 408 on July 30, 2007 I analyzed a speech given by Bernanke addressing this topic. [Letter No. 408 is included with this emailing in order to provide new subscribers with the opportunity to review this article.] O’Driscoll explains Bernanke’s point of view.

“In the 1980s Ronald Reagan and Paul Volcker worked together to get inflation under control…Alan Greenspan built on the Volcker legacy and, at least in the early years of his long tenure, continued the fight against inflation…After the collapse of the dot-com bubble in 2000, and then 9/11 and its aftermath, Mr. Greenspan again relied on the Fed’s credibility to drive down the federal-funds rate to 1 percent and then hold it there for a year. This time there was a rumbling of doubts. But eventually the Fed did reverse course to preserve its inflation-fighting credentials, and briefly hiked the federal-funds rate to over 5 percent…Now Fed Chairman Ben Bernanke has decided to try for a hat trick, and spend the Fed’s reputational capital on an easy credit policy.”

So Bernanke apparently believes that he can rely on the credibility of Volcker and Greenspan to get people to believe that the Federal Reserve will keep inflation under control. Even ignoring the fact that inflation results from too much money and not from people’s expectations, Bernanke’s thinking is seriously flawed because few today think highly of Greenspan’s tenure at the Fed and even less remember what Volcker did over twenty-five years ago.

What’s even worse, as O’Driscoll notes, is that Bernanke is experimenting with his loose-money policy “under considerably more adverse circumstances than his two predecessors.” Comparing the present to what Greenspan faced, O’Driscoll notes: “Thanks to Reagan and Volcker — and the credibility he built up on his own early on — Mr. Greenspan did not face strong inflationary forces in the 1990s. But Mr. Bernanke began his easy money policy with inflation already picking up steam.”

O’Driscoll then goes on to explain that Bernanke is also facing “the accumulated effects of seven years of loose fiscal policy.” O’Driscoll rightly chastises the politicians in Washington because they have “shown themselves quite unwilling to engage in honest budgeting. The best example is saddling Fannie Mae and Freddie Mac with $500 million of new (off-budget) obligations to fund cheap housing at a time when the two companies were already on the ropes. Is it any wonder the stock prices of these two companies are imploding?

The markets have long assessed the debt of Fannie and Freddie at AAA because of the Treasury’s guarantee, now explicit. But no one has ever seriously assessed the Treasury’s creditworthiness with Fannie and Freddie on its books. The public guarantee is entirely open-ended and unbounded. The appetite of the two companies to balloon their balance sheets and take on risk has not been curtailed. Meanwhile, Congress spends apace with new programs for constituents in an election year.”

The tragedy of our present situation is that “Anyone who works, saves, and invests is exposed to confiscation of his capital and earnings through inflation“, and I might add, confiscatory taxes.

O’Driscoll is providing everyone with a wake-up call. He makes it clear that the federal government will repay its debts with inflated dollars to surreptitiously lessen the burden of its debt. However, O’Driscoll does not go far enough, and consequently fails to draw the inevitable conclusion of an inflationary monetary policy.

The following words from the great Austrian economist Ludwig von Mises describe the inevitable outcome:

“This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people … who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and … increase their cash holdings.

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time … the things which were used as money are no longer used as media of exchange. They become scrap paper.”

In other words, by accommodating the federal government and providing it with all the newly created dollars it wants, the Federal Reserve is destroying the dollar. Periodic intervention by central banks may buy some time, but it will not change the inevitable outcome of debt repudiation by inflation and the collapse of the dollar. Gold will soar as a consequence.