State of play in Q32012: Fed and U.S. government policy is not enough to offset deflation

The U.S. national debt cannot be “inflated away” using typical policy tools, inflation is not possible without the government taking “extreme” measures, deflation remains the greatest threat and most government action will at best only cause stagflation.

U.S. national debt

In discussing the U.S. debt situation, it is first important to set the table.

U.S. GDP: $15.2 trillion
U.S. Federal Debt (hereafter referred to as federal debt): $16.0 trillion (as of September 2012)
U.S. Federal Public Debt: $11.0 trillion

The difference between the two debt figures is intragovernmental debt, such as the Social Security “trust fund.” Just looking at these numbers, we see that debt now exceeds GDP. This means if U.S. debt grows 1%, the economy must grow 1% just to keep the debt/GDP ratio constant. Currently, the U.S. is struggling to achieve 2% GDP growth and has a budget deficit of about 8% of GDP. It also means that if interest rates are 5%, the government must collect 5% of GDP in taxes just to pay interest on the debt. Historically, the federal government has collected about 20% of GDP. Put these two facts together, and the U.S. is only a few years away from debt levels that will bankrupt the government, should interest rates rise. (Japan, with government debt at more than 200% of GDP, is a disaster waiting to happen.)

The public debt number represents all the bonds held by everything from central banks to the individual investor. The rest is owed to government agencies, mainly Social Security. As the Social Security trust fund depletes in the next decade, Congress will not have the money to redeem those bonds, so it will issue new bonds to the public, basically rolling those bonds into the public debt column. In other words, it will eventually become public debt. Legally, Congress could change the Social Security program at any time and if it wanted to, it could effectively cancel out that debt and cut benefits, but that would require a politically unpopular and improbable act.

U.S. Federal Spending: $3.6 trillion
U.S. Federal Revenue: $2.3 trillion
U.S. Budget Deficit: $1.3 trillion (FY2012 through July 2012)

The budget deficit is more than 8% of GDP. That means if GDP does not grow by 8%, the debt/GDP ratio will get worse every year this large deficit remains (and despite rosy forecasts, it probably will remain). If you remember the deficit debates of the late 1980s and 1990s, there is no comparison, back then deficits that were 3% of GDP sparked outrage. Also, in the 1990s, the economy grew much faster than deficits and debt was shrinking as a percentage of GDP, even before the Republican Congress and Bill Clinton compromised and slowed federal spending growth. We are now in the opposite situation, where the growth of debt is reaching the point of escape velocity once compound interest takes over. When the government reaches the point of issuing bonds to pay interest, it will be game over.

Excessive debt slows growth

A widely cited statistic from a paper by Kenneth Rogoff and Carmen Reinhart, (whose book on government debt titled, “This Time Is Different: Eight Centuries of Financial Folly” examines the history of government debt and has made them two of the most sought after experts on the topic) says that when governemnt debt-to-GDP ratios reach 90%, GDP slows by about 1%. (Source: Growth in a Time of Debt) Some critics challenge this stat, but debt-to-GDP is now over 100% and growing at 8%-plus per annum. I think its a reasonable to assume it is now a drag on growth.

This is important because some budget control plans (specifically the widely referenced Ryan plan) assume stronger GDP growth. The longer the U.S. runs large deficits, the harder it will be to get back to 3% growth and the worse the situation becomes. At some point, the deficit reaches an unsustainable level and the government cannot slow its growth.

When will the debt become unsustainable?

The debt would be unsustainable once debt-to-GDP was high enough that interest payments consumed a large portion of government revenues. The Treasury provides us with a total interest rate on Treasury debt (Average Interest Rates on U.S. Treasury Securities), currently 2.65% (less than half the interest rate from 2001). Budgeted interest expense was $251 billion, or 6% of spending, plus non-cash interest of $203 billion for the Social Security Trust Fund, for a total of $454 billion. Far from unsustainable today, but that assumes rates stay low.

However, as we've seen with Greece and other indebted countries, once investors believe the debt is unsustainable, it is unsustainable. Collapse comes swiftly because interest rates rise rapidly. Interest rates are currently low and appear as though they'll stay that way for a few more years; and foreign governments and central banks will likely continue to support the U.S. dollar and U.S. Treasury market, allowing Uncle Sam more time to get the situation under control. Still, as the Social Security trust fund depletes and that debt goes on the books, cash interest expenses will rise (it would be above 10% of the budget today). If interest rates doubled (not difficult from such low levels) and the debt continues to grow, interest expense could quickly become 25% of the budget.

Can the deficit be cut?

Look again at the deficit and federal spending: the deficit is close to 40% of the budget. Social Security, Medicare and defense make up about 60% of spending. Had the tea partiers won in August 2011 and stopped the debt ceiling from increasing, the government would have had to immediately cut 40% of spending―and if it refused to touch these three large programs, the rest of the government would face an almost total shutdown.

The obvious area to cut is the wars in Afghanistan and Iraq, but even President Obama believes these are important (and in his acceptance speech at the 2012 Democratic Convention, he said he wants to spend the savings). The passage of Obamacare means that, even if the wars did end, most of those savings and probably more than 100% of it, would be spent on healthcare. Furthermore, Medicare and Social Security are growing as a percentage of the budget and will grow to 100% within a few decades: simply put, unless defense, Social Security and Medicare are cut, the budget cannot be balanced. Rising interest costs on the debt will mean even deeper cuts are needed.

To put the entitlement liability into numbers, the present value of the future liabilities (if all existing programs continue unchanged) is estimated at $120 trillion, a truly impossible number. Massive cuts are coming to entitlements no matter what: they can either come early and help balance the budget, or they will come later when the government goes broke.

Also, with a high and rising debt-to-GDP ratio, the U.S. is beyond the point at which GDP growth alone can close the budget deficit.

But wait, there's more

Thus far I've only spoken about the U.S. government. What about the private sector? Total credit in the United States is about $55 trillion: The private sector has debt of almost $40 trillion, while state, local and federal government combine for more than $14 trillion (this figure uses the federal public debt number). Even if there was no federal debt, private sector debt is unsustainable and requires deleveraging because it is about 250% of GDP. This is the total of all consumer debt, mortgages, banking sector debt, etc, as shown in the chart below.

The private sector began deleveraging in 2008, as the following chart shows. Debt is being destroyed, either through repayment or default―a lot was defaulted on by banks in 2008. Many homeowners defaulted on their mortgages or credit card debt. Since 2009, much of the deleveraging has happened because people slowly repay their debt over time (each monthly mortgage payment is for interest and principal) and they have not been taking out new debt.

In contrast, federal deficit spending has offset the deleveraging in the private sector, helping push total credit market debt up about $1 trillion since 2008, to $54.6 trillion. If the federal government did not offset this deleveraging, economic growth would have been negative over this period.

Put another way, the bulk of the deleveraging took place in 2008 and 2009―the crisis―and this was stopped by massive federal government and Federal Reserve intervention. The financial sector still needs to repay or default on trillions upon trillions in debt and that's why the risk of a crash is constantly in the background―if it happens in a “disorderly” manner, we get 2008 again.

Were the U.S. federal deficit small, it could continue replacing the private sector debt, moving private debt onto the public balance sheet as it did with the savings & loan crisis at the end of the 1980s. Instead, the federal debt is already hitting unsustainable levels.

Here we reach the ultimate dilemma, the Hobson's choice. On one side is Scylla, a rising U.S. federal budget deficit that slows the economy and eventually leads to national bankruptcy. On the other is Charybdis, a contracting economy that is being propped up by deficit spending, the ending of which will plunge the nation into deep recession. There is no good choice here, the is no painless way out, there is only the choice of pain today or more pain tomorrow.

Here's a look at the historical trend in debt by sector:

Inflate it away

Hang on, critics say, there is a solution: inflation. If the money depreciates, the debt becomes smaller. For example, if inflation is 5% and real GDP growth is 2%, then the nominal GDP (inflation plus real growth) will be about 7%. That nominal growth will bring in tax revenue, lower the debt-to-GDP ratio, and the situation will quickly go back to what we saw in the 1990s, where rising revenue and slowing spending can quickly stabilize and even reverse the deficit.

It'd be great if things were that simple, but we live in a more complex world. In the first place, as noted above, most of the future deficit is entitlements―spending that adjusts for inflation and will rise sharply due to changing demographics. Parts of the federal budget will rise as fast as the CPI and inflation does nothing to address those costs. Alan Auerbach, an econ professor at the University of California, Berkeley, estimates 90% of the budget would increase along with inflation because future government spending is almost 100% entitlements. If entitlements were reformed by delinking them from inflation, then it would be easier to implement an inflation policy―but no one is talking about ending cost of living adjustments because that would be the end of their political career.

Inflation also requires trapped investors. A 30-year Treasury bond worth $1,000 today at 3% interest will decline in value by about 50% if interest rates climbed to 8%, because the money investors receive back 30-years hence will be greatly devalued. The problem here is that investors (including foreign central banks) don't want to hold 30-year bonds, they are increasingly holding short-term bonds of 2 years or less.

The federal government likes a short-term debt structure because it hides the cost of the deficit through lower interest rates. However, this not only makes inflating near impossible (since the government constantly has to issue new bonds), it is also extremely dangerous. Investors hold short-term debt when they fear that interest rates could rise because they get their money back quickly and can buy new bonds at higher interest rates, avoiding the devaluing scenario outlined above. Even without resorting to an explicit policy of inflation, the federal government is increasingly at risk of a bond market crisis.

This risk is similar to the maturity transformation used by financial companies. There was fear that even blue chip firms such as General Electric (GE) could go bust in 2009 because they borrow heavily in the short-term commercial paper market and continually roll it over to finance long-term projects. It is like an old fashioned bank run: your money is lent out to your neighbor for 30-years, but you want your money today. In the case of a financial firm, it borrows 30-day paper at a low interest rate and lends it out at a high rate. If people stop buying that paper, however, the firm is bankrupt.

In other words, even if a firm or country can continue in existence, if it has a lot of short-term debt and for whatever reason, investors today fear it will go bankrupt, then it will go bankrupt because it relies on short-term funding. One of the notable aspects of this type of crisis is the inversion of the yield curve. Short-term interest rates surge, while long-term rates stay lower, because the government faces an immediate financing crisis.

In sum, inflation won't reduce the budget deficit and its effect on the bond market could trigger a crisis.

This isn't news to the Treasury

Despite the government's dismal fiscal picture, the U.S. government is not run by idiots―which is why the U.S. government is considering floating rate notes. From the linked article:
While it may seem like odd timing to start issuing floating-rate debt, since most analysts predict interest rates are unlikely to get much lower, Wall Street analysts say the changes make some sense.

...For one thing, the new debt products wouldn't necessarily increase Treasury's exposure to short-term fluctuations in rates. That is because the floating-rate notes mainly would be used in place of short-term debt―bills and notes that are issued with maturities of less than two years. Treasury is constantly issuing new bills, mainly to replace maturing debt.

Issuing a floating-rate note of two years in place of a series of three-month bills also would reduce the number of times Treasury would have to sell new debt, which it does via auction. That is appealing, bankers say, especially in light of the recent debt auctions of heavily indebted countries such as Spain and Italy. Those debt sales have been nail-biting events for the financial markets.

In early August 2012, the Treasury announced floating-rate securities are coming, possibly by late 2013.

In adopting this course, the U.S. government tacitly anticipates the exact scenario I mention above. Taking this step is a positive move, since it shows forward thinking, but it won't make inflating the debt away any more realistic. What it does do, however, is potentially avoid a Greek-style panic in the bond market because the government won't have to rollover as much debt.

Markets allow investors to fight inflation

In addition to the government's own costs rising with inflation, another reason inflation is a bad policy: it is not an unknown. In the past, individuals had few ways of dealing with inflation and information moved slowly. Today, it is possible to hedge inflation risk instantly in financial markets. If the government tries to inflate, interest rates will go up and the cost of the debt will remain the same in real terms. If investors sense the inflation coming, they will even accelerate the inflation rate as they convert cash to hard assets and cause interest rates to overshoot as they sell bonds. The Federal Reserve would be caught between a rock and hard place, with the economy in even worse shape.

In conclusion, if the government tries to inflate, it will find itself running in place, while running the risk of destroying the currency.

Hyperinflation hysteria

Some analysts expect the U.S. dollar will hyperinflate and this will destroy the debt. Depending on the definition of hyperinflation, this could mean a range of inflation rates, but most people bring up Wiemar Germany, Hungary and Zimbabwe as extreme examples. People toss these out as examples of hyperinflation, but in reality, hyperinflation was a symptom of societal collapse, not the cause of it. Both Germany and Hungary saw hyperinflation after losing a major war. Germany experienced civil war in the post-war period, with the constant threat of communism, while Hungary was taken over by the Soviet Union. Zimbabwe engaged in genocidal war against white farm owners, destroying the nation's economy in the process. Unless you expect the U.S. to lose a major war or for civil war to breakout, there's little chance for Wiemar levels of hyperinflation.

No signs of hyperinflation

I explained how the private economy is already deleveraging and the government's massive deficits are only offsetting this force. Some people think this situation could change quickly and people will start borrowing again, but there are major factors at work: demographics, social mood and peak debt.

Aging people do not take out loans. Global inflation soared in the 1970s because the Baby Boomers were starting families, borrowing to buy homes and cars. Newly created money went right into the economy and the overall effect created a psychological impact that made everyone want to join in.

Today, it is the opposite. Boomers are retiring and selling off assets to repay debt. The psychological impact is such that even younger Americans view debt negatively and do not want to borrow. Young Americans are already bogged down with student debt. We also have a test case overseas: witness Japan's 20-years of deflation/low inflation, in part caused by a similar demographic change that started earlier.

Aside from demographics is the change in social mood. American attitudes towards debt have shifted and Americans believe the country is on the wrong track, headed for worse economic times. This does not lead people to take out loans and bet on rising asset prices.

Finally, there's the idea of peak debt. To put it into individual terms, consider the college graduate of 2012 saddled with tens of thousands of dollars in debt, who can only find low wage labor in this tight economy. This debt will hang over them for years until it is repaid, delaying family formation and home buying—two life events that drive the demand for debt.

In order to see hyperinflation, even the mild variety that doesn't require warfare or a communist takeover (inflation rates of say 50%, instead of 50,000,000%), we need to see changing attitudes surrounding debt and the economy. At first, people will become very optimistic and take out more and more debt, only later realizing that this was the start of hyperinflation.

Not only is hyperinflation unlikely, there are even signs that we have seen the end of inflation for the time being. During the hyperinflation in Wiemar Germany, the financial sector rapidly expanded and came to dominate the economy. People were paid twice a day, and they immediately ran to the bank to cash their pay check before the value of the mark fell. Bank workers almost quadrupled from 1913 to 1923. The public also borrowed heavily and bought stocks.

In the early 1990s, right after the savings and loan crisis, financial stocks made up around 7% of the S&P 500 Index (SPY). This grew to roughly 22% at the market peak in 2007, and it has fallen to 14% recently. This growth in the financial sector occurred along with the massive $50 trillion in credit created by the economy. Credit functions like money in the economy and for this reason, if there's any comparison to Wiemar Germany, it may be the growth in debt and the financial sector from 1980 to 2008.

In fact, a strong case can be made that inflation is in the rear-view mirror. While some prices are higher due to specific supply and demand situations (such as rising Asian demand and the U.S. drought lifting food prices), prices alone are not inflation. Inflation refers to the growth in the total supply of money and credit, while deflation refers to the contraction of money and credit. When total credit and money supply increase, the value of existing money and credit declines, and vice versa. It is this process that leads to a general rise or decline in prices.

Here is hedge fund manager Hugh Hendry on the topic (starting around the 7:45 market in this video: Print More Money to Avoid Bigger Slump Hendry)

"In my crazy head, in this day and age when everyone is anticipating inflation, not just inflation―hyperinflation―I'm saying to you...what if we saw it? What if we saw it between 2002 and 2007, and it wasn't the quantitative easing of the Federal Reserve, it was the mercantilistic trading policies of the surplus countries, which kind of suppressed the value, kept their exchange rates cheap and therefore created these foreign exchange reserves, these sovereign wealth funds are really just quantitative easing programs, and if we look at that 5 year period, gold broke a 27-year trend and actually went up. It went from $250 to $1000.

The dollar lost 40% of its value―40! That is one of the biggest collapses in the dollar ever. 40%. Oil went from 10 bucks to 150. (as you said) But maybe we've had all the inflation. And today, prices are falling. Retail prices are falling. And yet, everyone wants to talk about hyperinflation. I'm just curious at these...shifting players, and how they don't seem to be aligned, expectations versus reality are a little bit skewed."

Hendry has also said, “The road to hyperinflation is via hyperdeflation.” There may yet be hyperinflation, but it will occur after a period of hyperdeflation that causes world governments to enact hyperinflationary policies.

Credit creation is driven by borrowers, not bankers

The key argument against inflation is that we live in a credit economy. Most people look to the money supply when they look for inflation and they point to rising M2, but credit functions as money and the total amount of credit is more than 5 times the amount of money.

Here's Steve Keen, as Australian economist, on the subject. In a post from January 31, 2009 titled “The Roving Cavaliers of Credit”, Keen demolishes the standard model of money creation. Here are two snippets from a very long post:

Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.

Here's a grossly simplified explanation. Most people think of money creation like this: a saver deposits money in the bank and then the bank loans the money to borrowers. If the banks want to lend more money, but don't have enough deposits, the Federal Reserve can increase money supply―it prints up some money and sends it to the banks, who then loan it to people. In this model, the Federal Reserve can “create money” and cause inflation.

In reality, there are no deposits and the central bank isn't giving the banks money to lend. When you walk into a bank and ask for a mortgage, you are responsible for creating credit, and since credit also functions as money, your action, together with the bank's, creates money. Later, the central bank will create new base money to give the banks reserves, in order to stabilize the banking system.

In plain English: banks create money when they lend money to a borrower. The system is demand driven by borrowers, and the loans are the deposits.

Here is Professor Keen again:

In some ways these conclusions are unremarkable: banks make money by extending debt, and the more they create, the more they are likely to earn. But this is a revolutionary conclusion when compared to standard thinking about banks and debt, because the money multiplier model implies that, whatever banks might want to do, they are constrained from so doing by a money creation process that they do not control.

What Keen is telling us here is that banks are not restrained by regulations or the central bank. Let me explain in more detail: the way the money multiplier works, according to standard models of banking taught in most economics classes, is that when you deposit $100 in the bank, the bank has to keep an amount in reserve. If the reserve requirement is 10%, the bank (Bank A) must hold $10 for reserves and can lend $90 to a borrower. The borrower takes this $90 and puts it in their bank account (at Bank B), and that bank lends out $81 and keeps $9 for reserves. If we follow this to the end, it means the banking system can loan out $1000 dollars on $100 of deposits.

In the money multiplier system, the banks are constrained by reserve requirements and they cannot lend an unlimited amount. But Keen is telling us, this isn't how it works. Instead, the banks have no deposits. A borrower borrows $100 and this becomes deposits at another bank. Later, if deposits aren't sufficient, the central bank creates money to fill the reserves.

The central bank is following the lead of the banks, not constraining their actions. The Federal Reserve doesn't create money, it keeps the banking system afloat by lifting the money supply in concert with rising credit. The Fed is a passive actor―it needs the banks to lend, otherwise there is no money creation.

Keen goes on to explain what does regulate the banks:

However, in the real world, they do control the creation of credit. Given their proclivity to lend as much as is possible, the only real constraint on bank lending is the public’s willingness to go into debt. In the model economy shown here, that willingness directly relates to the perceived possibilities for profitable investment―and since these are limited, so also is the uptake of debt.

What limits bank lending is the desire of people to borrow. When people believe they can make money borrowing, they do so. During inflationary periods, prices of everything rise because the money supply is expanding. It is profitable to borrow money and buy stocks, houses, farm land or whatever asset is rising in value.

If Keen is right, then banks cannot lend money if people don't want to borrow. They can try cutting rates, but if people expect prices will fall, then even 0% interest loans are unprofitable. With private debt-to-GDP of 250%, the public cannot afford to finance the debt it has and wants to reduce the total. They don't want loans, if anything, they want debt relief!

It might shock you that the IMF agrees. In a recent working paper titled, “The Chicago Plan Revisited”

In a financial system with little or no reserve backing for deposits, and with government-issued cash having a very small role relative to bank deposits, the creation of a nation’s broad monetary aggregates depends almost entirely on banks’ willingness to supply deposits. Because additional bank deposits can only be created through additional bank loans, sudden changes in the willingness of banks to extend credit must therefore not only lead to credit booms or busts, but also to an instant excess or shortage of money, and therefore of nominal aggregate demand.

Now consider U.S. demographic changes and “peak” debt levels. Americans do not want to take on more debt because they cannot afford it―they are maxed out. Also, as the nation ages, more people are moving out of the peak borrowing years of middle age and into the debt repayment stage of their life. If people repay more debt than is created by new lending, the amount of total supply of money and credit shrinks.

Without credit growth, the economy is stagnant. In order for the government to create inflation in the absence of economic growth, it must offset the deleveraging of the private sector. The federal government must borrow the money that Americans won't borrow themselves.

Can't the Federal Reserve just print money?

Keep the above in mind as we travel deeper into the rabbit hole. I'm going to show you why the Federal Reserve not only isn't all powerful, it is basically a trend follower.

Most of the time, central banks follow interest rates, they do not set them! (see: De-mystifying RBA Setting of Interest Rates) Consider that Federal Reserve interest rate cuts have failed to spur the market, but in come cases, bond investors have pushed yields into negative territory (German bonds being one recent example, see: Europe: When losing money makes sense). Bond investors are willing to accept negative interest rates, but the central bankrates are higher. Even now, in the midst of unprecedented central bank policy, central bankers are following the market, not leading it!

Here's another thing you probably didn't realize. The Federal Reserve does not print U.S. dollars, it prints Federal Reserve Notes. What is a FRN? It is a debt instrument. The Federal Reserve does have printing presses, but when the Fed “creates money,” it buys existing credit paper. As in Keen's model, the bank creates credit when it makes a loan to a borrower. Later, it will sell some of those loans to the Federal Reserve, which will give it FRNs to hold as reserves.

Previous to the crisis, the Fed would mainly buy U.S. Treasuries from banks. After the crisis, the Fed started accepting other debts of much lower quality in an effort to support the banking system.

As Steve Keen as shown, the standard model is completely wrong. The Fed isn't creating new money, it is back-filling the already created credit money. If we imagined a world with no new debt, the Fed would have nothing to buy and would be unable to create any new money. The Fed is entirely dependent on the willingness of banks to loan, and the banks are entirely dependent on the willingness of borrowers to borrow, a total reversal of what is taught in standard economics classes and textbooks!

However, the U.S. government to create inflation. The U.S. government is also a borrower and if it decides to spend vast sums of money, it can print Treasuries and sell them to the Federal Reserve, which will give them FRNs they can use to buy goods and services (or just mail checks to everyone).

But, you may be thinking, why can't they just print paper money? They can't, not physically and they won't, because they don't want to. The Federal Reserve published its 2012 New Currency Budget, and it shows no ramp in currency printing and no plans for it. There's no sign of a plan to create a sea of paper money. As for their plans, consider that the $500 and $1000 bill (and even higher denominations) were taken out of circulation decades ago. Governments are increasingly moving towards digital currency because it cannot hide. Drug dealers starting switching to the euro a few years ago because the euro has a 500-euro note, which means more cash can be moved physically via euros. There's no evidence of government plans to return to a cash economy. Printing cash would generate inflation: in a cash economy, if I borrow $1000 and then default, the $1000 in cash is still in the economy. But in today's credit based economy, when I default, the $1000 is destroyed.

The Federal Reserve could credit everyone's bank account with money. They could add a zero to every account and devalue the U.S. dollar by 90%. However, this is another extreme solution, something never before done by the Federal Reserve. It would require a political decision in Washington, D.C.

An estimate of the required deflation

There are many ways to estimate how much the Federal Reserve would need to print in order to create inflation. One way is to consider the ratio of credit money to M2. Assuming the economy will return to its “starting position” in 1980, when base money (M2) was one-third of credit money, the economy either needs to deleverage $25 trillion or the Fed needs to print $8 trillion. I do not hold this out as a definite estimate, but I believe these huge numbers are reflective of the depth of the current crisis.

Are there any solutions to the debt crisis?

If inflation isn't a solution, the only real solutions are cutting government spending and wiping out the debt, because spending and debt are causing the problem. The choice is between voluntarily cutting spending and wiping out debt, with the benefit of long-term planning, or waiting for a market panic that requires instant cuts, with little time for debate.

The death of the dollar is greatly exaggerated

Since there's no sign of spending discipline anywhere in Washington, D.C., many people expect the death of the U.S. dollar. If the dollar did die, it would collapse rapidly, leaving no time for people to adjust. Instead of inflation over the course of years, all the inflation might happen in a week or month. The price of oil would shoot to $200 a barrel, gold would go to $10,000 an ounce and that would be it for inflation. Americans' standard of living would drop, they would be unable to import foreign goods and American goods would be very cheap, driving an export boom. It would be similar to the collapses seen in the Asian Crisis, Russian default and elsewhere.

As mentioned above, however, the government already anticipates potential market crises. If those in charge want to stay in power, they will certainly defend the currency, in any event, U.S. finances are not yet as bad as Greece's.

And that brings up a major ace up the sleeve of Uncle Sam. Europe (with a bigger welfare state and worse demographics) and Japan (the worst demographics and government debt-to-GDP above 200%) are likely to collapse first and in every instance thus far, panic means U.S. dollar and U.S. Treasury buying (even last year's downgrade of U.S. Treasuries led to lower interest rates as investors panicked).

Until the crises around the globe play themselves out, the U.S. and the greenback are safe by virtue of being the healthiest horse in the glue factory. Besides investor buying, the world relies on the U.S. dollar as reserve currency and therefore almost all governments and central banks work to support the dollar. Exporting nations in Asia and South America also do not want a weak dollar because it will damage their economy. When the Federal Reserve launched it's second round of quantitative easing, the Brazilian finance minister complained of a “currency war.” Nobody wants to see a very weak dollar and the loss of the dollar as reserve currency because the entire global economy is built on a the dollar.

Finally, only the U.S. has large and liquid stock and bond markets. The eurozone was a potential competitor, but we see how that is going. Other nations are too small. Consider the plight of a major financial center, Switzerland: the country instituted a peg with the euro because so much money flowed in to Swiss banks, it forced the franc higher and threatened to kill the Swiss economy. The only market that can handle a massive global wave of money is the United States.

The U.S. can use these strengths to kick the can and delay the crisis, or it could make use of the cheap debt to reform, but the death of the dollar won't arrive until the situation is so bad that nothing can delay it.

As an aside, this is why $5,000 price targets for gold are not crazy and why many analysts have very high price targets for gold, such as $10,000 or more. If the U.S. dollar did fail as a safe haven, a lot of money would rush into very, very small markets by comparison, including gold. I don't expect those high gold prices in the near future because I see the dollar holding up, but the logic is sound.

Ending the dollar as reserve currency

I doubt the U.S. could achieve a major bout of inflation without ending the U.S. dollar as reserve currency and replacing it with gold. One way to achieve a rapid devaluation of the dollar, while maintaining some control over the global financial system (desired by the politicians), would be for Federal Reserve (or U.S. Treasury) to devalue the U.S. dollar against gold. The Fed would step into the market and announce that it would pay $5,000 (a low estimate for a gold revaluation) per ounce of gold. They would choose a price at which the U.S. 8,000 tons of gold is large enough to dominate the market and offset government debt levels. Currently, U.S. gold is worth about $400 billion (at $1600 an ounce), so a move to $5,000 would increase the value to about $1.3 trillion.

Jim Rickards, in his book Currency Wars: The Making of the Next Global Crisis , outlines a fictional scenario where the Russians decide to launch a gold currency to weaken the United States by damaging the U.S. dollar. He argues that a scenario such as this is increasingly likely and that the U.S. should choose to use gold, rather than have it forced upon them. He has also dubbed the United States the “Saudi Arabia of gold” due to its holdings, the largest in the world.

Gold can handle it

Gold is already becoming the safe haven of choice because if the dollar fails, the entire global financial system will collapse, meaning no currency is safe. Any country with a favored currency would see their economy collapse if they allowed it to appreciate (see the Swiss reaction to the decline in the euro), so they would all depreciate their currencies in response. In contrast, many central banks still hold literally tons of gold and no one would need to stop “hot money” from flowing into gold because it wouldn't be as disruptive to the economy.

Think of it this way: if Chinese yuan is 6 to $1, and a pen costs 6 yuan, it also costs $1 for an American.

Now, what happens if China's currency collapses to 600 to $1? Suddenly that pen is very cheap and everyone in America would buy as many as they could. So when we see a single currency depreciate against others, it's goods and services become very cheap, and other economies exports become very expensive, causing massive economic disruption.

What happens if everyone devalues against gold? The price of gold rises in dollars, euros, yen and yuan, the relationship between the currencies will not change as dramatically. Gold can act as a pressure valve because it can absorb capital inflows without as much economic disruption.

Revaluing against gold also takes away the desire for a safe haven by folding it back into the U.S. dollar and the global financial system. Instead of thinking of how to protect their assets, investors would invest their money, with many gold holders selling their gold to collect their profit. However, while a number of advocates for monetary reform have suggested revising gold's role, they remain on the fringe in Washington, D.C.

Debt wipeout

Another possible scenario is a debt jubilee. Taken from the Biblical jubilee, where every 50 years slaves were set free and debts canceled, a modern jubilee (as proposed by Steve Keen) would have the government or central bank send a certain amount of cash to every citizen. The money must be used to pay down debt, but if a person has no or little debt, they would receive a cash infusion to their bank account. This is similar to the Federal Reserve's quantitative easing program, but the money would go directly into the economy.

For example, let's say the government sends every American $50,000. If you have a mortgage of $100,000, your balance is cut to $50,000. If you owe $25,000 in student loans, you are debt free and have $25,000 to spend. If you are debt-free, you receive $50,000 to spend as you please. It would be a quantitative easing program for the people, not the banks, and it would cut debt levels massively by wiping out debt and devaluing the currency simultaneously.

The worst case

I don't call this a solution, but it would eliminate the debt―the U.S. government goes full banana republic and starts spending even vaster sums of money, printing the cash to pay for it. The federal government would “print” Treasury bonds and sell them to the Federal Reserve, which would give it cash to spend into the economy. Or the government would simply have the U.S. Treasury directly spend into the economy. The government wouldn't worry about taxes anymore, it would simply print money and spend it.


Hyperinflation is unlikely without an explicit political decision. The two cases of hyperinflation during U.S. history occurred during the Revolutionary War and the Civil War. The historical evidence from around the globe supports the hypothesis that a government must collapse, be feared to collapse, or engage in willful destruction of its economy (Zimbabwe) in order for its currency to become completely worthless.

This doesn't rule out high rates of inflation, but as I explained above, deflation is far more powerful today and without an “extreme” and explicit policy of inflation, it's unlikely there will be any. Even if there is inflation, it doesn't get the U.S. government out of its debt problems or impossible entitlement spending estimates.

The most likely course is the one we are on: global central banks will hold deflation at bay for as long as possible, until they cannot and global investors send the markets lower once again. I do not expect a Japan scenario for the West, it will be far messier because the culture and political systems are more volatile.

Even if the deflation scenario wins out, inflation becomes more and more likely with each passing day. Governments always act far too late: the U.S. government passed Glass-Steagal after the Great Depression; they repealed it at the top of a 20-year bull market; they passed Sarbanes-Oxley after Enron went bankrupt and Dodd-Frank after the 2008 crisis. In security, the U.S. upped airline security after 9/11; they made passengers take off their shoes after the shoe bomber passed security; they started doing full body checks after the underwear bomber was discovered, etc. If there is ever an explicit policy to inflate, it will almost certainly come after a major deflationary wave has wiped out enough debt to reboot the economy―and therefore will come at precisely the wrong time.

For this reason, it makes sense to hold some gold. I expect that even if spot gold prices tumble during another 2008-style crisis, it may be hard to obtain physical metal as premiums rise (this happened during the first phase of the 2008/9 decline). Once an inflationary policy is announced, gold prices will take off. There may only be a very small window, if any, for investors waiting for the last possible moment. And should world governments choose to reform the global monetary system, it will likely include revalued gold. 

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