This goof made his money selling Endudda World Y2K BS. I pay him no mind.
“This goof made his money selling Endudda World Y2K BS. I pay him no mind.”
Actually, he made his money buying (and recommending to his newsletter audience that they buy) area cell phone rights back when the government auctioned off local cell-earmarked bandwidth to the highest bidder. Those who followed his advice made considerable fortunes, as he did.
He (appropriately) suffered a huge loss of credibility over his wrong call on Y2K. His taxonomy of official default scenarios is nevertheless worth digesting. He’s a better historian than prognosticator. The basic advantage that the governments and their “independedent” (snicker) central banks have over Bernie Madoff is that they can transform their IOU’s into money (for a while, a long while as it turns out). As Madoff proved even without the ability to monetize his IOU’s, it is possible to run a financial scam for many decades. Discount North all you like, but keep in mind that since its founding in 1913, the value of the Federal Reserve Note has plummeted by over 95%.
As I said, North is a better historian than prognosticator. He offers several historically plausible scenarios for governments to follow as they stiff their creditors, and offers his guess as to which scenario will emerge in the US (without being so cock-sure about it as he was about Y2K). So, he has learned something from his misfortune. Perhaps you can too.
NORTH’s DEFAULT TAXONOMY
Default has four major forms. We need to consider all of them.
1. OUTRIGHT DEFAULT
This scenario assumes that the central bank refuses to buy the government’s debt. This has not happened since 1694.
At some point, the government will not be able to find buyers at low interest rates. Rates will rise. The economy will sink into a depression. Revenues will decline. Expenditures will rise. The government will not be able to pay all of its obligations. So, it will raise taxes. The depression will get worse. Revenues will again fall.
Investors will know that the government is likely to default. No credit-rating service will have the courage to downgrade the government’s debt, but rates will rise as if they had. The government will reach the day of reckoning. It will default on all of its debts.
Every institution that has government debt in its portfolio will suffer a loss. Its share price will fall. The depression will get worse. Insurance companies will be hit hard. The largest banks, which swapped their toxic debt with the FED at face value in late 2008 will find that they own the most toxic debt of all.
Foreign central banks will refuse to buy any more American Treasury debt. Technically, their portfolios fall to the extent that they held Treasury debt. Then those governments must decide. Should those banks be allowed to inflate to overcome these losses?
The inverted pyramid of debt will topple. The great default will produce the great depression. Unemployment will rise. Depositors will finally go to their ATMs to draw out currency. The banks will default: no withdrawals of currency.
The division of labor will contract. Everyone will get much poorer.
Because a default on all Treasury debt would have such widespread consequences – immediate consequences – economists have argued that this will not be allowed to happen. The central bank will buy the debt. But if it does, at some point it must stop buying or else create hyperinflation. Hyperinflation has the same consequence as default and deflation: a contraction in the division of labor.
I know of only one economist who predicts an outright default: Jeffrey Rogers Hummel. On August 3, 2009, he published an article on the free market site, Library of Economics and Liberty: “Why Default on U.S. Treasuries is likely.” His argument is simple: the only alternative is the Zimbabwe option: hyperinflation.
He goes through the numbers. He makes an impressive case. He does not discuss the level of interest rates that would bring on the crisis, but at some point, the Treasury will have to offer high rates unless the FED intervenes.
He says that the welfare state is going to die, all over the world. I think he is correct. I am not convinced that outright default is likely – not before much higher price inflation arrives.
The strategy of the FED is the same as the strategy of Congress: kick the can.
SELECTIVE DEFAULT
Hummel admits that selective default is a possibility. I think it is more than a possibility. I think it is likely. He writes:
The Zimbabwe option illustrates that other potential outcomes, however unlikely, are equally unprecedented and dramatic. We cannot utterly rule out, for instance, the possibility that the U.S. Congress might repudiate a major portion of promised benefits rather than its debt. If it simply abolished Medicare outright, the unfunded liability of Social Security would become tractable. Indeed, one of the current arguments for the adoption of nationalized health care is that it can reduce Medicare costs. But this argument is based on looking at other welfare States such as Great Britain, where government-provided health care was rationed from the outset rather than subsidized with Medicare. Rationing can indeed drive down health-care costs, but after more than forty years of subsidized health care in the United States, how likely is it that the public will put up with severe rationing or that the politicians will attempt to impose it? And don’t kid yourself; the rationing will have to be quite severe to stave off a future fiscal crisis.
The rationing will have to be severe. The promises will not come true.
INFLATION
There are two forms: mass (up to 50% per annum) and hyper (the sky’s the limit).
Mass inflation seems more likely over the next decade. If the world’s central banks can coordinate the expansion of money, thereby funding the national welfare states, the public will not be able to escape. They will pay the inflation tax.
The ways around this are limited to investing in real goods: commodities, small farms, used goods stores, small-town real estate. Not many people will see this in time. Of those who do, few will take action. These escape hatches are for people who are hedging against default. The average voter has no financial reserves. Of the 20% who do have reserves, 80% will be stuck in conventional investments. They will believe the Establishment’s Keynesian line. “The government can fix it if you just hang on.”
Inflation means the erosion of money. It means a hidden default on the political promises. Why hidden? Because the politicians will blame speculators. They will not blame the Federal Reserve for having bankrolled their promises.
CONCLUSION
Ultimately, it is either the great depression or the Zimbabwe option. Ludwig von Mises called this the crack-up boom. It means the destruction of money and the collapse of the division of labor. It would mean devastation.
I think central banks will at some point refuse to fund governments any longer. They will bail out the largest banks instead. Foreign politicians may force hyperinflation on their central banks, as agents of the government. But as long as the Federal Reserve System maintains its selective independence, it will not adopt hyperinflation as a policy. That would not be in the interest of the largest banks. It would also not be in the interest of central bankers. Their retirement promises would die.