Friday, August 28, 2009

Hummel: The US Will Default On Its Debt

John Carney|Aug. 27, 2009, 4:01 PM|20
PrintTags: Economy, Money, Debt, U.S. Government, Federal Reserve
The flood of debt that the US is taking on in its efforts rescue to economy will combine with huge social insurance obligations--Medicare, MedicaidSocial Security--to create an unsustainable level of public indebtedness, economist Jeffrey Rogers Hummel argues in at length here.

Faced with this mountain of debt, policy makers will have just two choices: repudiate the debt or engage in hyper inflation to monetize it, Hummel writes. And faced with that choice the Treasury will likely protect the currency and default on Treasuries.

Here's the scary conclusion:

It is not literally impossible that the Federal Reserve could unleash the Zimbabwe option and repudiate the national debt indirectly through hyperinflation, rather than have the Treasury repudiate it directly. But my guess is that, faced with the alternatives of seeing both the dollar and the debt become worthless or defaulting on the debt while saving the dollar, the U.S. government will choose the latter. Treasury securities are second-order claims to central-bank-issued dollars. Although both may be ultimately backed by the power of taxation, that in no way prevents government from discriminating between the priority of the claims. After the American Revolution, the United States repudiated its paper money and yet successfully honored its debt (in gold). It is true that fiat money, as opposed to a gold standard, makes it harder to separate the fate of a government's money from that of its debt. But Russia in 1998 is just one recent example of a government choosing partial debt repudiation over a complete collapse of its fiat currency.

A more likely outcome, it seems to us, is that the US will make good on Treasury debt but repudiate soft obligations like Social Security and Medicare. That way the US would continue to be able to borrow in the future. And all it would require would be a Congressional vote lowering the outlays for these programs.

But maybe all this is unnecessary doomsaying. AIG is up HUGE, so we're sure everything will be just fine.