GLOBAL DEBT REDUX
By Karl Arnold Belser
6 May 2015
This post is a continuation of my previous post Is Huge Global Debt Bad? in which I concluded that the debt was ill advised but probably not a disaster.
In this post I suggested that the most likely outcome would be a muddle through handling of the debt accumulated by the first world nations to prop up their economies until these economies recovered. This assumes that the governments will have enough income after services and interest payments to pay off the loans. This payment schedule I think is doable but would be onerous such that the gross world product would probably grow very slowly if at all.
I personally would have preferred that the government allow the large banks to fail and then take over the banking function temporarily until order was established as I described in my previous post Mental Models and World Economics. I would also have preferred Structural Reform that would have reduce government regulation such that a rebirth economy could have occurred. This is basically what Sweden successfully did in the early 1990s and what the Baltic countries successfully did in response to the current recession.
The question I want to explore in this post is "what happens if the governments can't pay off the debt?".
In this effort I read the book The Death of Money by James Rickards in which Rickards discusses why the current world monetary system is fragile and likely to collapse. The Amazon link has a review that gives a good summary of the book. This book has made me more aware of what might happen. However, I note that the negative conclusion implied by the book's title is a leading indicator of the author's pessimistic attitude toward the situation, similar to my comments about John Mauldin's singularity in my previous post Is Huge Global Debt Bad?.
The tipping point would come once confidence in the American dollar as the world's reserve currency is lost. This would be the Minsky Moment.
According to the book, the first thing would be that the American dollar would cease being the reserve currency. In its place the international Monetary Fund (IMF) would probably make their Special Drawing Rights (SDR) the new world reserve currency. The SDR would be made up of several currencies that are heavily backed by gold. The currencies would probably include those of Europe, Japan, China, and Russia in addition to the United States. China and Russia are not currently in the SDR, but they have been accumulating gold to the point that they could be included.
The conversion of the world reserve currency would stop money printing by the US. The Federal Reserve's interference in the price discovery of the markets would be stopped. I would expect a significant transient in stock and bond prices until price discovery was completed. Specifically I would expect interest rates to rise, which in turn would cause the price of real estate, bonds and shares to decline. Hence th initial response would be even more deflationary than it currently is.
The next thin that might happen is that the US dollar would be forcibly devalued relative to the SDRs such that it would be clear that the remaining debt and other obligations could be paid. Banks would be allowed to fail and the government would take over the banking system. Government promises such as pensions, medical payment and loan obligations would be dramatically reduced or even eliminated. The united States as well as other countries would suffer a drop in living standard, which in turn might cause civil unrest similar to what happened recently in Greece. The government undoubtedly knows that this is a possibility because it is investing in non-lethal weapons for domestic control. See my post Civil Unrest and Non-Lethal weapons.
What might also be needed is the elimination of government policy that limits efficient economic activity. In the end the International Monetary Fund may have to "bail out" even countries like the United States by imposing structural adjustment. The United States will be in between a rock and a hard place if this happens.
So what does one do to protect oneself from this kind of government default?
Rickards suggest cash, gold, raw land and fine art as stores of intrinsic value. He apparently thinks that initially there will be deflation rather than inflation because he recommends holding cash. the advantage of cash is that it is liquid and can be used immediately to buy up assets at depressed prices.
Since I really don't know if a monetary collapse might or might not occur or whether there might or might not be inflation, I am choosing to hedge my bets in stocks, bonds, real estate and cash so that I will end up with some valuable assets no matter what happens.
Last updated June 12, 2015
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