On November 30, 2009, Sandy Leeds, CFA, a Senior Lecturer at The University of Texas at Austin, provided at his website, LeedsonFinance.com, an excellent, crystal clear analysis of the Dubai debt default situation (see “Why Dubai Matters” here).

Interestingly, most of the comments from Mr. Leeds’ readers focused on a small aside that he made about the U.S. government’s own debt situation:

“Emerging nations may have trouble paying their debt, even as the global economy improves. (Personally, I’m not sure why everyone is simply talking about emerging nations – the US will never be able to pay back its debt either.)”

Mr. Leeds’ readers wanted to know if he could elaborate on his aside, answering how exactly it is that the U.S. government will never be able to pay back its debts and what the market and economic consequences might be.  As of December 5, 2009, Mr. Leeds had not responded to his readers’ comments, so I decided to take a stab at a response myself. I reprise below what I had to say at Mr. Leeds’ website.

Logan Flatt, CFA

————————-

Perhaps I can help clarify Mr. Leeds’ comment regarding the U.S. government not being able to pay its debts. The question comes about through differing definitions of the term “default”.

First, we have to remember that the U.S. dollar and all other U.S. government debt (the dollar is simply unsecured, non-interest-bearing debt of the U.S. government**) are predicated on the “full faith and credit” of the U.S. government. What that means is that the U.S. government says “Trust Us” and promises to never allow its financial house to get too far out of order whereby investors in U.S. dollars and U.S. interest bearing debt would have to worry about 1) the U.S. government’s ability and willingness to pay the interest on the debt, 2) the government’s ability and willingness to pay back the principal on the debt ON TIME, and 3) the U.S. government paying back the interest and the principal with a currency — the U.S. dollar — that has lost significant purchasing power from the point at which the original investment was made and the point at which the interest and principal repayments are made.

[**NOTE: The U.S. dollar USED to be secured by the U.S. government's gold bullion ("Fort Knox") up until 1971 when President Nixon "closed the gold window" on the European banks who were hastily redeeming their U.S. Dollars for the U.S.'s dwindling gold reserves after the U.S. government started overspending on the Vietnam war and on Johnson's "Great Society" entitlement programs during the mid- to late-1960s.]

Where China, Japan, Saudi Arabia and other large holders of U.S. government debt (both interest-bearing and non-interest-bearing) are getting nervous about their vast U.S. holdings is on #3 above. What good is an investment in the debt of a government when the government can — if it freely chooses to do so — multiply the size of its money supply and credit facilities (see a chart of the U.S. money supply from 1917 to 2009 here) such that the purchasing power of the currency issued by the government falls, say, in half? In real terms, the present value of the investment falls dramatically and the holder of the debt is screwed when it receives future repayments in a highly devalued currency.

On the surface, it is currency risk. In reality, it is political risk: the investors made an investment in a government that, to the investors’ collective chagrin, could not be trusted to stand behind its promises. This has happened to many investors in developing country debts over the decades (e.g., Mexico, Argentina, Zimbabwe, etc.) and the investors in U.S. debts are beginning to question — and rightfully so — the integrity and veracity of the U.S. government in keeping its promises to never allow its financial house to get too far out of order.

So, what I — and maybe Mr. Leeds too — am suggesting is that the U.S. government will EFFECTIVELY default on its debt obligations by continuing to expand the money supply and its credit facilities (through the machinations of the U.S. Treasury and the Federal Reserve System) such that the purchasing power of the U.S. Dollar falls precipitously, thus screwing over its creditors (see the definition of “beggar thy neighbour” here). Yes, NOMINALLY the U.S. government could make its interest and principal payments to its creditors and thus legally not be in default; but, in REAL terms, the U.S. government will have proven to its creditors (and any future investors) that the government is not to be trusted to keep its promises and will have effectively defaulted on its creditors by paying them back in paper currency worth far less than the same paper currency the creditors lent to the U.S. government only years earlier. It is important to note that this default action is under 100% control of the U.S. government since it and it alone controls — via the U.S. Congress (see Article 1, Section 8 of the U.S. Constitution, the Enumerated Powers of Congress here) — the monetary policy, the money supply and the credit facilities that determine the value of the U.S. Dollar at any given time (Congress sets policy that the Fed is supposed to follow; i.e., the Congress can redirect the Fed IF Congress has the willpower and collective knowledge to do so). Therefore, the ‘default’ will be a conscious decision of the U.S. government, not a market-based outcome.

Alas, the U.S. government has shown little sign as of late in keeping its financial house in order as it bails out private, politically-favored companies under the guise of “too big to fail”, layers on even more entitlement programs under the guise of “health care reform”, funds a vast empire of 800 military bases scattered throughout the world that cost nearly $1 trillion per annum just to MAINTAIN, and fights multi-trillion dollar wars in Iraq, Afghanistan, and Central and South America (the “War on Drugs”) caused by its own misguided foreign and economic policies. And these trillions don’t even begin to touch on the UNFUNDED obligations (estimates I’ve seen are $50 TRILLION to $80 TRILLION in current dollars) that the U.S. government faces over the coming years as the entitlement programs of Medicare and Social Security become effectively insolvent through poor social policy and bad government program design stemming all the way back to FDR (1930s) and Johnson (1960s) and their ill-fated attempts to ’socialize’ the United States in the same vein as many European countries (who, however, don’t share the same Constitution as the United States, which itself effectively makes ’socialist’ government policies unconstitutional — i.e., the whole point of the U.S. Constitution is to LIMIT the size and power of the U.S. federal government, not to expand it!).

So, unless the U.S. government completely reverses course and begins to shrink itself by slashing spending and cutting departments and programs wholesale — a highly unlikely occurrence with either of the two major U.S. political parties currently in power who lack the political will to do what is right by the American people who will also be screwed by a hugely devalued U.S. dollar — the U.S. government is on a straight and narrow path to a massive currency devaluation fully under its control that will effectively lead to a ‘default’ on U.S. government debts over the next two to ten years, I suspect. At that point, yield to market rates on U.S. Treasuries will be in the double digits as investors demand far more compensation for the risks they are taking by investing in a demonstrably untrustworthy government.

It’s sad, and I wish it weren’t so; but, here we are.

Copyright 2009 LoganFlatt.com. All rights reserved.

• Previous Entry: Transform with Gratitude
• Next Entry: What Is Consumer Relationship Marketing (CRM)?