Thursday, October 24, 2013

Jim Grant: Another US 'Default' Inevitable

Jim Grant says that a US debt default is inevitable but not the way you usually think of it. In fact, we've 'defaulted' in our history a number of times. The default that I'm talking about is from inflation or 'devaluation' that dilutes the value of our currency and reduces the value paid to our foreign and domestic creditors.

A little history lesson: The dollar was defined in post US revolutionary time as 1/20th of an ounce of gold. This lasted until FDR, when he devalued to 1/35th of ounce of gold. That lasted until the Nixon administration where he abandoned the Bretton Woods accord (1971) and let the dollar price float and freed it altogether from it's anchor in gold. Today, one dollar is 1/1,325th of an ounce of gold. US prices since the formation of the Federal Reserve have risen 23 fold in 100 years, a 95% devaluation.

Although a good bit of dollar devaluation occurred after 1971 but also occurred during periods where the gold standard was in force.  But it is the rise of federal deficits, chronic trade imbalances, chronic current account imbalances and money printing that have occurred after 1971--all of which threatens another Great Depression.  We barely avoided depression in 2009.  Since nothing has been fixed, expect more crises and more brushes with disaster. 

The gold standard has many problems but those problems will pale in comparison to the troubles ahead with the "PhD standard."

From Jim Grant in the Washington Post:

The U.S. government defaulted after the Revolutionary War, and it defaulted at intervals thereafter. Moreover, on the authority of the chairman of the Federal Reserve Board, the government means to keep right on shirking, dodging or trimming, if not legally defaulting.

Default means to not pay as promised, and politics may interrupt the timely service of the government’s debts. The consequences of such a disruption could — as everyone knows by now — set Wall Street on its ear. But after the various branches of government resume talking and investors have collected themselves, the Treasury will have no trouble finding the necessary billions with which to pay its bills. The Federal Reserve can materialize the scrip on a computer screen.

Things were very different when America owed the kind of dollars that couldn’t just be whistled into existence. By 1790, the new republic was in arrears on $11,710,000 in foreign debt. These were obligations payable in gold and silver. Alexander Hamilton, the first secretary of the Treasury, duly paid them. In doing so, he cured a default.

Hamilton’s dollar was defined as a little less than 1/20 of an ounce of gold. So were those of his successors, all the way up to the administration of Franklin D. Roosevelt. But in the whirlwind of the “first hundred days” of the New Deal, the dollar came in for redefinition. The country needed a cheaper and more abundant currency, FDR said. By and by, the dollar’s value was reduced to 1/35 of an ounce of gold.

By any fair definition, this was another default.  Creditors both domestic and foreign had lent dollars weighing just what the Founders had said they should weigh. They expected to be repaid in identical money.

Language to this effect — a “gold clause” — was standard in debt contracts of the time, including instruments binding the Treasury. But Congress resolved to abrogate those contracts, and in 1935 the Supreme Court upheld Congress.

The “American default,” as this piece of domestic stimulus was known in foreign parts , provoked condemnation in the City of London. “One of the most egregious defaults in history,” judged the London Financial News. “For repudiation of the gold clause is nothing less than that. The plea that recent developments have created abnormal circumstances is wholly irrelevant. It was precisely against such circumstances that the gold clause was designed to safeguard bondholders.”

The lighter Roosevelt dollar did service until 1971, when President Richard M. Nixon lightened it again. In fact, Nixon allowed it to float. No longer was the value of the greenback defined in law as a particular weight of gold or silver. It became what it looked like: a piece of paper.

Yet the U.S. government continued to find trusting creditors. Since the Nixon 'default,' the public’s holdings of the federal debt have climbed from $303 billion to $11.9 trillion.

If today’s political impasse leads to another default, it will be a kind of technicality. Sooner or later, the Obama Treasury will resume writing checks. The question is what those checks will buy.

“Less and less,” is the Federal Reserve’s announced goal.  Under Chairman Ben Bernanke (with the full support of the presumptive chairman-to-be, Janet Yellen), the central bank has redefined price “stability” to mean a rate of inflation of 2 percent per annum. Any smaller rate of depreciation is an unsatisfactory showing to be met with a faster gait of money-printing, policymakers say.

In other words, the value of money has become an instrument of public policy, not an honest weight or measure. In such a setting, an old-time “default” is impossible. How can a creditor cry foul when the government to which he is lending has repeatedly said that the value of the money he lent will shrink?

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