Tuesday, April 15, 2008

Government Debt: Endgame

In examining government debt, I will consider again the distant risk of hyperinflation, before (in the next post) presenting a scenario of moderate inflation.

Excessive government spending offers plenty of reason to worry the cash investor. But as it chugs along and treasuries are floated, it has no effect on money supply. Rather, capital is simply shifted from private enterprise to government. If you buy a treasury security, cash is briefly lost from the economy when the bond is purchased, and the same amount is reintroduced when the government spends it to pay interest on the debt and fund its services. If the government were to print a treasury bill as direct payment, the recipient is being paid cash over time rather than getting a lump sum right away. Either way, money creation and fractional reserves are unaffected. That is, up to the point where the government can not afford to borrow any more.

The theoretical upper limit of government borrowing is when interest payments on its debt equal tax revenues. When that limit is reached, some tough decisions will need to be made. When the interest payment on the debt equals tax revenue, the government has the option to: (1) increase taxes, (2) default, (3) print money, or (4) cease to exist.

As much as they can, politicians will raise taxes to expand the amount of interest government can afford and debt it can accrue. After that, the only realistic solutions are to default on debt, or print. Defaulting goes something like this: one evening the president comes on TV and says “We are the U.S. government. We are not going to honor our treasury bonds anymore, and since we used your money to build the most powerful military in the world, you can’t make us.” Alternatively, the government can direct the Fed to crank up the printing presses, and pay off its bonds with quickly devaluating dollars. In a situation where the government is facing default, the printing presses would be a worrisome option.

So this is a scary scenario for anyone invested in the dollar. On the one hand, you have banks and private bond holders invested in a lot of debt who want to keep the dollar strong. On the other hand, you have holders of treasury bonds who want to be paid. Each group is represented by the wealthy and powerful. To the degree this financial elite can influence the favors of politicians, the government could go either way—choosing to default on its debt, or print. But if the government prints, then all money disappears for both Treasury bond holders AND other lenders, and so the only real option would be to default. That means nobody buys U.S. Treasury Securities anymore, and our government has to live within the means of its tax base.

As always the holder of cash has to monitor the amount of money being printed, or any changes of patterns. Overall, I think this scenario is a ways away.

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