Doomsday and Why America Should Not Default

March 14, 2011 

By John Griffing

America nears the brink of financial collapse.  If action is not taken to reduce American debt, a tidal wave — called the “doomsday scenario” by economists — will consume American economic power, effectively ending American preeminence.

Obama’s proposed budget has caused a row that some have said might lead to a government shutdown, freezing spending and interrupting certain government services.  New stop-gap measures have temporarily prevented this possibility.  But if American spending levels continue on their present trajectory, a true government shutdown — one that would destroy American wealth and power — will occur.  At the present time, U.S. debt equals GDP — the first time debt has reached this level since WWII.  War permits great extravagance, but in what universe is peacetime debt of the size proposed by the Obama administration permissible?

Over the next decade, interest payments to foreign creditors will account for 80 percent of the debt added, meaning that less money can be spent on the programs demanded by citizens.  Now that American debt is 100 percent of GDP, America will not be able to credibly incur new debt.  And if America is not able to pay, foreign creditors will no longer have any reason to continue funding American indebtedness.   

By lowering the value of existing holdings, one-hundred-percent credit as a monetary standard will significantly harm foreign debt stakeholders currently funding American extravagance.  When America increases its debt, the Fed prints new dollars to offset the increase, which decreases the value of debt held by foreign creditors.  Under these conditions, foreign owners of American debt are incentivized to divest their securities and flee the United States for safer shores rather than face the inevitable default.  The “doomsday scenario” holds that as debt stakeholders shed their assets, the falling value of retained assets prompts further dumping, resulting in the inexorable collapse of the U.S. stock market.

Due to the financial linkage of many nations’ economies to American consumer spending — called “coupling” by economists — any drop in American markets will have an immediate impact overseas.  Coupling is a trend that developed in the wake of the Bretton Woods conference following WWII.  America pledged to prop up global prosperity with sizable debt, and the world pledged to invest surplus dollars back into the United States, creating systemic interdependence and the resulting coupling of market trends.

Doomsday is closer than many would care to admit.  Net federal liabilities currently exceed $100 trillion.  World GDP hovers around $58 trillion.  Planned U.S. spending exceeds world GDP.  The implications of these staggering levels of spending are obvious: such decadence can never be paid for.  If owners of U.S. debt demanded the principal, instead of interest, America would cease to function as an economic entity.  In short, American global power would be virtually gone.  What power America would be allowed to keep would be contingent on the goodwill of creditors. 

For perspective, consider that the Chinese are requesting ownership of U.S. infrastructure as collateral on future loans.  Presumably, if America is unable to “pay up,” public roads and buildings will become Chinese property.  China is already the only supplier of the rare-earth magnets used in U.S. bombs.  China is calling American debt its “nuclear option.” 

While there is still time, America must begin to apply a simple understanding of how money works — an understanding lost due to a century of Fed debt-monetization in which the printed pieces of paper circulating have never-endingly increased, diminishing purchasing power and permitting government to expand exponentially.

Real money, and not merely printed pieces of paper, must be created through the production of goods.  Production creates new money.  Services move existing money around.  The idea of an economy supported solely by services is laughable.  Classical economists knew this to be the case.  Industry is the source of wealth, and services depend on industry.  Currently, American services depend on Chinese industry. 

As German economist Friedrich List once explained, “[t]he forces of production are the tree on which wealth grows[.] […] The prosperity of a nation is […] greater in the proportion in which it has […] more developed its powers of production.” 

Until we apply basic financial principles like debt management, charades like the one in Wisconsin — in which government employees demand that taxpayers fund their positions with more and more debt — will continue to push America to the brink. 

The only alternative to fiscal discipline is to default, which would have many of the same financial consequences as those associated with the doomsday scenario.  Some writers at American Thinker have suggested this course as a viable option, but a nation as large and integral to the global economy as the United States could never recover from unconditional default, since nations that trade with the United States would no longer be able to take America at its word.  Why should nations support a mountain of debt if no tangible capital exists to back up American promises to pay?  Indeed, why should nations continue to invest in a nation that has defaulted on sizable loans? 

Remember the Plaza Accords.  In the late eighties, the U.S. dollar was inflated, disrupting global trade.  Through a cooperative global process, the dollar was gradually devalued to permit greater balance in the international trade system.  America’s trade partners were being harmed by an overvalued dollar, and they therefore possessed a direct interest in cooperative mechanisms of currency valuation.

Due to the coupling phenomenon described above, U.S. financial implosion would ripple to partner economies, so these countries have an incentive to assist America in the goal of managed debt reduction.  Since current prosperity, such as it is before the global meltdown, is driven almost entirely by American consumer spending — 20 percent of world GDP, in fact — the transition proposed would necessarily involve America’s partners.  Those nations dependent on American consumer spending would need time to diversify portfolios and increase trade with other countries that have growing consumer markets — e.g., China, which now boasts around 300 million “middle-class” consumers, making for a quantity as large as the entire American market.

American debt need not be completely eliminated, given that it possesses defensible utility as a source of investment, a fact realized by American patriarch Alexander Hamilton nearly three centuries ago.  Instead, our target should be to lower the proportion of debt relative to GDP.

The problem of American debt can no longer be passed to the next administration.  America lives on borrowed time, and time is not as forgiving as the Chinese.

Graph for the Day for March 1, 2011

Randall Hoven

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“We are better than these last eight years.”  Barack Obama, 28 August 2008.

Source:  USA Inc., by Mary Meeker, via BusinessWeek.
Hoven’s Index for March, 2011
Federal receipts/revenues as percentage of Gross Domestic Product:
1960-2000 average:  18.2%
2006:  18.2%
2007:  18.5%
2008:  17.5%
2009:  14.9%
2010:  14.9%
2011:  14.4%
Source:  White House Office of Management and Budget.

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