The US is awash in debt on every level: Federal, state, local, as well as households and businesses. But for the private part of the economy, there is a different consequence for bankruptcy than for the public side. If a private individual or business goes under and fails to pay their bills, the creditors lose money, of course. But when a government goes under, it tends to go under in a way that inevitably affects everyone, for it devalues the currency.
Of course no government destroys its own currency with malice aforethought, but the pressures that come to bear on governments are such that destroying the currency seems at the time to be the right thing to do, given other options. Circumstances are already headed in that direction now, and pressure on the dollar continues to build in the face of rapidly expanding Federal debt.
The current Federal debt is $11,659 bil, and with the stimulus and other unfunded expansions in Federal spending, it’s widely believed to expand by at least another $1,800 bil in the next year alone, and to nearly double in ten years. It’s an open question as to how the Federal government expects to get the funding for that level of debt, as our foreign creditors are already reducing their purchases and seeking to ‘diversify’ their assets. China is inking trade agreements with Brazil and Argentina to conduct trade in the Renmimbi rather than in dollars. China is also channeling more of its massive currency hoard into durable commodities like copper, gold, and oil. Every day it seems, the discussion of the status of the dollar becomes a bit more open, a bit more honest, as countries seem to feel increasingly free to point out that the dollar’s days as the reserve currency of the world are numbered. Dollar-denominated Treasury debt is like a game of musical chairs: in the end, not everyone will get a seat.
In the past, the US has relied on economic growth to reduce its debt. Is that possible now? Total Federal government revenue was $2,554 bil in 2008. Let’s say that average rates of US growth resume immediately (3% per year) and continue indefinitely. Say that Federal revenue increases at the same pace. Say we immediately run surpluses, so that we can pay the interest on the debt plus an additional 1% of Federal revenue to pay the principle. (In 2008, that combination would cost $451 bil in interest plus $25 bil in principle, instead of the $458 bil deficit that actually occurred). Even with these rosy assumptions, it would take about 90 years to pay back the debt. Ninety years of solid economic growth and perfectly balanced budgets (plus the 1% surplus). No government on earth has such a record. (This analysis doesn’t include all the unseen obligations the US government has, such as Social security and Medicare, which add up to trillions more).
It seems likely that at some point, the United States’ largest creditors will demand repayment in some other form than dollars. Perhaps they would demand payment in their own currency, but that seems unlikely. The traditional asset for international settlements is gold, so gold is the most likely candidate, especially given that our two largest creditors, China and Japan, have relatively low gold reserves, while the US has the largest gold hoard in the world.
Let’s consider what would happen if the debt would have to be paid off in gold. According to the US Treasury (www.fms.treas.gov), the US government is in possession of 261,498,899 Troy ounces (8,133 tonnes) of gold, which at a gold price of $964, is worth $252 bil. The US gold stock is unaudited, and since it is also routinely leased to other parties, how much of it is owned free and clear by the government is unclear. The way that gold is leased is through a kind of repurchase agreement called a gold swap, which gives the US Treasury cash in exchange for a firm commitment to buy back the gold at a specified point in the future. For example, Goldman Sachs may give the US Treasury $1 bil today, using the gold as collateral, to receive $1.05 bil in one year, whereupon the gold reverts to the Treasury’s possession, though the gold has never left the vault. While 5% isn’t a great return, I’d say that Goldman can use the contract as an asset, since it’s backed by gold and the full faith of the US Treasury, which allows Goldman to obtain a risk-free return on the $1 bil, and still put the money to work in other ways to obtain returns.
The Gold Anti-Trust Action Committee (GATA) has estimated that the total amount of gold that is leased through gold swaps is between 12,000 and 15,000 tonnes, about half the total of all gold held by central banks. Individual nations don’t publish the extent of their gold swaps, but let’s say that half of the US Treasury’s gold has been leased, meaning that the gold is no longer an asset, but rather an obligation. If the Treasury really owns just half the gold in its possession, then it has about 131 mil Troy ounces of gold, worth $126 bil.
Now let’s imagine that a few of the large holders of US Treasury debt were to demand that the debt be repaid in gold rather than in dollars. The US Treasury holds its gold at a book value of $42.222 per Troy ounce, rather far below market prices. (If only one could buy a few ounces at that price!) Say that China and Japan (which own $1,477 bil) demand repayment in gold. Of course, these countries wouldn’t be so unreasonable as to ask for all the money all at once; let’s say they simply stop buying new debt, and ask for the interest on the debt outstanding to be paid in gold. If any large buyers were to stop or even slow their buying, yields would rise. Let’s say the yield rises only to the historical mean of about 6.5% (an event like this would probably push the yield far higher). At that yield, the interest would come to $96 bil a year, which would quickly drain the US Treasury’s entire gold stock. In fact, it would be gone in less than 18 months. If China and Japan started asking for gold, other countries would no doubt follow, as would large domestic holders, both institutional and individual. If the entire interest bill had to be paid in gold, it would come to $63 bil per month, and the Treasury would be out of gold in two months.
Now if there are no new buyers for Treasury debt, either the Federal government must immediately balance the budget, which seems unlikely, to put it mildly. More likely the Fed will step in and buy the debt directly, with money it conjures out of thin air. This leads to further depreciation of the dollar against gold, and would probably lead to a lot more demands for payment in gold, as creditors realize that their dollars will get less gold than before.
So we can’t grow our way out, and we can’t fall back on gold. The only other possible avenue is to depreciate the dollar. But how much depreciation would it take to reach the equilibrium that markets demand? If the situation arises where gold is sought for repayment rather than dollars, the question is, at what price? The US government will have give up the accounting fiction that the gold is worth $42.22 an ounce, and set an exchange rate between the dollar and gold. The rate chosen will not be below the market price, it will be well above the market price. How high is anyone’s guess—I’ll say $10,000 an ounce just to get the guessing started. This option allows the US to service its debt without the humiliation of an outright default, though it will still probably result in chaos, just as it did when the US last tried it, in 1933. It also creates a de facto gold standard. With gold at $10,000, the Treasury’s gold is worth $1,310 bil, and can now be used to pay the interest on the debt!
Where things go next is hard to foresee. But it’s clear that the debt is far too large to pay off, and that the United States’ creditors will demand payment in an asset that the US government can’t depreciate at will. The signal to investors is pretty clear: get out of Treasury debt and into gold. One way or another, the US will repudiate its debt. The other lesson is equally clear: the inevitable depreciation of the dollar simply follows the logic of the market, and cannot be denied by either money creation or fiscal stimulus.
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