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Worst Case - 10/8/2010 PDF Print E-mail
Written by Dan Petrey   
October 08, 2010

Worst Case

The world is awash in public debt.  (No surprise there!)  Some would argue that the Governments response to the financial chaos was to transfer debt from private hands to public debt, and that is partially true.  More specifically, (and more importantly to all of us) the United States is loaded with debt.  I have repeatedly explained that the only long term successful path to solve this current problem is to grow our way out of this fiscal crisis.  (Of course the successfulness of this growth strategy will be dependent upon those who receive the money to NOT spend it.) I believe the Government has (directly or indirectly) chosen another path. 

Once public debt is unserviceable, I believe the Government has two choices.  For the sake of this writing I will assume the worst case scenario that we currently cannot, (and will never again have the ability to) service our debt, although I am nowhere near convinced this is a long term foregone conclusion. The first choice is to default on our debt.  To not pay any debt and declare ourselves fiscally unfit and maybe approach the International Monetary Fund with our tails between our legs for a bailout!   Obviously, as the worlds reserve currency this would be almost unfathomable due to the kind of global havoc this would cause.  However, this would halt almost all our ability to borrow, ergo politician's ability to spend, and force the "system" to reboot and hopefully prevent a similar recurrence decades later.  Also, as the largest economy in the world I am unsure that the IMF and the rest of the world would even be able to bailout such a mess.  For many reasons, I do not believe this is going to happen.

The other option is to pay our debts with excess monies that have been devalued by their oversupply.  This is often referred to as the monetization of debt.  Basically, the Federal Reserve buys debt (U.S. Government bonds) with money they have printed.  This adds liquidity to the financial system and is reflected by rising asset prices.  In essence they inflate the system and pay off older debts with dollars that have less value than when they incurred the debt.  This strategy is dangerous because it can lead to hyper or runaway inflation and eventually lead to the same destruction option one causes.  If you look at precious metals prices and the falling dollar index an argument could be made that this is the current path of choice. Why choose this path if it leads to the same destination as option one in the end you may ask? 

Well, there is the hope that the Federal Reserve can inflate enough to assist with paying back the debt with devalued dollars, all while stimulating the economy enough allowing more tax revenue to be collected, further easing the debt burden.  Hopefully of course, that increased tax revenue is not spent by our Government.  As asset prices inflate and the public is happy to see their 401k's increasing in value, they are unaware that inflation and devalued dollars are eating their purchasing power away faster than their assets are increasing.  That fine line the Federal Reserve is walking is tenuous at best.  Overdo it and inflation gets out of control.  If they do not provide enough stimulus to the economy then we may have a stagnating economy with enough inflation to place the onus on the Federal Reserve to again decide which path to choose.   I liken it to an inexperienced tightrope walker one hundred stories up with a stiff wind and no safety net.   The worst case scenario looks mighty ugly, and even if it does not materialize there may be many unintended consequences.

Written By: Daniel Petrey, CFO, MBA
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