Friday, October 11, 2013

Default by Another Name

It’s not just Obama who is wrong about default. When Goldman Sachs CEO Lloyd Blankfein declared that America had never defaulted he too was wrong.

So says James Grant:

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.

When Grant talks about “not legally defaulting” he means that when you pay back your creditors with inflated currency, currency that is worth far less than the money that was lent, you have effectively defaulted. 

You will notice that Grant believes that money should be backed by gold. Otherwise it is merely paper. After FDR cheapened the value of money by changing the amount of gold it stood for, Richard Nixon took America off the gold standard and made it all just paper.
Grant writes:

… 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.

Grand understands perfectly well that risk is built in to any investment. The question is how much:

Lend us your dollars for 10 years, the Treasury proposes. We will pay you the lordly interest rate of 2.7 percent per annum. And at the end of those 10 years, we will hand you back your principal, which will almost certainly buy less than the money you lent.

The devil is not in the details. It’s in the inflation. When investors lend money at very low interest rates they are factoring in very little inflation. They might even believe that deflation is more likely. Yet, with the Federal Reserve churning out money that has no basis in reality, Grant is saying that they will inevitably be seriously disappointed.

He is cautiously optimistic:

Let us face facts: We have defaulted in the past. Let us confront the implied message of the Federal Reserve’s pro-inflation policy: We will default in the future, though no lawyer will call it “default.” And let us preempt the world’s flight from our intangible money by taking steps to fashion a 21st-century improvement. We have the gold and the brains to find the solution.

Let’s keep in mind, James Grant was one of the very few to forecast the financial crisis of 2008 well in advance.

One dismisses his view at one’s peril.


Anonymous said...

The financial system has two kinds of financial instrument: (1) money and (2) investments.

The financial system has two modes of operation. In mode 1 society tries to convert money to investments. The investments include savings accounts at banks which help banks circulate bank reserves to make interbank payments while expanding bank credit. In mode 2 society tries to convert investments back into money. Banks cannot do this! Banks are designed to create money from thin air only by exanding the amount of loans with matching liabilities, the liabilities are money as transaction accounts and investments in banks payable as money in the future. This is true under a gold standard or a fiat currency. If society is under a gold standard and begins to generate deflation, then money is more valuable to hold than investments, and society "runs" the aggregate bank, essentially it tries to convert a pile of future payment obligations into a pile of gold (which does not exist in quantity) in the present! Mode 2 does not work which is why government go off the gold standard one way or another, it is not a sustainable social practice and only results in a form of wealth transfer by social disaster in a massive bankruptcy.

Anonymous said...

"Risk is built into any investment."

According to the law established in England, a deposit of gold into a bank was not like storing gold in a warehouse, it was an risky investment in the business model of the banker.

So in a society where the government decrees "gold is money," and where market forces and private contracts give rise to gold reserve banking, the result is a transfer of wealth through the banking system when banks fail in a panic, and because the government is minimimal in this scheme, it is foolish to blame the government for bank failure under a gold standard! The market plus the gold standard generates an unstable financial system all by itself!

Anonymous said...

Suppose money is fixed as gold and productivity of society drives a sustained deflation characterized by the steady decline of prices and wages. This is a simplified view of how the economy could "work" under a gold standard with minimal government.

However modern society must finance industrial assets over long time frames: a bridge, electric grid, oil well field, are funded with investment money in fixed dollar contracts. If prices fall in the future the investment returns on these long term finance projects result in a loss not a profit.

Mild inflation is necessary to validate past investments and keep the investment and saving cycle in "smooth" operation. Letting prices fall results in transfer of assets in bankruptcy. Of course a wealthy person holding purchasing power can increase holdings of actual wealth in a deflation cycle but the real economy has never operated under persistent deflation except in the mind of some economists who envision an ideal world with minimal government and other working assumptions which history has never demonstrated to exist.

The low interest rates on Treasury securities now are caused both by the Fed doing quantitative easing and by the world markets wanting to hold risk-free assets rather than take investment risk. While there is demand for risk free assets there is no danger of inflation, because markets are trying to convert risky investment into money or risk free investmetns, which drives down interest rates. This is deflation psychology and if the Fed and federal government adopt an austerity approach it only causes less aggregate demand for goods from partially idle factories and causes more deflation.

Default by inflation is not the issue when the Fed and federal government are trying to fight deflation and stave off a massive bankruptcy in dollar-denominated long term investmens. Only when society decides again to try to convert money to a bigger pile of investments will inflation begin to become the problem, then Fed may have a challenge or not controlling inflation.

Google this paper for a great discussion of inflation in the late 1960s:

Burger, Albert E., A Historical Analysis of the Credit Crunch of 1966, Federal Reserve Bank of St. Louis, September 1969.

The credit system causes inflation along with government transfer payments that increase demand for goods and services available. If the credit system is saturated with people who want to save or pay down debt rather than borrow then aggregate demand is reduced relative to its prior levels which keep the economy at or near full capacity.