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.