Will the US Devalue the Dollar?

By Darryl Robert Schoon
Mar 3 2010 11:33AM
www.drschoon.com

The ability to wage war on credit gave the West an insurmountable advantage over the East. The West’s credit, however, has now turned to debt and the West has lost its advantage. But the return to parity will not be easy.

The three hundred year economic expansion fueled by debt-based capital markets is coming to an end and with it, the hegemony of the West over the East. During that period, debt-based paper money propelled first England then the US to world dominion because of the ability to wage war on credit and to print money ad infinitum.

That era is now ending because the critical balance between credit-driven expansion and debt-driven contraction has now shifted significantly in favor of the latter; and in 2010, both East and West now find themselves on the edge of a growing deflationary sinkhole created by the sequential collapse of two large US bubbles, the dot.com and US real estate bubbles.

The US caused the 1930s deflationary depression and is again cause of the current contraction; and although similarities exist between the two, the differences between them insure a far more consequential outcome today than in the 1930s.

Global demand is again falling as credit contracts, a sign that debt-driven deflation is back but, today, there is an additional danger as well. Since 1971, because of the US default on its gold obligations, money no longer possesses intrinsic value and the consequences will soon become apparent. Deflationary depressions and a collapse in the value of fiat money have happened before but never simultaneously. Soon, they will.

We are in what Stephen Roach, Chairman of Morgan Stanley Asia, calls the end-game, the resolution of past monetary excesses and imbalances, excesses and imbalances that reached never-before-seen heights in the last decade. The long awaited day of reckoning has arrived.

THE PROBLEM

Capitalism cannot function unless its constantly compounding debt is serviced and/or paid down. Today, the US, the world’s largest debtor, can no longer pay what it owes except by rolling its debt forward and borrowing more, what the late economist Hyman Minsky called ponzi-financing, financing common in the final stages of mature capital systems.

The amount of outstanding US debt has now reached levels that can never be paid off:

… the United States government and its agencies have, by far, the largest pile-up of interest-bearing debts ($15.6 trillion), the largest accumulation of unsecured obligations (over $60 trillion), the largest yearly deficit ($1.6 trillion), and the greatest indebtedness to the rest of the world ($4.8 trillion).
Martin D. Weiss, www.moneyandmarkets.com

The unpayable levels of US debt are not just the problem of the US. Because the US dollar is the lynchpin of today’s fiat money system, US debt is everyone’s problem. The US dollar is the world reserve currency and a default by the US will have far-reaching consequences, especially in China, its largest creditor.

INFLATE, DEVALUE AND TAX

Bill Gross, co-founder of PIMCO, the world’s largest bond fund and an expert in matters of debt, wrote in 2006, the way a reserve currency nation [such as the US] gets out from under the burden of excessive liabilities is to inflate, devalue, and tax.

Inflation destroys the value/cost of liabilities by eroding the value of money. Debts are paid back with inflated currencies, a process which benefits the debtor and injures the creditor. This is why reserve currency nations usually inflate their way out of debt by printing what they owe.

Devaluation is another option afforded reserve currency nations. By devaluing the value of their currency, the value of what they owe falls relative to other currencies. Again, the benefit is to the debtor at the expense of the creditor.

Taxation is another option but is no longer available to the US, as its liabilities are now too high. It would be like forcing the elderly and morbidly obese to engage in strenuous exercise to regain youth. Of the three, inflating away debt is by far the preferred option but it is one the US can no longer choose.

Managing Director and Chief US Economist at Morgan Stanley, Richard Berner, recently discussed the reasons in We Can’t Inflate Our Way Out, February 24, 2010. (http://www.morganstanley.com/views/gef/ ... c960980e46)

It's tempting to think that the US can inflate its way out of its fiscal problems. A faster, sustained increase in prices would erode the real value of past debt, and higher future inflation would - other things equal - reduce the real resources needed to service and pay back the promises we are making today.

However, inflating away US debt won’t work because as Richard Berner points out nearly half of federal outlays are [now] linked to inflation, meaning that increments to debt would [also] rise with inflation.

Inducing monetary inflation would also raise aggregate US debt resulting in a self-defeating cycle of higher prices and higher debt. However, there is also another more fundamental reason why inflating away US debt won’t work, to wit: Inflation is almost impossible to induce during severe deflationary contractions.

Fed Chairman Ben Bernanke understands this difficulty quite well. Bernanke’s late mentor, Milton Friedman, theorized the Great Depression could have been prevented by sufficient monetary stimulus and so in 2008, faced with the possibility of another deflationary depression, Bernanke put Friedman’s theory to the test. It failed.



http://jutiagroup.com/2010/01/27/lookin ... the-abyss/

Unfortunately, when tested, Friedman’s theory didn’t work. Despite Bernanke’s massive monetary expansion, global credit is still contracting and lending is drying up.

The Telegraph UK reported on February 17, 2010: lending has fallen by over $100bn (£63.8bn) since January, plummeting at an annual rate of 16%. "Since the credit crisis began, $740bn of bank credit has evaporated. This is a record 10% decline,â€