Bankruptcy US Style
It is rare indeed to find any person, family, corporation or
government entity that has concluded both of the following:
1. It is on course for bankruptcy.
2. It is going to do nothing about it, or is going to make
bankruptcy even more likely.
Don’t believe this ever happens? Take a look at the US
If anyone should know about the US federal government’s
finances, it is David Walker. Mr. Walker
is the nation’s chief accountability officer and head of the U.S. Government
Accountability Office (GAO). From the web site… “GAO’s mission is to help
improve the performance and assure the accountability of the federal government
for the benefit of the American people. GAO has earned a reputation for
professional, objective, fact-based, non-partisan, non-ideological, fair and
balanced reviews of government programs and operations.”
David Walker’s “60 minutes” interview is currently available
in the Video section of my web site (www.ChrisBelchamber.com).
The interview displays Walker’s conviction that urgent action is needed to
avoid bankruptcy for the US federal government. It also suggests that most
politicians in Washington do not disagree with his basic conclusion, but the
most remarkable part is that apparently no-one wants to talk about it, because
no-one wants to do anything about it!
Indeed it is clear that David Walker has also reached this
conclusion. So the only thing he believes he can do is go on a “Fiscal Wake-Up
Tour”, to try and explain the issue directly to voters. However, it is a tough
sell, as politicians know, and even if he is able to “wake” a few voters to the
current fiscal peril, it is a long, long road to get anywhere near to
sufficient action in Washington.
This may or may not be disturbing to you, as this is a long
term issue and a “tipping” point still seems several years away. However, as an
investor, I believe this issue has now become too significant to be ignored any
longer. This note discusses how and why
the coming “Sovereign Bankruptcy US Style” is already having an impact. It
could be influencing your investments much sooner than you realize.
Bankruptcy is a painful process for everyone involved. The
bankrupt entity can no longer pay its debt and so no longer has access to
credit. In most cases this means that it ceases to function in its current form
and has to face drastic measures in order to survive at all. Creditors see
their investments disintegrate and struggle to find a least painful solution to
retrieve any asset value at all.
There is little doubt that the best action to take is to
avoid the whole situation if at all possible. This takes a great deal of
insight and courage of convictions, because usually most people do not see it
coming. Also we need to be aware that sovereign bankruptcy has some special
aspects that make an important difference to bankruptcy resolution.
The unique factor in the case of the US is that almost all
of the debt is US dollar denominated. Of course, the US controls its own issuance
and supply of currency, so this already informs us of the nature of what would
happen if the US continues to move relentlessly towards bankruptcy. There would
not be a sudden foreign exchange crisis in the manner of Thailand in 1997, or
Argentina in 2001/2, as the combination of fixing currency levels, with very
high levels of foreign debt were the main features in these cases, and were
pushed to breaking point.
In the case of the US, it is much more likely that when the
US finds itself in a situation where raising taxes and/or reducing spending is
no longer feasible (are we there already?), printing dollars will be the only feasible solution. As the US has become so dependent on foreign
capital, the key indicator will be the dollar and long term bond yields. Although
both of these indicators can be influenced by central banks, international
confidence and support is increasingly important.
There is little doubt that this situation will be managed
carefully, however, what we do know, is that as policy moves down the road of
dependence on monetary stimulation, conventional investment rules get thrown
out of the window, and very often far before actual bankruptcy or a “tipping
Before we return to how the US is likely to resolve this
issue, it is instructive to look at the extreme case of Zimbabwe. I am not for
a moment suggesting that the US will follow the same path as Zimbabwe, but what
has happened there describes how financial markets can be turned upside down in
terms of how they react to changed circumstances. Let’s take a look at what
happens when a country takes money printing to the extreme.
The tragedy of Zimbabwe has played out over a period of
decades. Our focus is on the financial policy imposed by an increasingly
dictatorial government. Disastrous policies have led the country towards
effective bankruptcy. However, as the government controls the money supply and
it is impossible to take capital out of Zimbabwe, bankruptcy has apparently
been avoided by printing money to excess.
Printing money at first seems to have benign effects.
However, beyond a certain point it becomes very hard to turn off the money
supply and return to discipline. Excessive money supply simply becomes standard
procedure. In this instance the logic of financial planning is turned upside
down. Cash holdings and fixed income bonds become increasingly worthless. The
only assets that provide any security of purchasing power or return are equities.
In Zimbabwe, the country’s farming, tourism, and most other
businesses have collapsed. Unemployment is said to be near 80%. Yet the key
Zimbabwe Stock Exchange is the best performing stock exchange in the world. The
key Zimbabwe Industrials index is up nearly 600% this year and up 12,000% over
the last year. Even though inflation is said to be around 2000% this still
represents a huge gain in real terms for equities. At the same time cash and
bonds are worthless, so not only do equities outperform, in this instance, they
also provide the only hope of retaining any purchasing power.
Think this cannot happen in major
From an economic policy standpoint the Zimbabwe experience
has many similarities with Germany in the 1920s. At that time Germany was one
of the largest economies in the world, with an unsustainable level of debt, and
once again excessive money supply became the only short term solution to debt
financing. So, of course, this kind of outcome can and does occur even in the
largest economies. The Roman Empire (Market Notes 7) devalued its currency
consistently for hundreds of years prior to its own final demise.
Indeed, coming back to the US at current times, the chart
above shows that the purchasing power of the US dollar has already been falling
significantly since the link with gold was broken in 1971. What is disturbing
is that over this period the asset position of the US has continued to
deteriorate at an accelerating rate, and the US has become more dependent than
ever on foreign capital. If anything the pressure to accelerate devaluation is
In the case of the US, capital controls may well be far less
likely, than in the case of Zimbabwe. Capital controls would have a dramatic impact
around the globe, so it is more likely that central banks around the world
would attempt to smooth the impact of dollar devaluation. Indeed aren’t they
already doing this through the explosion of foreign exchange reserves?
Nevertheless, a much softer version of excessive money
supply than Zimbabwe, is still the likely safety valve to smooth out government
profligacy. With this background how safe do you believe cash and bonds are
over the next ten years? Do you still believe that they will maintain their
purchasing power? Investors, and particularly retired investors, will need to
think very carefully about their genuine inflation protection. The orthodox
“safety” of cash and bonds could well turn out to be an illusion. You might
just be locking yourself into a guaranteed loss of purchasing power.
Conventional wisdom tells us that the safest assets are cash
and bonds. However, if the purchasing power of the currency you are in is
falling at a rapid rate, then this thinking can be dangerous and misleading.
Rather than providing a safe store of wealth, cash and bonds could just be
locking you in to a sure loss of purchasing power. Equities may have a great
deal more short term volatility but in the longer term they may well provide a
far more reliable store of value, particularly if they are linked to tangible
Much depends on the rate of devaluation and the compensating
level of interest rates. However, we are now in a situation where bond yields
are near record lows for the post 1971 fiat money period, and the US is increasing
its level of debt and dependence on international capital at an accelerating
rate. As regards safely retaining purchasing power, this does not seem like a
promising background for cash and bonds.
may still be far into the future, but that is no guarantee against an
accelerating devaluation in the purchasing power of US dollars far in advance
of a payments crisis. Miscalculating government policy’s influence on a
currency’s purchasing power could be highly detrimental to long term wealth
creation or even just maintaining the real value of savings.
All material presented herein is believed to be reliable but
we cannot attest to its accuracy. Investment recommendations may change and
readers are urged to check with their investment counselors before making any
Opinions expressed in these reports may change without prior
notice. Chris Belchamber (the author) may or may not have investments or
positions in any assets or derivatives cited above.
Communications from the author are intended solely for
informational purposes. Statements made by various authors, advertisers,
sponsors, and other contributors do not necessarily reflect the opinions of the
author, and should not be construed as an endorsement by the author, either
expressed or implied. The author is not responsible for typographic errors or
other inaccuracies in the content. We believe the information contained herein
to be accurate and reliable. However, errors may occasionally occur. Therefore,
all information and materials are provided “AS IS” without any warranty of any
kind. Past results are not indicative of future results.