Sovereign 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 federal government.
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 point” occurs.
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.
Zimbabwe Financial Markets
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 economies?
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 building.
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 assets.
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.
Apparent bankruptcy 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.
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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.
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