WC Varones

Don't lend your hand to raise no flag atop no ship of fools

Inflation or default?

I write about this topic a lot, because it is the single most important question facing investors deciding on asset allocation. It also will have a direct bearing on the form and severity of the coming social and political troubles.

There are two ways out of the U.S. debt crisis: printing or defaulting. I've leaned toward believing the Fed/Treasury/bankster complex would choose inflation for a couple reasons:

1) It's not as sudden or dramatic as default so the politicians and Fedheads think the consequences will be less severe (not that they've thought that far ahead yet; but that's what they'll think when they get to that point).

2) The powerful get richer (see Goldman Sachs during the Reign of Terror of Zimbabwe Ben) as their highly leveraged asset holdings skyrocket in price, and inflation steals from the asset-poor working and middle classes.

Prior posts touching on this include The Slow Puncture (November 2007) and What Comes Next (Oct 2008).

But today I belatedly (it's an August article) came across a thought-provoking contrary opinion by Jeffrey Rogers Hummel, who says default on U.S. Treasuries is likely. We agree that taxes and spending cuts cannot be sufficient to service the debt, but Hummel thinks inflation won't work either. His conclusion:
It is not literally impossible that the Federal Reserve could unleash the Zimbabwe option and repudiate the national debt indirectly through hyperinflation, rather than have the Treasury repudiate it directly. But my guess is that, faced with the alternatives of seeing both the dollar and the debt become worthless or defaulting on the debt while saving the dollar, the U.S. government will choose the latter. Treasury securities are second-order claims to central-bank-issued dollars. Although both may be ultimately backed by the power of taxation, that in no way prevents government from discriminating between the priority of the claims. After the American Revolution, the United States repudiated its paper money and yet successfully honored its debt (in gold). It is true that fiat money, as opposed to a gold standard, makes it harder to separate the fate of a government's money from that of its debt. But Russia in 1998 is just one recent example of a government choosing partial debt repudiation over a complete collapse of its fiat currency.
And Hummel thinks default is not only what will happen, but what we should do:
To be clear, I am not denying that a Treasury default might be accompanied by some inflation. Inflationary expectations, along with the fact that part of the monetary base is now de facto government debt, can link the fates of government debt and government money. This is all the more reason for the United States to try to break the link and maintain the second financial firewall. We still may end up with the worst of both worlds: outright Treasury default coupled with serious inflation. I am simply denying that such inflation will forestall default.
Read the whole thing. And don't you EVER buy a security backed by the full faith and credit of Timmy the Tax Cheat and Zimbabwe Ben.

HT: Henry Blodget via Repudiate the Debt.

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