Thursday, January 15, 2009

Why the US Government Would Be Bankrupted By Deflation


Inflation benefits issuers of debt. This can be seen with the intuition that inflation makes each unit of currency less valuable every year. So in an inflationary environment, each dollar you borrow becomes worth less as time passes.

For an individual the link between your interest owed (mortgage, credit cards) and your cash flow (job, investments) may not benefit as quickly from inflation. Wages lag behind traditional metrics tracking inflation (CPI, PPI). For a business, however, the link is clear.

Suppose that you are CEO of Metal-Free Paper Clip LLC. Each year for 10 years the price of a paper clip has risen 10%. You have a great incentive to borrow to finance anything, because you can make 10% more revenue next year even if you sell the same amount of paper clips -- purely from inflation! So if you took a loan in 2004, each year inflation made it easier for you to pay your debt service.


When investors pour money into an asset, two things can happen. If the supply of the asset stays the same, then the price will rise. But if the price stays the same, you can bet good money that the supply has increased to absorb the new cash.

The latter is what happens every month in the market for US treasury bonds. We have already seen how exporting nations have huge incentives to reinvest dollar reserves in US government bonds. Since the price of these bonds (especially the shortest maturities) is not doubling and quadrupling every decade, we can be sure that the supply has been increasing. This can also be seen in the ballooning US national debt figure. That number is financed by government bonds.

The latest multidecade boom in world trade had set off a wave of inflation that made the US government bond market one of the most liquid in the world as exporting nations scrambled to reinvest currency reserves. This made it easy for our government to deficit spend and issue debt to make up the difference. All this debt issuance and spending further increased systemic inflation, which was fine with the government, since inflation benefits borrowers. Past debt could be repaid by an ever expanding market for future US treasury debt.


The financial crisis has brought the prospect of a sustained deflationary environment closer to reality than it has been at any point in the post war period. This is frightening to those in government who are privy to our leveraged position. If world trade were to decline; if inflation were to decline; if the government bond market were to lose its increasing liquidity momentum, the government would be up sh@#$ creek without a paddle.

Deflation is good for debt holders. When prices are falling, they are promised a stable rate of return and preservation of capital. This is, of course, holding everything equal. If the debt you hold is US government paper and we continue our current deflationary cycle, then its bad for you too.

The government runs a gigantic ponzi scheme to finance its perpetual deficit spending. If the market for government bonds was to contract in a meaningful way, the government could go bankrupt overnight. This is compounded by the fact that the government went "all in" by using increased short term financing to retire long term debt. This exposes the US treasury to the same financing risk that took Bear Strearns out back by the woodshed.

2009 will be an interesting year. As with all declines, there will be wild switches made by consumers as their lives are affected. People will shift from ipods to food, with a million more switches to come as the recession deepens. This will provide opportunities for upside profit. But everything will be short-lived. We are still firmly in a deflationary spiral. Until government intervention takes hold, the case for a coming US currency/debt crisis is extremely compelling.

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