If the USA Defaults Again It's Not the End of the World

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Includes: AGG, DIA, QQQ, SPY
by: Avery Goodman

Big banks, politicians and financial writers in the mainstream press are doing everything they can to convince the American people that a temporary cessation of payment on some financial obligations of the Federal government will cause the end of the world. Certain key facts, however, are not being pointed out.

When the U.S. Congress first enacted a flat rate Federal income tax in 1894, it was declared unconstitutional by the U.S. Supreme Court. The Court ruled that a direct tax could not be levied upon citizens individually, because it was not apportioned state by state, as envisioned by the Founding Fathers. In response to the ruling, the 16th amendment was eventually ratified in 1913, and this ended the argument that the income tax was unconstitutional. It effectively overturned the Supreme Court and allowed the Federal government to tax individual income for the first time.

Because of the passage of the 16th Amendment, 1913 was the first year of the U.S. income tax. Things were different back then. Back in 1913, for example, gold was selling on the open market for about $18.99. The U.S. government, however, would not sell gold for less than $20.67 per troy ounce. It was, therefore, cheaper to buy non-coinage gold, in the open market, than to convert dollars into gold coins, giving the dollar a tiny signeurage over gold. That, of course, is exactly as it should be. Most interesting was that for the 100 years that preceded, there was almost no inflation, other than temporary inflationary times, such as the Civil War period. These bouts of inflation were almost always followed by a bout of deflation, such as that of the 1870s. Both the official and market price of gold had been almost exactly steady, at their respective levels of pricing, for almost 79 years. Along with the Internal Revenue Act, the Federal Reserve Act was also passed in 1913. The so-called "Fed" came into existence the very next year, bringing with it a wave of continuous inflation that has never ended.

Back in 1913, America's per capita GDP exceeded that of the U.K. for the first time. It stood at an impressive (for that day and age) $5,301 per year. More than 98% of the population earned less than $20,000 per year. The tax rate on a married couple, earning from $0.00 to $20,000.00 was 1%. The tax rate on an income of $20,000.00 to $50,000.00 was 2%. Only about 1/4 of 1% of the population earned more than $50,000 per year. But, even for those who earned more than $500,000 (the richest of the rich of that day and age) the top tax rate was 7%. American growth rates, year after year, prior to 1913, were consistently in the double digits, or very close to that, even during the so-called "depressionary" deflation years of the 1870s. And, during the 1870s, in the midst of what was supposed to be the deepest depression ever experienced until the 1930s, the standard of living of most Americans rose dramatically, as did their productivity and average personal income.

As noted, prior to 1913, our nation also existed happily without the stealth taxation imposed by the Federal Reserve's endless monetary debasement of the U.S. currency. By 2011, as most economists know, this stealth taxation/debasement campaign, all in the name of increasing the welfare of our nation, has resulted in a loss of 98.7% of the purchasing power of the U.S. dollar when measured in gold. Indeed, aside from stealth taxation, the current rate of open personal income taxation would have been inconceivable back then. Every congressman and senator who voted in favor of 16th Amendment, and the income tax it facilitated, back in 1913, would turn over in his grave if he knew that the rates that average middle class people are forced to pay in the USA and elsewhere in the crumbling western world. Individuals and private industry, alike, pay onerous tax rates. Money is placed into the hands of government, from whence it is redistributed from those who pay to those who are the favorites, for one reason or another, of the Washington D.C. crowd. Yet, in spite of all this, a majority of bankers, politicians and financial writers are now pressing for increased taxes and new powers for the Federal Reserve!

Worrying about irresponsible spending by the U.S. government, however, is nothing new. The main difference is that the levels of irresponsibility have multiplied exponentially. But, the debt limit goes as far back as 1917. It was first passed into law out of concern of excessive borrowing, in association with the passage of an Act of Congress authorizing the sale of "Liberty Bonds." The money gathered by their issuance was used to finance the entry of the United States into World War I. In each and every year since we have had more and more bond issuances, and more and more money printing by the Federal Reserve, and in every year the debt limit has been raised, making the limit essentially meaningless.

In spite of this history, fear-mongers claim that tax increases are far preferable to either spending cuts, or the possibility that America temporarily stops paying some bills as a result of congressional gridlock. They say it would be the end of the world as we know it. But, like all the other history they ignore, they also ignore the fact that the U.S. government has defaulted many times in the past. It defaulted in 1933, when Franklin Roosevelt refused to pay privately held gold denominated bonds, and, instead, confiscated all American owned privately held gold. It happened again, in 1968, when the Federal government refused to deliver physical silver in exchange for the silver certificates it had issued. It happened again in 1973, when Nixon defaulted on gold debts to foreign nations by unilaterally closing the door on America's inter-governmental gold obligations.

Hopefully, a review of history will teach readers that the possibility of a technical or temporary default by the U.S. government is meaningless in the long term. It is even more inconsequential when viewed against a background of previous debt defaults. Indeed, such an event would be cathartic. The least painful part of the payment shortfall would surely be targeted first. A very large part of the debt is owned by a quasi-public/private central banks we call the Federal Reserve. Other parts of the government also hold treasury bonds. Payments to those entities can be delayed with few consequences, and without even incurring a legal "default" because so long as creditors agree to a cessation of payments, there can be no default under the law. It bears noting that the profits of the central bank, most of which come from payments on Treasuries, are supposed to be turned back over to the Treasury at the end of every year.

Frankly speaking, a default is never a good thing. A U.S. government default may cause higher interest rates and a falling stock market. But, the people who are the most severely exposed are those running the casino-banks and related hedge funds, who were stupid or greedy enough to issue $26 billion worth of credit default swaps on U.S. government debt. When they issued them, they received very low premiums in exchange, because they believed that their lobbyists could insure that money-printing policies would make a U.S. government default impossible. Yet, if their lobbying and fear-mongering campaign fails, that is exactly what will happen, at least technically. The losses, however, won't come even close to $26 billion. First of all, the net liability, after an offset for opposing CDS, is less than $5 billion. Second, whenever a default happens, technical or real, the official practice is to have an auction. It is very likely that buyers will scoop up Treasury debt at any small discounts offered, on bids that are almost equal to the preexisting value. In other words, not even the reckless international casino-bankers would lose much.

For everyone else, after the initial shock a temporary payment shortfall, the end of the world is not even close. Stock market indexes, like the S&P 500 (NYSEARCA:SPY) and Dow Industrial Index (NYSEARCA:DIA) will probably fall, at least for a while, very dramatically. But, stocks are quite pricey now, and should fall anyway. The value of U.S. Treasury bonds will probably go down to a greater or lesser extent. But, this is a very small price to pay for the benefit of forcing massive spending cuts. The alternative is unthinkable. If the uncontrollable spending monster cannot be stopped now, in the midst of so much worry about sovereign insolvency, when can it be stopped? Will it be allowed to grow and consume more and more until not one more dime is available to borrow, or left in the pockets of taxpayers, so that the economy is destroyed permanently?.

The value of Treasuries is unlikely to drop suddenly or dramatically, at least not as a result of a technical default. Almost everyone knows that eventually any unpaid interest will eventually be paid. The big danger is the possibility that the Federal Reserve will continue to debase its "Federal Reserve Note" dollar into oblivion. If there is a dramatic drop in Treasury or equities prices, as a result of a temporary default, a buying opportunity may arise. Stocks and U.S. Treasury bonds might become cheap enough, for a while, to be worth buying. Whether they become a good investment depends, of course, on how low they drop.

Investors nowadays should look at history. The greenbacks printed during the Civil War dropped as low as $0.20 to the gold coin dollar. It seemed to most people at the time, that the U.S. government intended to default on its greenback emissions. In those days, of course, defaulting was defined as never being willing to pay them off in gold specie. Eventually, however, the U.S. government made "good" on greenbacks, and redeemed them for true U.S. dollars in the form either of gold or silver coin, or in true U.S. Notes (which, unlike the greenbacks, were overtly redeemable for gold). The government paid 1 ounce worth of gold coin based dollars for every $20.67 worth of greenbacks, which was exactly the same price offered for all other versions of the U.S. dollar.

People willing to accept the "greenbacks" that no one else wanted, during the Civil War, bought them on the cheap, and eventually made huge profits. Similarly, people willing to buy treasuries, during any upcoming period during which a temporary cessation of payments takes place, may also earn big profits. If the opportunity comes, savvy investors will leap on it. Yet, because so many people are hoping to leap on any such opportunity, the opportunity will be prevented from happening. Treasuries can be expected to decline over time as a result of continuing unsound monetary and fiscal policies. However, it is unlikely that the failure to raise the debt ceiling, right away, will have a significant effect on their trading value. And, so, we can say to another USA defaul t..."so what?"

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.