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At this point in our 236 year history, the United States is faced with making a choice between bankruptcy or depression. The problem is that the "choice" may ultimately not be much of a choice at all.

Our Founding Fathers' Perspective

"They say paper money has improved the country. . . not one syllable of this is truth; it is errors from beginning to end. It was CREDIT which did these things and that credit has failed. . . All emissions of paper for government purposes is not making of money, but making use of credit to run into debt by."

One might initially surmise that these sentiments were penned by a Ron Paul supporter. However, it was Thomas Paine who penned these words in 1786. In fact, he went so far as to consider it an act of treason when a government incurs excessive debt "because it operates to take away a man's share of civil and natural freedom, and to render property insecure."

In fact, many of our Founding Fathers maintained a similar perspective, which was contrary to the sentiments of Alexander Hamilton, the United States' first Secretary of the Treasury. However, since Hamilton was George Washington's closest political ally, Hamilton's view carried the day. This led to the establishment of a national bank, and Hamilton has, therefore, been considered the father of our national debt. But, what many do not point out is that it is this same Alexander Hamilton who also unsuccessfully fought for the United States to appoint and empower a King to run its newly created government. Unfortunately, those that struck down this idea did not have the foresight to see the flaws in Hamilton's fiscal perspective.

Thomas Jefferson felt quite strongly that our government should never incur debt with repayment terms beyond nineteen years, and that it must be paid off fully within that time frame. From his perspective, one generation did not have the right to cause a succeeding generation to be bound by its indebtedness.

In an letter dated June 24, 1813 written by Jefferson, who vigorously opposed Hamilton's views, Jefferson made it quite clear that excessive debt would lead to "oppression, bankruptcy, and it's inevitable consequence, revolution." Jefferson continued that "the unlimited emission of bank paper has banished [Great Britain's] specie, and is now, by a depreciation acknowledged by her own statesmen, carrying her rapidly to bankruptcy, as it did France, as it did us, and will do us again."

As we are now several centuries removed from Hamilton's experiment, we are left with Jefferson's prescience resounding in our minds and coffers.

The History of the Federal Reserve

The United States has a fractional reserve banking system. This means that a bank does not maintain a dollar of currency, or greenback, for every dollar represented by deposits at its bank. When you deposit one hundred dollars into your bank, the bank may retain five dollars of that in its vault, and the remaining ninety-five dollars is loaned out in the regular course of its business operations.

If there is some event that may cause the depositors of that bank to demand their money, it would potentially cause that bank to call in loans, sell investment holdings, or withdraw its own deposits that are held in other banks. This puts pressure on the other banks and financial markets, which may be forced to do likewise. This cycle reverberates through the financial system and can bring the entire banking system to its knees.

This is exactly what happened to the banking industry in 1907, in what became known as the 1907 Bankers' Panic. This panic spread throughout the country, and caused many state and local banks to file for bankruptcy.

In 1913, with the enactment of the Federal Reserve Act, the Federal Reserve was created as a response to the 1907 panic. The Fed was given the power to inject more cash into banks in order to avoid another 1907 panic.

As the Great Depression was just around the corner, the Fed would have its first real test. In 1931, Great Britain came off the gold standard. At the time, there were significant gold withdrawals from the United States. The Fed then acted to prevent a further drain of gold reserves by raising its discount rate charged to member banks, which supposedly halted the gold drain. However, not long after the Fed's action, there was a run on banks across the country and over 10% of all banks suspended their operations.

Even though the Fed increased its currency infusions into the banking system during this period of time, the banking industry spiraled into a vicious cycle, which resulted in the Banking Holiday of 1933, during which every bank in the United States was ordered closed by government decree to prevent further runs on banks and resulting bank failures. However, by this point in time, nearly one-third of all banks in the country had gone out of business.

Irving Fisher, an economist of note who lived through the Great Depression, observed that:

The Federal Reserve System, from February to December 1931, increased the issue of Federal Reserve notes by 80%. These issues were due to bank failures which made necessary a larger use of cash. Yet, after a wave of bank failures . . . both banks and their depositors began raiding each other in a cut-throat competition which more than defeated the new issues of Federal Reserve notes.

Irving Fisher, Booms and Depressions, 1932

In fact, his experience in the Great Depression caused Mr. Fisher to change his perspective on the cause of depressions, and surmised that it was actually excess credit proliferation that ultimately leads to depressions. As you can see, he also recognized that the Fed was somewhat powerless during this deflationary spiral.

Of our more contemporary economists, Milton Friedman has put into question the effectiveness of the Federal Reserve in fulfilling its mandate of economic stability.

The stock of money, prices, and output was decidedly more unstable after the establishment of the Reserve System than before. . . [which] should give the reader pause before he takes for granted, as is so often done, that an agency as long established, as powerful, as pervasive as the Federal Reserve System is performing a necessary and desirable function and is contributing to the attainment of the objectives for which it was established.

Capitalism and Freedom, 1982

Our Current Predicament

We are currently living through a period of time during which we are presented with a plethora of potential sovereign debt collapse scenarios. While I do not intend to go through the specific details of potential market shocks that loom on the horizon, you may look up the writings of James A. Kostohryz on Seeking Alpha, who has most eloquently and fully explained the potential pitfalls facing world governments today. However, the most important fact to take away from this is that the United States is not an island unto itself and contagion is highly likely in the event of any type of deflationary event as pertaining to European sovereign debt.

Furthermore, our own government has exhibited an ever increasing lack of fiscal responsibility, as our budget deficits have been hitting record levels, with no current plans for curtailment. Moreover, we have not even been operating under a federal budget for the last three years. Additionally, the United States lost its triple-A credit rating for the first time in the history of our country, and without evidence of fiscal responsibility, we are likely to suffer further downgrades.

Although many have pointed to politics as being the underlying cause of our current situation, I do not agree, and will offer two quotes to potentially explain the single underlying current that has driven us to our current state of affairs.

In a speech to the Constitutional Convention in June of 1787, Benjamin Franklin, one of three people who signed the truce with Great Britain to end the Revolutionary War, recognized the flaws within our governmental system, and surmised that it would ultimately end:

In these sentiments, Sir, I agree to this Constitution, with all its faults, - if they are such; because I think a general Government necessary for us, and there is no form of government but what may be a blessing to the people, if well administered; and I believe, farther, that this is likely to be well administered for a course of years, and can only end in despotism, as other forms have done before it, when the people shall become so corrupted as to need despotic government, being incapable of any other.

It seems that Franklin foresaw, over two hundred years ago, what Milton Friedman recently noted, in that "instead of Lincoln's government 'of the people, by the people, and for the people' we now have a government 'of the people, by the bureaucrats, for the bureaucrats.'" Since it would seem that self-interest has been the underlying cause of our predicament, there really is no political solution to this debacle, despite hopes to the contrary.

In fact, to this end, Alan Greenspan noted:

The cause of economic despair, however, is human nature's propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship. Regulation, the alleged effective solution to today's crisis, has never been able to eliminate history's crises.

Alan Greenspan, Financial Times, 2008

As for the state of our overall economy, I do not think that there is a reasonable person with an iota of economic knowledge that would argue that our supposed "recovery" is quite flimsy, and will most likely result in another dip in the economy. The facts are that the true unemployment statistics are not very pretty, and the real estate market has not provided evidence that a bottom has truly been hit, as presented by the latest Case-Shiller Home Price Indices.

Furthermore, as many investors are viewing this recent "rally" in the financial stocks as a positive factor, the fact is that the financial stock index ETF (NYSEARCA:XLF) has only retraced 25% of the decline from the 2007 market top, and only 62% of the decline from the 2011 market top. When you consider that most other markets have exceeded their 2011 market highs, this does not present an attractive picture regarding the health of our banking system.

With many clear potential shocks to our economic system looming before us, and without even hypothesizing about potential shocks that currently aren't as foreseeable as the above mentioned, there are a myriad of opportunities for the United States to be heading back down into the economic abyss.

In the event that we, as a country, do fall back into an economic chasm, it will then leave the government and the Fed with two options.

1. Bankruptcy

If the government and the Fed attempt to provide a further backstop to the financial industry and the economy, and offer more TARP/TALF/QE, etc., then more credit/debt will be created, which will place our already precarious credit rating in further peril.

If bond holders worldwide see further and further QE and other stimulus being pumped into our markets, it will only be a matter of time before those bondholders become less trusting of our government's ability to pay its ever increasing debts, as our debts continue to grow at an exponential pace. Cleary, this would result in further demands for higher interest rates, especially if we experience another likely debt downgrade due to our inability to get our fiscal house in order.

As interest rates inevitably rise due to the questions that will arise as to our ability to repay debt, it places our ability to pay the ever increasing interest payments in question as well. This would result in our debt obligations increasing at a further exponential pace.

Yet, if the unprecedented amount of stimulus has not ignited our economy to any meaningful degree since 2007, what makes us think that further stimulus would do so? In fact, the law of diminishing returns argues that it would not. Therefore, the hopes that the economy would recover sufficiently to sustain this ever increasing debt obligation would be dashed. And, as Ben Franklin has said, "He that lives on hope will die fasting."

More importantly, history has shown us that further stimulus would not provide the desired benefits. The only result would simply be further indebtedness and fiscal irresponsibility, which could very well result in higher interest rates and push us towards the abyss at a much more rapid pace.

In fact, at a Congressional hearing on September 13, 2011, Alan Greenspan warned of "devastating" damage to financial markets unless Congress addresses the nations soaring debt. Clearly, increasing it through further stimulus would potentially be even more devastating.

As Jefferson astutely noted almost 200 years ago, the "unlimited emission of bank paper [will carry us] rapidly to bankruptcy."

2. Depression

The alternative would be to allow the markets to correct and return to the mean. For the last 70 years, we experienced the most significant credit proliferation in history. When more credit was made available to the public, they had significantly greater purchasing power with which to buy the limited goods and services available in the market. Clearly, this growth in buying power placed price pressure on the limited goods and services available in the market, thereby causing upward pressure upon the prices for those goods and services. This was inflationary.

From an Elliott Wave perspective, we know that this historic credit proliferation was the fuel for the Supercyle 5th wave of the Grand Supercycle 3rd wave. Once this 5 wave move in public sentiment completed at the top of the Grand Supercycle, then it became time for the subconscious sentiment of the public to shift in the opposite direction, which was simply a natural cause of events in the human psyche, and not the operative effect of some exogenous event. Therefore, the public went from a sentiment of growth and credit expansion to a sentiment of regression and credit contraction. This change in sentiment is deflationary, and we see evidence of this sentiment change worldwide as the focus has moved towards austerity here and abroad.

Furthermore, as Irving Fisher noted, excess credit proliferation ultimately leads to depressions:

I venture the opinion . . . that in the great booms and depressions, each of the above-named factors has played a subordinate role as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after.

The Debt-Deflation Theory of Great Depressions, 1933

Moreover, in 1949, Ludwig Von Mises stated that:

The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, again and again, to lower the gross market rate of interest by means of credit expansion. There is NO means of avoiding the final collapse of a boom brought about by such credit expansion.

Human Action, 1949

Lastly, in 1957, Hamilton Bolton, a recognized bank expert, noted that "in reading a history of major depressions in the U.S. from 1830 on, I was impressed with the fact that they were BOTH set off by a deflation of excess credit."

Conclusion

"The definition of insanity is doing the same thing over and over and expecting different results." Benjamin Franklin

As one country after another has been dealing with its excessive debt loads, for some reason, the alarms in the United States have not been sounding loud enough. Rather, after further engaging in debt increasing programs such as TARP, TALF, QE1 and QE2, our economy is still languishing with high unemployment and severely depressed real estate, and is unable to generate the intended escape velocity to bring on the next economic boom.

So, if government/Fed programs have failed in their intended consequences during deflationary periods throughout history, I guess the most reasonable path would be to attempt it again, and take us down the path of bankrupting our country, as foreseen by our founding fathers!? Is this not the definition of "insanity," as expressed by Franklin?

However, if the path less "insane" is chosen, or even if the more "insane" path is chosen but is not effective, then we, my fellow countrymen, are headed over the cliff into a deflationary spiral.

Therefore, at this point in time, the United States seems to be rather imminently headed towards one of two very unpleasant destinies, which history has shown to be clearly within our future. In my humble opinion, I believe that the perspectives of Von Mises, Fisher and Bolton will ultimately prevail, and a deflationary spiral will potentially grip the country within the next year or two. Of course, this does not preclude the possibility for bankruptcy beyond that period of time, so it is even quite possible that both "choices" before us may, indeed, not be a choice at all.

Those who cannot remember the past are condemned to repeat it. George Santayana, Reason and Common Sense (1905)

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

Source: The United States Has Two Choices: Depression Or Bankruptcy