How We Would Know if U.S. Were About to Default

Includes: UDN, UUP
by: One Eyed Guide

The first and most important sign will be the U.S. issuing debt in something other than the dollar like european countries do in Euros. Until this occurs there is nothing that the U.S. can default on even though there is plenty of press on it. The real question is who is taking the other side of trades in CDS's on U.S. debt obligations given the current situation?

The History: Back during the gold standard days, the U.S. issued Gold Certificates with stated values of “XXX Dollars in Gold Payable to the Bearer on Demand.” You could take your money and trade it in for a nice pile of shiny gold coins. If the U.S. ran out of gold, well, it would have been bad and it could have defaulted which is why it went off the gold standard in 1971.

Gold Certificate
Today: Now all you can do is trade your dirty old money in for fresh new bills. If the U.S. runs low on money to pay its debts it simply prints more money. Problem solved.

Maybe U.S. CDS buyers are anticipating an event where the USA is forced to issue debt in something other than dollars? There are 2 possibilities:

  1. The U.S. agrees to use an alternative currency such as Special Drawing Rights (SDRs) for international obligations. While the U.S. might end up backing SDRs as a trade currency, it will be because of the advantages to the U.S. China, one of the countries whose currency is in SDRs, is almost certain to scuttle any use of SDRs or any basket of currencies to finance trade as it would eliminate their ability to continue to manipulate their currency. In any case the SDRs in their current form are not usable as a trade currency.
  2. Deterioration in the U.S. economy causes freshly printed dollar to no longer be acceptable to pay for foreign purchases. China is selling dollar denominated debt so perhaps this indicates that the dollar is deteriorating. Actually, all this is indicating is that the Yuan is undervalued, causing instability/inflation in China and the Chinese are lowering their exposure to dollars before devaluation. It would be irresponsible of the Chinese to not cover their losses on their own currency manipulation.

The current situation is a probably a global shortage of safe assets such as US dollars, just as it was in 1969 which caused SDR’s to be created. In fact, China is complaining about the lack of U.S. debt obligations.

This could change if the U.S. economy undergoes hyperinflation due to excessive debt and currency growth. The thing to understand about hyperinflation (technically, inflation in excess of 50% per month but whatever makes you uncomfortable for the layman) is that it can only happen when there is an increase in spending of money combined with a lack of goods to spend money on. In the high inflation in the 70s/80s (which was not hyper) the cause was external oil price shocks, which led to a round of cost-push inflation.

Currently the U.S. is in a recession due to a lack of spending/demand (which may have been triggered by oil price shocks when oil peaked over $140/barrel). Once inflation creeps high enough to make people want to spend before their money’s purchasing power disappears, all excess capacity will have to be used up before there can be hyperinflation. Unemployment will have to drop from the current 9.7% to a full employment 4.5% and capacity utilization increase from the current 72.6% to a normal 82%. Anybody who thinks this is not years in the future is a blind optimist or disingenuous.

People who incite hyperinflation fears using Germany after WW1 and Zimbabwe after Mugambi had his thugs take over the farms don’t understand that today’s problem is a lack of demand, not capacity like in these examples. Germany and Zimbabwe economies were destroyed and did not have the productive capacity to satisfy demand which resulted in hyperinflation. This is not the case in the U.S.

So why are there CDSs sold on U.S. debt? My explanation: There’s a sucker born every minute.

It will be interesting to see if the proposed regulation of CDS bans products that have no rational for being.

Disclosure: No Positions

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