Thursday, December 11, 2008

US Default and Dollar Devaluation

The government poured billions of taxpayer dollars into the banks and the GSEs to keep the credit markets working. Not only are credit markets still dysfunctional, but we are on the deflationary expressway to depression.

WPA: unemployed shown at Volunteers of America Soup Kitchen: Washington, D.C. (Circa 1936). Courtesy of the Franklin D. Roosevelt Library Digital Archives, National Archives and Records Administration.

The latest idea for greasing the rusty credit system came out of Washington yesterday, as Jon Hilsenrath and Damian Paletta of the Wall Street Journal reported in Fed Weighs Debt Sales of Its Own. The Fed is considering asking Congress for permission to directly issue its own debt, not tied to Treasuries.

The prospect of another source of US debt issuance has naturally raised a lot of eyebrows. For example, Jesse's Cafe Americain was asking Is the Fed Taking the First Steps Toward Selective Default and Devaluation?

What an image. The NY Fed as a GSE, the new and improved Fannie and Freddie. Zimbabwe Ben can simply print a new class of Federal Reserve Notes with no backing from Treasuries. BenBucks. Federal Reserve Thingies.

Perhaps we're missing something, but this looks like a step in anticipation of an eventual partial default or devaluation of US debt and the dollar.

It is prudent to consider this risk. In an earlier posting, Will Quantitative Easing Crater the Dollar?, we have seen Nouriel Roubini's warning that the Fed's quantitative easing

... will eventually leads to much higher real interest rates on the public debt and weaken the US dollar once this tsunami of implicit and explicit public liabilities and monetary debt driven by rising twin fiscal and current account deficits will hit a world where the global supply of savings is shrinking – as most countries moves to fiscal deficits thus reducing global savings – and foreign investors start to ponder the long term sustainability of the US domestic and external liabilities.

But when will this "eventually" occur? There are good reasons to believe that the big risks lie rather far in the future.

So far, money injected by the Fed seems to be falling into a deflationary pit ... that is, it is not effectively offsetting money lost as the private financial system deleverages. And borrowers and lenders are all extremely risk averse right now.

So, the risks of default or dollar devaluation appear to be mainly in the future -- after the financial crisis ameliorates, credit starts flowing, and the economy shows some signs of life again.