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A default would be unprecedented and has the potential to be catastrophic” U.S. Treasury Secretary Jack Lew October 3, 2013

The U.S. Department Of The Treasury released a report today warning that a default would be unprecedented and potentially catastrophic. It notes that the credit markets could freeze, the value of the dollar could collapse, and U.S. interest rates could soar, potentially resulting in another financial crisis that could be worse than the one following the 2008 crisis.

Click here to see the entire report.

The current impasse in Washington over the budget highlights the question: What is money and how is its value derived?

The United States dollar has no intrinsic value. It has not been backed by gold since 1971. The dollar is valued, however internationally because it is considered the world’s reserve currency, a title bestowed upon it in 1944 at the United Nations Monetary and Financial Conference at Bretton Woods, New Hampshire. The United States at the time was leading the allies to victory in World War II and therefore positioned itself to be the dominant economic and military power in the world replacing the United Kingdom. At the conference the dollar was selected to be the world’s reserve currency to be backed by gold. Click here to read more on the U.S. Dollar, the Gold Standard and the Bretton Woods system.

People all over the world often accept and favor the U.S. dollar over their local currencies because they take confidence that the dollars are issued in the United States and are backed by the full faith and credit of the rock solid economic and military superpower, the United States.

The trust therefore in the dollar is based on human action and perception, not intrinsic value. As long as people are comfortable with the status and actions of the issuer of the currency, the issuer’s currency retains the perception of value.

If, however, an issuer of currency abuses its ability to print endless bills as Zimbabwe did in 2008-09 and the Weimar Republic in Germany did from 1921-23, confidence is lost in the issuer’s ability to maintain the integrity of the currency and the currency rapidly loses value creating hyperinflation.

Jack Lew is correct in noting that allowing a default by the United States would be disastrous for the country and the dollar. Faith in the United States’ military and economic prowess backed by sensible monetary and fiscal policies are what make a U.S. dollar worth more than one issued by Zimbabwe. The ink and the paper are worth the same, but the fiscal stability of the issuers are not.

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In recent years the Federal Reserve’s monetary policy has been “accomodative“. As part of its quantitative easing program (QE) the Fed has printed trillions of dollars to support the U.S. banks and economy and to drive down the rate of interest the U.S. Treasury pays to its bond holders. The U.S. dollar has received a free pass in recent years as its value has held steady even though trillions of dollars created out of thin air have emanated from the Fed. The dollar has been able to retain its value because of the perception that U.S. Treasuries, while they may not pay much interest, are Triple AAA rated and therefore principal and interest payments are considered secure.

The current default talk in Washington, however, is bound to make holders of dollars and U.S. Treasuries nervous. Because Congress in recent years has not passed a budget and relies on continuing resolutions to fund the government, fiscal policy appears dysfunctional. Highly accomodative monetary policy and dysfunctional fiscal policy are not confidence builders.

When one lends money and receives a bond from the issuer one must trust that the issuer has the means and intention of paying back principal and interest. The less confidence one has in the bond issuer’s ability to repay, the more the lender will require to be paid in interest before making the loan.

The United State already has two strikes against it in the form of accomodative monetary policy and dysfunctional fiscal policy. It can’t afford a third strike in the form of a default. Congress can also easily pay the interest on the United States’ debt from incoming tax receipts. It may not be able to fund everything else, but it can pay the interest on its debt. That should be the starting point in any budget debate -take the threat of default off the table.

It is unlikely that an agreement, at least to pay the U.S. debt obligations when they become due, won’t be reached but, it is a possibility. Even if an agreement is reached some damage will have been done to the prestige of the dollar because of the talk of default. The sooner bond holders are assured that their interest payments will be paid on time, the faster confidence can be regained in the dollar.

Usually during currency crises gold and silver rise in value as they are considered stable monetary metals. Gold and silver don’t default or threaten to default. They don’t shut down and have no counter party risk. This is why they have been universally accepted as money for 5,000 years.

Further Reading:

Buying Gold and Silver

The Dark Side of Artificially Low Interest Rates

Why are interest rates being kept at a low level?

Buy Gold and Silver

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