Bankrupting the System to Save It, Part II

I continue where I ended in my previous post on this subject:

The most important asset is regulatory democracy – this cannot be lost.  Sovereign default can ensure the same game can be continued.

Regulatory democracy, with some form of monopoly control over money and credit, provides the best means to ensure control over a willingly compliant population.  Such control results in one very valuable side-effect – the extraction of wealth by the elite over-and-above what would otherwise be available in a free market.

Therefore I conclude that the elite will employ any method to keep such a system in place – but it must be a method that will keep the system in place!  This won’t be a sudden shift to a boot on the face – the willingly compliant population is a key feature of the system.  This also won’t end in hyperinflation, at least not for any of the main currencies.

Multiple actions are being taken in an attempt to keep the system afloat without overt default.  These actions aren’t uniform, nor do they need to be.  The actions aren’t mutually exclusive – several options can be taken at the same time, each providing some breathing room for the system.  The actions can be taken sequentially or in parallel.  Other than the overriding objective of keeping the faith in the system afloat, I am not sure the elite have an over-riding objective.

These actions include cutbacks to government support of the lower and middle classes; the press calls this austerity, but there is little to no austerity for the connected classes.  Overall government intervention in markets is not shrinking anywhere, certainly not in aggregate.  Schemes such as delaying retirement age, reducing government-sponsored medical care, means-testing of benefits, etc., are all virtually certain to come.

There is also inflation.  This method is tried and true; it has worked for thousands of years.  As long as it is kept in tolerable bounds, it will continue to work.

There are other schemes – taxing wealth, asserting more control over investment of private, tax-advantaged accounts – pensions, individual retirement plans, etc.

All of these will help to kick the can, and at least for a time bend the line.  But these options cannot do more than this.  In many economies, the promises made by government to the subject population are far too large to keep.   Estimates for US unfunded liabilities range up to over $200 trillion.  A can that large cannot be kicked forever.

I believe the current system is so valuable to the elite that eventually there will be default on the debt in a final attempt to save it – a default desired by those who benefit from the current system.  Not a soft default – a real, no-kidding, declaration of default.  Bondholders don’t get paid.

The problem, as Gary North points out here in referencing my first post (sorry, members only; he has graciously allowed me to quote from the article) is that this will wipe out banks that are holding sovereign debt.  So when I suggest that the general public will cheer the fact that the bankers got stiffed, Dr. North points out…

The problem here is that these same voters have bank accounts. If there is a wave of big bank bankruptcies, voters will demand that the government intervene to bail out the banks….

I think making depositors whole to the limits of government insurance would get done, and done by the central banks – it is nothing but digits on a computer.  After all, the elite want the system to remain legitimate.  The system will lose legitimacy if depositors aren’t kept whole up to the insurance limits. 

If banks go under, there will be mass monetary deflation.

Given the $200 trillion in unfunded liabilities, I think there will be ample opportunity for the Fed to stave off any deflation, if this raises its head. 

Meanwhile, by defaulting, the national governments will have stiffed the central banks. If the United States government defaults on its Treasury debt, the biggest single loser will be the Federal Reserve System. Its portfolio is about 100% of IOUs issued by the U.S. government.

I do not know if it matters that the Federal Reserve gets stiffed.  I have read a few things wondering about just this question, but I don’t know if there is anything definitive.  I do expect that the Federal Reserve has a better chance of surviving if bank deposits are kept whole, even if the Fed’s balance sheet is a disaster.  The Fed’s survival is faith dependent, not balance sheet dependent.

To summarize, it seems to me that legitimacy in the current system – regulatory democracy buttressed by central banking – is the most valuable asset that the elites have.  With the system in such dire straits, the technocrats (not to be confused with the elite) are doing all they can to keep the system afloat – kicking the can in every way imaginable: so-called austerity, inflation, various new tax schemes, forced investment options on retirement plans, etc.  Anything to keep a true default from occurring. 

The elite, who have secured their wealth in real assets and therefore have minimal relative exposure to fiat currency risks, will allow these technocrats to do that which they have been trained to do up to a point.  That point will be somewhere before the people lose faith in the system.  The people will lose faith if the promises of security disappear.

True default will be declared before this is allowed.  Combined with this will be somewhat reduced benefits to the people.  As long as the people see the bankers getting stiffed – perhaps including some perp walks – the reduction in government benefits could be politically tolerated.

There are enough elements pushing and pulling between inflation and deflation that the default could be delayed for an extended time.  As long as deflation is pushing, central banks can inflate the money supply with little immediate price ramifications.  The $200 trillion of unfunded liabilities gives the Fed a lot of room to inflate.

A muddled mess.  I cannot say it any better than Dr. North has:

This seems like a hall of mirrors. It seems like a maze that we are trapped in. That is because it is a maze. We are trapped.

In the long run, the system must fail – too many dependent, too few independent.  This cannot be sustained, and inflation won’t make it disappear.  I still anticipate a longer term trend of decentralization and more freedom.  I believe this to be so for several reasons.  Suffice it to say that markets will not be mocked forever.  God (or justice, if you please) will not be, either. 

In the meantime, the system will not be allowed to lose legitimacy – even to include default, if necessary.