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Consider this a milestone. Yellen’s statement, though assumed by most investors, is just “another sign of the times.”
For those who haven’t realized it yet, we are experiencing the first exploding global sovereign debt bubble in 100 years and the first shift in the currency system in 50 years.
Sovereign debt bubble? Currency system shift? Yes I heard that well. When Janet Yellen, the former chair of the Federal Reserve and current US Treasury Secretary, stated that the United States would not be allowed to default on its debt obligations, she was right.
The federal government will not explicitly default on its debt, but will default implicitly, which is in fact exactly what is happening today.
What exactly is the difference between an implicit and an explicit default, you wonder? While the history of government defaults is very accurate, we will briefly examine two examples of sovereign defaults, both of which occurred in the United States over the past century, to provide context.
roar of the twenties
The 1920s were known as the Roaring Twenties, and for good reason. After World War I ended, productivity soared in the United States as inventions and technological advances such as the mass production of radios and automobiles led to the most prosperous times in recorded history.
Not only was technological progress happening, but the stock market just soared, fueling enthusiasm as people got richer each day, as the Dow Jones Industrial Average (DJIA) grew nearly fivefold, from 1920 to 1929.
However, the stock market boom was not the result of a “new paradigm” of productivity or financial markets as many believed at the time, but was mostly due to uncontrolled credit expansion that created a huge asset bubble.
During the last years of the 1920s, many individuals and entities were only borrowing to invest in a stock market that seemed to only be rising.
Collateral values increased -> more creditworthy borrowers -> credit facility -> further expansion of credit -> asset prices increased. virtuous course.
However, like all credit-fueled asset bubbles, there was a crash at the end, and what followed was among the most famous crashes in financial markets ever. The Dow Jones Industrial Average has collapsed 85% in just under three years, as the benign cycle of the credit boom worked in the opposite direction.
Collapse of asset prices -> forced margin calls due to depreciation of collateral -> lower creditworthiness -> stricter lending terms.
However, in this time period, the dollar was pegged to gold, which limited the Fed’s ability to dilute, since any easing of the money supply had to be backed by additional gold reserves. Thus, all the credit extension and the “money” partly held in circulation collapsed back on the gold peg as the bad investment tried to liquidate itself from the system.
Here is a quote from Ray Dalio’s book, “Principles for Navigating Major Debt Crises”:
“Governments with financial systems tied to gold, commodities, or foreign currencies are usually forced to adopt stricter monetary policies to protect the value of their currency than governments with monetary monetary systems.
But eventually debt contractions become so painful that they fall back, break the bond and print (eg they either abandon these systems or change the amount/pricing of a commodity they will exchange for a unit of money).
For example, when the value of the dollar (and thus the amount of money) was tied to gold during the Great Depression, holding up the promise to convert dollars into gold so that the currency could devalue and create more money was key to creating bottoms in the stock and commodity markets and the economy.
Printing money, buying assets, and offering guarantees was much easier during the 2008 financial crisis, because it did not require a legal and formal change in the currency system.”
Historically, gold served not only as a hedge against monetary inflation during the credit boom, but also during the deflationary period that followed and the corresponding counterparty risk.
In 1933, President Roosevelt issued Executive Order 6102, which mandated that all privately owned gold be turned over to the government. Soon after, in 1934, Roosevelt revalued the gold peg from $20.67 an ounce to $35 an ounce. The stated reason for this was that “hard times caused hoarding of gold, stalled economic growth and exacerbated depression.”
The truth is that this was not the fault of the “greedy gold hoarders”. This was an obvious shortcoming. The US dollar, which was pegged to a known quantity of gold, was no longer redeemable at the conversion rate, and it was US citizens who were burdened with devaluation. There was not enough gold in the reserves to recover all the claims in circulation. This was a direct result of the partial bank reserve.