Friday, July 15, 2011

Will the US technically default? By Shan Saeed

I dont think that US will default on Aug 2, 2011 as there are too many stakes involved with the biggest economy of the world. If the US default, it would have a ripple effect on the global financial markets and real catastrophe. I don't think the U.S. will default in terms of not paying the interest on its debt. They will though default via a falling dollar as Bernanke begins printing more money i.e. Quantitative Easing 3. With such uncertainty gripping the markets, investors should run for Gold/Silver. The risk is not to hold gold. Whilst there is the potential for 10 percent downside in the short term over the next five to ten years the gains will be big. Or put another way, the purchasing power of paper money will fall. Cash is very risky asset except in times of major market corrections. Talk of fresh monetary stimulus has sent stocks soaring and bonds falling. The market wasn't thinking there would be any mention of QE3 whatsoever and here we're finding out QE3 is not being ruled out. It's a tantalizing headlines. QE3 would be a disaster for the US dollar, making it weak for several years till 2014.

So, what should be done?
A new era of an austerity is the only way to put things in order. The US government borrows $4.5 billion a day just to keep going, that the national debt is now an existential threat to its economy. No wonder this is being called the most predictable crisis in U.S. history. Austerity is always contractionary leading to recession. So, the big question is the US economy heading for Japanese style of lost decade. I dont rule out the possibility.

Knowledgeable people in finance are aware that the U.S. Federal Reserve has been buying 70 percent of all new Treasury paper, making the government by far the largest client of its own debt. This is possible only by increasing the money supply and the balance sheet of the Fed itself, a practice that sooner or later must blow up. Increasing the monetary base adds to inflation and loss of purchasing power of consumers who are already under debt. Price inflation can be reduced through monetary deflation.
Most american consumers are deleveraging themselves. The household debt to GDP ratio is 122%. It requires $5/6 trillion to deleverage to bring it back to 100% of GDP. Thus , it would lead to sub-par growth and stagnation in the economy with high unemployment.

Economists Carmen Reinhart and Kenneth Rogoff from Harvard Business School have shown that economic growth deteriorates as total government debt exceeds 90 percent of gross domestic product. America is already in that range. The real facts are even worse and people in Capitol Hill are aware of this precarious situation. It is already at $1,645 billion for the next fiscal year. The Congressional Budget Office concludes that President Obama’s most recent budget underestimates spending while also overestimates revenues.

According to the Wall Street Journal reports that Standard & Poor’s has taken the unprecedented step of putting U.S. short- and long-term debt on CreditWatch negative and saying there’s now a one-in-two chance they will downgrade the U.S.’s debt within three months. US requires $2 trillion for the next month. Will it survive the turmoil remains an arduous question?

Disclaimer: This is just a research piece and not an investment advice. All financial transactions carry a RISK

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