Sunday, September 28, 2008

Can US treasury default?

Greg Mankiw call the "Capital flight" worrisome. Whether the story is true or not (not is the result), there is already some pressure on the Chinese government to manage their foreign reserve, mainly in the US Dollars or USD denominated assets, wisely. Should the foreign capital stop flowing into the US financial system, the only way for the treasury to finance the bailout/deficit etc, is to issue Bonds/bills directly to the Federal reserve system (which is what they do now), which is a classical recipe for hyperinflation as long as the Fed does not sterilize/recoup the injected liquidity, which according to most people, they do for these days. If the Fed still want to control inflation and refuse to inject more liquidity, the result will be that the treasury eventually run out of money. Which asset is risk-free then? The only thing that I can think about is ... GOLD.

Added on Oct 29, 2008: the current situation is this -- the credit market broken after a sequence of adverse events (Lehman Br. AIG, and bad earnings of banks etc.), the Fed is working very hard to re-inflate the liquidity flow in the economy, which is why the Fed has started to directly lend to businesses. Even if they do not sterilize the liquidity they are injecting into the economy, there may not be inflation pressure since the monetary multiplier has broken down.

However, once the order in the credit market/monetary multiplier is restored, inflation pressure will pile-up if the Fed does not shrink the monetary base fast enough. At that time, financing the deficit may be harder if the global investors are reluctant to buy US Treasury bonds/bills.

So, for now, US dollar looks good and Treasury is still safe. The danger is on the way of recovery after the credit market back-up working again. Since US Treasuries are denominated in the US dollars, if the Treasury decides to print money in order to avoid default, the default will take the form of depreciation of US dollars.

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