What would happen if the Government repaid all its debt?

Imagine you are personally in debt. You have three choices: Repay, Refinance, or Default.

What's your plan? I hope it's to live within your means, and gradually repay your debt, or at least keep it stable.

If on the other hand you are living beyond your means, (spending more than you earn), you'll have to keep borrowing. You will not only need to borrow to re-finance your debt but also to pay the ever growing interest on your debt. Your debt will grow faster and faster as interest piles on top of interest. (Compound interest is a killer for borrowers - just as it is magic for the lenders).

It's not mathematically possible to indefinitely increase your levels of debt and interest. It can't keep increasing forever at a faster pace than your income.

Sooner or later something is going to happen. Either you'll get your finances in order (spend less or earn more), or you'll have to default when nobody is willing to lend you any more money.

Western governments including the USA are living beyond their means. Debt levels have passed the point of no return. Spending exceeds income and debt is piling on top of debt. Interest at ever higher rates is accelerating the growth in debt levels. The will to spend less or earn more has gone.

Sooner or later, something is going to break and it won't be good for those who are exposed to cash and bonds, either directly, or indirectly through their pension plans. The debt balloon is going to pop.

A typical reaction from those who don't understand how things work is to simply assume that things will carry on, as they are. "In any case the govermnent can print as much money as it wants, so it's never going to default".

Let's "assume" that last comment is "true". How would it play out?

You'll wake up one morning and the jangle from our bedside radio is interrupted by an important announcement from the President.

"Greetings ladies and gentlemen and to all citizens and residents of our great country. The present crisis cannot be allowed to continue. Prices are rising too fast. Many items in the shops are disappearing into the hands of hoarders. Financial markets are in disarray, and our bond market has lost all support. The levels of national debt, and the interest on it are beyond control. This clearly is not our fault. It is the fault of {insert scapegoat}. This cannot be allowed to continue."

"We are faced with the inevitable and unhappy challenge of dealing with it."

"As a consequence, in accordance with powers vested in me by the Central Bank Act, which passed into law yesterday, I hereby proclaim that with immediate effect our Central Bank shall pass into the control and ownership of the Treasury. Furthermore, with immediate effect I ordain that the Central Bank shall immediately pay off the entirety of the National Debt together with interest, by way of electronic transfers of lawful currency into the hands of the holders.

"We can not allow this newly issued currency to be spent in a way which will cause further hoarding or shortages to the detriment of the general public."

"Therefore, to prevent such kinds of speculation from happening, I am temporarily placing immediate restrictions on how much lawful currency each individual will be allowed to spend on a variety of items, goods and services. For each individual the monthly amount will be limited to {insert amount} per month. This maximum spending per individual will be known as his personal "allowance". Certain exceptions may be granted, for which permission will need to obtained...."

"As a temporary measure, to allow financial systems to be updated, the banks and exchanges will remain closed for a period of two weeks or such further period as may be necessary."

What happens next?

Apart from the predictable rioting and protests, you won't be allowed to spend more than your "allowance". You won't be able to use your old money. The old money, (if it can be traded at all), will be worth at best 70% of face value. within a month or two you will be lucky to get 30%. Eventually, and probably very soon, it will be worth nothing.

Do I think this will happen? No. There are other scenarios which are more likely. None of them are good for holders of fiat denominated assets like cash, bonds, deposits and money market funds.

The picture accompanying this story is of an Australian 1oz Gold Nugget from 1988. It's a $100 coin worth about US$2000.