Why the US is heading for a currency crisis

America's government is in debt, its citizens are saddled with $8.7trn-worth of mortgage debt, and it's running a huge trade deficit. All of which means that the country is heading for the biggest financial train wreck in history.

Poor Ben Bernanke. The greatest financial train wreck in history is going to happen on his watch, and it will be mostly his predecessor's doing. But not the work of Alan Greenspan alone. The Washington elite and their compulsively clever counterparts around the world have set the US (and global) economy up for a currency crisis of gargantuan proportions.

When? Soon.

US government debt: it out-dated deficit excuse

The lamest deficit excuse, a story left over from the 20th century, is that government can use borrowed money to stimulate the economy. It can't. While it's true that government can spend borrowed money to encourage particular favoured activities (the ones with the right political connections), the borrowing dampens the rest of the economy by depriving it of capital.

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What's worse is that the favoured activities are usually of the wasteful, rat-hole variety: wars, regulatory agencies, fatter subsidies for uneconomic farming, more complex Medicare programs, and bigger budgets for public schools that don't teach and for colleges that teach whining. Meanwhile, commercial projects that add real wealth get cut off from the capital they need or have to bear the added costs that come from the government competing for investor funds. And so the government is left with more debt to pay and a smaller economy for its tax collectors to feed on.

It's not rocket science. Arithmetic is the same for a government as for the guy driving a Mercedes on a Volkswagen budget: spending more than you make, let alone more than you will likely ever make, leads to ruin. The only difference is that it takes governments longer to get there.

And if we're not there yet, we are getting very close. The US government has run up a truly horrific debt of $8.2 trillion. That's $28,000 for every man, woman and child in America. By itself, the debt would be a serious but not catastrophic problem for the economy. But unfortunately, it is not a stand-alone problem. It feeds other problems, including among others inflation.

Why the budget deficit is inflationary

Just how is the US government's budget deficit inflationary? The answer is partly political and partly economic.

The political part is simple. Government debt makes inflation attractive for politicians. Inflation is a slow-motion default a default on the instalment plan that reduces the real burden of servicing the debt and leaves more resources for the politicians to play with. Inflation is especially attractive for them when the debt is owed to foreigners, who don't get a vote. Politicians bemoaning inflation, those responsible at any rate, cry on the outside while laughing on the inside.

The economic part is more complex. Because the deficit handicaps all the industries that aren't being bottle-fed by government spending, much of the economy will tend to languish which is a signal for the Federal Reserve to expand the money supply. It is the increase in the money supply that directly causes inflation.

And there's a second chapter. The government finances its budget deficit by selling IOUs. In the case of the US, the IOUs are primarily short term, especially US Treasury bills. From an investor's point of view, the T-bills are an interest-earning substitute for cash. So a government deficit decreases the demand for dollars themselves and that reduction becomes a second, independent source of price inflation.

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If the US were alone in the world, that would be the end of the story. All the T-bills (and T-bonds) would be sold to people in the US, so that the government deficit would be offset by private saving. The deficit would give the economy nothing worse than a low-grade feverchronic but unspectacular inflation accompanied by a stunted growth rate.

But the US isn't alone in the world, and it isn't just another country, so there is more to the story. It is the US' singular role in the world economy that will turn US deficits into global economic disaster.

The world functions on a Dollar Standard and has done so since the end of World War II. The USD is accepted as cash in most countries. Many millions of foreigners rely on it as a second currency and use it as a store of value. And the US dollar is the world's de facto reserve currency: it is used by central banks to back their local currencies. The volume of dollars and dollar-denominated assets accumulated by foreigners during the reign of the Dollar Standard is staggering and without historical precedent. Any move away from the dollar would be...well, problematic.

US mortgage debt: how Americans racked up $8.7trn

Americans used to be savers. Not anymore. As recently as 1990, Americans, on average, saved about 7% of their income (which allowed them to buy up much of the debt the government was issuing). But the savings rate fell over the 15 years that followed, hitting zero in 2005. Unlike in China, where the average savings rate is said to be 20% (some unofficial reports have it as high as 40%), or even in some European countries where it is reported at 10%, the savings rate in America is now negative.

The debt Americans have been building up isn't just a number that sits on a balance sheet. And it isn't spread evenly through the population and through the economy. It is concentrated in one area, residential real estate. And it is concentrated in an unstable fashion, thanks to the government's efforts to stimulate the economy.

After the equities boom faltered and the US economy showed signs of weakening in 2000-2001, the Fed started cutting interest rates and worked its way almost to zero. Americans borrowed and spent as never before. Anyone who didn't own a house borrowed to buy, increasingly with no money down or with interest-only loans. Those who already owned a house borrowed against it to buy furniture, cars, boats, yard-wide televisions and trips to Hawaii. And the process didn't stop with just one round.

Empowered by ultra-low housing rates, people bid up the prices of existing houses, allowing their owners to draw even more spendable cash at the refinancing window or to use their equity to bid on an even more expensive house, or even second and third homes, in the process taking on even bigger house payment commitments and pushing home prices ever higher.

So it's not just the US government that is in debt, but also individual Americans who have racked up $8.7 trillion in home mortgages (many with adjustable rates that are now rising) and $2.2 trillion in consumer credit ($36,333 per person).

What the end of the housing bubble means for indebted Americans?

We all know there's been a housing bubble in the US. But with interest rates now rising - the Fed has hiked rates without a break in the last 16 FOMC meetings what comes next?

The US housing boom is over. Prices have softened in many areas and in others prices are beginning to decline. The reason? Interest rates have risen to a point where housing loans no longer look like free money. The refinancing market, which is a good barometer of how high or how low rates "feel" to the public, shows this in emphatic fashion. Borrowers have gone on strike, and without borrowing, the best the US real estate market can do is to tread water.

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Yes, the US housing boom is over, but the story of the housing boom isn't. The house loan is still there, saying "FEED ME" every month. If interest rates keep going up, US home buyers will cut back on what they are willing to pay, so prices will decline.

Homeowners will see their equity shrink and then disappear. Housing loan lenders will swallow huge losses as many home owners default.

Homeowners with adjustable-rate housing payments will be squeezed; and many will be forced to sell, so prices will decline. The rest will cut back on consumer spending in order to keep their houses and so will push the economy toward recession.

The Federal Reserve has been letting interest rates rise because it is concerned about the prospect of inflation. But the unravelling of the US real estate market, if interest rates keep rising from here, is so automatic, so ugly and so obvious that the Federal Reserve must know what the consequences will be if they push rates much higher. The Fed might choose to tolerate a little more inflation rather than risk a deep recession. Too bad that's not the only decision they face.

The US trade deficit: stream of foreign credit to dry up

The US government is running a chronic deficit, going deeper and deeper into debt. The US public is running a deficit, going deeper and deeper into debt. So where is the credit coming from? The short answer is that it's coming from nearly everyone who isn't an American and isn't dirt poor.

The longer answer is that the US has been able to tap into a river of foreign credit by virtue of the third deficit: the trade deficit. Foreigners, in the aggregate, sell about $2 billion per day more of goods and services to Americans than they buy from Americans. The Americans, in the aggregate, make up the difference by selling investments to foreigners, most conspicuously US Treasury bills. The traffic in this two-way street has been growing rapidly.

If you have a very good credit rating, you may be carrying credit cards with limits of $10,000, $20,000 or perhaps much more. But however good you may look to lenders, there is a limit to how much they are willing to lend. And however good the US may have looked to lenders in the past, there always were limits to what it could borrow. The difference between then and now is that today the US is straining those limits.

By Doug Casey for The Daily Reckoning. You can read more from Doug and many others at www.dailyreckoning.co.uk