The Keynesian Endpoint

On the whole, I expect the federal government to maintain deficit spending at roughly its current level, until market forces intervene and force it to make cuts in a hurried, unplanned manner.

That is the Keynesian endpoint, but it can come in different ways. One way, which I think is less likely, is through a substantial drop in the value of Treasuries, meaning a rise in their yields. ... A substantial rise in Treasury yields would force the government to cut spending, exacerbating the recession and spurring further yield rises, until the market was satisfied that public borrowing had been reduced to sustainable levels. But the government shouldn’t have to default, so I see this as the rosy scenario.

A second way to reach the Keynesian endpoint, and I think the more likely way, is through a rise in inflation. If the government continues its high deficit spending while the Fed tries to combat renewed recession with large-scale quantitative easing, the increasing volumes of dollars in the economy would eventually spur inflation, either through excess spending or through a loss of confidence in the dollar. An increase in inflation would send rates on private debt upward and bring the latent private debt burden down on the economy’s weak shoulders. Also, yields on Treasuries, suppressed by the Fed’s monetization of the deficit via QE, would turn substantially negative in real terms, prompting a sell-off by private holders. At that point, the Fed could choose to increase QE and also monetize the rolling-over of maturing federal debt, which would spur hyperinflation and fiscal collapse. Or, the Fed could call off QE, forcing the government to default and sharply cut spending.

Weighing those two options, I think a default would lead to a severe global depression, by shattering the global economy’s confidence in and dependence on the US government, US consumers and the US dollar. On the other hand, hyperinflation would grind all confidence and dependence on the US economy into dust, and lead to an even more severe global depression. When the time comes, I think it will be obvious to everybody that default is the lesser of the two evils.
--http://keynesianfailure.wordpress.com/2010/09/10/delayed-deleveraging-meets-the-keynesian-endpoint/

Comment: We have 2 options in front of us, option 1: to default on the US debt, which would lead to a severe global depression, and option 2: hyperinflation, which will destroy the value of the dollar and lead to an even more severe global depression.

With option 1, at least the dollar will still exist as a global reserve currency, and the global financial system will be intact and the depression, although severe, would be over in a few years and would be mostly limited to the US. Although the US government would lose much of its power because investors would not be willing to buy its bonds except for at a high interest rate.

Option 2 would be a disaster. The dollar would disappear, there would be a global depression from which the world might never recover, and the US would lose any influence on the world stage leaving a power vacuum to be filled by a totalitarian Chinese government and Islamic militants. It would lead to a new Dark Age.

We might be able to delay making a choice for as many as 20 years, but not forever.