Third World Debt and the Consequences of Default

A noted economic analyst explains the consequences of default if developing countries can't pay back their loans — a likely outcome given the scale of Third World debt.

third world debt consequences of default - illustration of a fat piggy bank and a starving piggy bank

Expect tight money and deflation as consequences of default if and when Third World debts aren't repaid.

Illustration by Fotolia/strels

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Probably the single biggest threat to our national economy — and to our own individual abilities to make ends meet — is the likelihood that the billions of dollars loaned by U.S. banks to various Third World countries will never be repaid. And with that likelihood inexorably moving toward certainty, we think that the following essay by Vern Myers on Third World debt can provide a worthwhile description of what the overall consequences of default might be. Now, we're not saying that Vern's predictions are 100% sure, mind you, but we are saying that he's been too danged right too many times when his wisdom has graced this column in the past, and therefore he can’t be safely ignored.

"There is no chance of any principal being repaid for a decade or more." — Henry Kissinger.

Let's you and me take it as a fair statement that the debts [of the Third World countries] are not going to be paid for at least ten years, if ever.

How is this to come about, and what is the likely effect on us? Here are the possibilities:

[1] The debtor countries will declare a default, and the banks will go broke.

[2] The banks will declare the debtor countries in default, and the banks will go broke.

[3] Neither the banks nor the debtor countries will cry default, but the debtor countries will just stop paying — a de facto moratorium.

[4] The debtor countries will pay a little bit of interest once in a while.

The scenarios in [1] and [2] above will not happen. The debtor countries would have nothing to gain and would only be cutting their throats to declare a moratorium or a default. The banks would bring the ax down on their heads right away rather than suffer gradual severance. In the process of gradual destruction, there is always a chance they might get away.

The third and fourth are the most likely probabilities, and the fourth is a little more likely than the third, because the debtor countries mostly don't have even the money to pay full interest. This will produce a gradual public deterioration of bank credibility, and in confidence that banks can survive. What we are looking at, then, is the total demobilization of $300 billion or $400 billion that, up to now, we included in the liquidity of our Western monetary system.

Let's face it, as long as the situation can go on this way, the U.S. government is not going to pay the banks, and it is not going to pay the debtor countries. So there will be no extra dollars floating around on that account. Indeed, the net result of this will be a great tightening of the existing liquidity. Banks will become very tightfisted, will take few chances. It's a period of contraction in lending.

If any banks should go broke in the process, this will bring on a further tightening of credit and a further reduction of liquidity. In this kind of an atmosphere, business will not expand. Everything will be pointing to a contraction. This knowledge is widespread enough now to bring on an inevitable contraction in the marketplace and through the general public. People facing this will buy less. Unemployment will increase.

It's a mystery to me how so many of these writers can holler, "More inflation." Where does the inflation come from? Where is there a plentiful money supply? We have just said that over $300 billion in the liquidity barrel is leaking out and will eventually come right out of the barrel. Let the Fed try to put in funds at the rate they are disappearing or being destroyed. And we have only started so far. No way in God's world can the Federal Reserve of the United States handle this global problem. Even if some extra money is created by the Fed, it will be as a drop in the bucket compared with the general climate of contraction and the huge loan losses suffered and finally admitted.

We may not have dramatic bank failures — only a chorus of gaspings as some of them go under almost unnoticed.

The interest payments which the banks have counted on must be stricken from the books. The earnings statements that accountants look at when they advise on the reasonable price of a stock will be drastically knocked back because of the loss of this interest. Also, loans will necessarily have to be written down by degrees. We are not going to bury this corpse in one piece. We'll hack him up and do it gradually. But the smell will be around, and the days of plentiful money — the era of inflation — will have been banished for a long, long time to come. What we are facing, therefore, is a deflation starting out mildly at first and growing more severe as time passes. And the results of that will be classic.

[1] Cash will be king, and the same amount of dollars in cash will buy more next year than this year, and still more the following year. This will be a reversal of a 30- or 40-year trend, when the idea was always to owe a lot of money so you could pay it back with cheap dollars. Now if you owe a lot of money, you'll pay it back with more expensive dollars, or it will be foreclosed, and you will lose the article you have bought.

The population is not ready for this.

Deflation cannot be stopped by a simple move of printing more money by the Fed. Creating more figures in books does not stop a shrinking economy. The idea that printing mountains of money results in an inflationary depression is baloney. There is no such thing as an inflationary depression. A depression means that there is very little money around. So how can you possibly and ridiculously have an inflationary depression, which some newsletter writers mouth around as if it were a real and honest-to-goodness term? They read it somewhere, and they think it sounds good. Plentiful money and tight credit do not coexist.

[2] In the second place, there is absolutely nothing in the wings now to indicate any grounds for a gold standard in the world.

The United States is way too short of gold to impose a gold standard on the world. And the only way a gold standard will be imposed on the world is through a mighty economic power making absolute declarations of what will be money and what money will be worth. The U.S. long ago slipped from that position of power. No other country is in any position to even think of introducing such kind of money either by itself or in conjunction with others.

The result will be that the price of gold will have no justification for going up or even staying where it is while other prices are going down.

Gold is about 11 times its 1967 price, while other commodities are about three times. There is only one set of circumstances under which gold could make a significant rise. That is wild inflation—which, we have just seen, is not about to happen. As an alternative then, gold ought to be priced near where the average commodity is. That would be between three and four times its official price and certainly no more than five or six times. It would look to me as though $250 would be a maximum ceiling on gold. Either gold will be down around that figure, or it will be up well over the $1,000 mark.

People will not be buying gold when they need bread.

Countries will not be buying gold until it is part of the world monetary standard.

Commodities like silver and platinum will go down along with other commodities, but they will not fall proportionately with gold. Later on, because of their worldwide scarcity and their worldwide strategic necessity, they will recover in price before other commodities.

The stock market cannot possibly survive in such a climate, any more than a tomato can grow in Alaska in the winter. The stock market is due for a fall of several hundred points — not an adjustment, a smash.

Excerpted courtesy of Myers Finance & Energy